How the Economy as a whole works?

Decisions and interactions of people with regards to finances and goods together make up “the economy.” The principles concern the workings of the economy as a whole.

A country’s standard of living depends on its ability to produce goods and services.

The differences in living standards around the world are staggering. In 2003, the average American had an income of about $37,500. In the same year the average Mexican earned $8,950 and the average Nigerian earned $900. Not surprisingly this variation in average income is reflected in various measures of the quality of life. Citizens of high income countries have TV sets, more cars, better nutrition, better healthcare, and a longer life expectancy than citizens of low-income countries.

Changes in living standards overtime are also large. In the United States, incomes have historically grown about 2% per year after adjusting for changes in the cost of living. At this rate, average income doubles every 35 years. Over the past century, average income has risen about eightfold.

What explains these large differences in living standards countries and overtime? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countries’ productivity that is the amount of goods and services produced from each hour of a worker’s time. In nations where workers can produce a large quantity of goods and services per unit of time, most people enjoy a high standard of living; in nations where workers are less productive, most people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income.

The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance. For example it might be tempting to credit labor unions or minimum wage laws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another example, some commentators have claimed that increased competition from Japan and other countries explained the slow growth in US incomes during the 1970s and 1980s. Yet the real villain was not competition from abroad but flagging productivity growth in the United States.

The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect our ability to produce goods and services. To boost living standards, policy makers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods and service, and have access to the best available technology.

Prices Rise When the Government prints too much Money:

In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than 2 years later in November 1922, the same newspaper cost a few hundred times. All other process in the economy rose by similar amounts. This episode is one of history’s most spectacular examples of inflation, an increase in the overall level of prices in the economy.

Although the United States has never experienced inflation even close to that in Germany in the 1920s, inflation has at times been an economic problem. During the 1970s for instance the overall level of prices more than doubled and President Gerald Ford called inflation public enemy number one. By contrast inflation in the 1990s was about 3% per year; at this rate, it would take more than 20 years for prices to double because high inflation imposes various costs on society keeping inflation at a low level is a goal of economic policymakers around the world.

What causes inflation? In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money. When a government creates large quantities of the nation’s money, the value of the money falls. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of money was also tripling every month. Although less dramatic, the economic history of the United States points to a similar conclusions: The high inflation of the 1970s was associated with rapid growth in the quantity of money and the low inflation of the 1990s was associated with slow growth in the quantity of money.