1. The economy has two main components which are microeconomics and macroeconomics
While Microeconomics studies the behavior and motivations of consumers, prices, profits…, Macroeconomics examines the economy on a broader scale, including larger values like interest rates, GDP, and other tools often seen in the economic section of newspapers. In general Microeconomics is more useful for managers, while macroeconomics is more beneficial for investors.
2. The law of supply and demand: The foundation of economics
Whenever supply increases, prices will decrease; and when demand increases, prices will rise. For example, if you overproduce grain, food prices will fall, and vice versa. This law holds true universally, and you can clearly observe that stock price fluctuations are closely tied to supply and demand.
3. Marginal utility
Each time you gain one more unit of something to use, its value to you decreases. For example, $100 will be more valuable when you earn $1,000 per month than when you earn $1 million per month. This concept is widely applied in pricing strategies.
4. Gross domestic product (GDP)
This is the most basic tool for measuring the size of an economy. By definition, GDP equals the total income of all citizens in a country or the total market value of all products and services produced within that country. For example, the United States is the world’s largest economy by GDP (approximately $14 trillion). This means that $14 trillion worth of goods and services are produced in the U.S. annually.
5. Growth rate
The development of an economy is measured by GDP growth rate. Since GDP measures a nation’s income, the GDP growth rate indicates how much the average citizen’s income increases each year.
6. Inflation
You may already know that the prices of most products today are higher than in our ancestors’ time. Inflation (measured as a percentage) shows how much the price of goods has increased compared to the previous year. In a developed economy, annual inflation is about 2%, meaning that prices of goods increase on average by 2% each year. The central bank’s fundamental role is to manage this rate and keep it at a low positive number. Below is a chart showing the inflation rate in the U.S. over the past 100 years.
7. Interest rates
When you lend someone money, you expect to receive compensation. This compensation is called interest. The interest rate is a positive number that reflects the additional amount you will receive compared to the original amount you lent.
As shown in the interest rate chart above, in the short term, interest rates are often set by central banks, or in the U.S., the Fed. Currently, the interest rate in the U.S. is approaching zero. In the long term, interest rates are determined by the market and depend on inflation rates and the economic outlook. The mechanisms used by central banks to control short-term interest rates are called monetary policy.
8. Interest rates – inflation – growth
There is almost an inverse relationship between interest rates and GDP growth rate. Additionally, interest rates can directly affect the inflation rate. Therefore, when you increase interest rates, inflation tends to decrease, but economic growth also slows down.
This explains why setting interest rates is always a challenge for policymakers. In the U.S., the Federal Reserve is responsible for setting short-term interest rates, and this remains one of the most closely watched economic indicators.
9. Fiscal policy
Governments can control the economy by adjusting spending. The set of mechanisms that utilize the national budget forms fiscal policy. When the government spends more, demand rises, causing prices to increase.
This means that the economy grows well but also brings higher inflation, and vice versa. As a result, governments tend to spend more during periods of low growth and low inflation, and tighten spending during times of high growth and high inflation.
10. Economic cycles
The economy goes through periods of boom and bust in cycles of approximately 7 years. A cycle begins with an economic boom, followed by a peak of prosperity, then moves into a recession (a period of negative growth or rising unemployment), and finally transitions into the next cycle.
11. Opportunity cost
When performing an action, you often compare the benefits of that action with other possible actions. For example, on a Friday night when you’re working hard on a project, you might think, “I should be doing something else.”
That “something else” (in this case, partying with friends) has a high value, proving that the current project must be better or more appealing. The value of the action you gave up is called “opportunity cost.”
Therefore, if you quit a job that pays $120,000 a year to start something new, the opportunity cost of starting over is $120,000 per year. You should choose work that generates more revenue than the alternatives you’ve given up.
12. Comparative advantage
You are developing a technology project, and one day, a client asks if you can build a website for them. Would you agree to take on the task or pass the opportunity to a friend? How do you decide?
Typically, a person calculates how much time it would take them to build the website and whether that time could be used more profitably on their current project. Then they assess whether their friend could complete the website more efficiently.
If your friend can produce better results and you have plenty to do with your current project, you will pass on the opportunity. This is known as the theory of comparative advantage. Your friend has an advantage, and you have no reason to take on that job. Countries, businesses, and individuals should focus on tasks where they have strengths and leave the rest to others.