The economy of a country is a network of producers and consumers of goods and services in that country. And all these producers and consumers participate in exchange of goods and services for money or credit. This exchange constitutes a transaction, the building block of the economy. So we can say that summation of all transactions is ECONOMY.
An important thing to remember is that all transactions are being made by human beings and thus, are affected by human nature. Every exchange of money or credit in return of goods or services is a transaction.
While zillions of transactions take place within an economy, not everyone has enough money at all times. That’s where credit comes in.
Let’s take an example.
A person who provides IT services realizes that a laptop can be a great asset to his business, helping him improve the services he’s selling to buyers and earn more money.
So he visits the market and buys a Laptop by paying in cash. But what if he doesn’t have the money? Then he can’t buy the laptop, can’t increase the productivity of his business and can’t earn more money. Thus, instead of money, he buys the laptop on credit with the hope that when his income increases, he’ll pay it back.
Transaction With Credit
A transaction with credit is when the person purchases the laptop with a promise to pay the sum he’s borrowed with interest at a later date. If the lender believes that he can pay back the principal and interest, he agrees to the transaction, generating debt. While the debt is an asset to the lender, at the same time, it’s a liability for the borrower. When the borrower repays the amount with interest, the transaction gets settled waving off the Asset and liability with the settled transaction.
Now, what if the borrower fails to pay off the debt?
Role of Debt
Debt plays a crucial role in the economy. Let us see how it shakes the economy.
The purpose of the credit is to drive the economy, thus encouraging people to indulge in transactions. When one opts for credit, it could be to increase productivity which creates more money or to enjoy a luxurious asset which doesn’t. If the borrower is able to create more value with the asset he purchased, he’ll be able to repay his debt within the promised timeline to the lender. But, if it’s spent for luxury then the payment becomes dependent on the remaining assets he carries to settle the transaction.
Over the long term and extrapolating this situation to the economy at large, a growing debt is like driving with the emergency brake on. This creates a financial bubble, where the economy is running on assets that don’t exist or aren’t as valuable or productive as they look on paper. As the debts rise, the borrowers realise that they can’t payback the debt and the lenders face an increasing risk that they won’t be repaid. This realization results in the bursting of the bubble and depression sets in. Let’s see how.
Government, Transactions & Economy
Two biggest buyers and sellers making continuous transactions are the Central Government and the Central Bank. Transactions are carried out by both but in a different manner.
The central government is meant to make a transaction by collecting taxes from the public and spending it for the public. Whereas, the Central Bank responsibly collects the credits, aims for proper adjustment between Demand and Supply of Money, Suitable Interest Rates, and Debt Management.
An economy with credit helps the public to boost their spending capacity. But an increase in overspending (which is spending beyond the means to repay the debt) boosts the price rise and causes INFLATION.
To control inflation, the Central Bank increases the interest rates on lending which in turn curtails the borrowing and results in a decrease in spending capacity. Spending less leads to less earning and pulls the price down.
It’s cycle. If it goes up it comes down as well.
As the spending decreases, prices fall and create DEFLATION. Deflation slows down the economic activities and gives rise to RECESSION. A severe recession is then settled by the Central Bank by lowering the interest rates to encourage borrowing, thus boosting the economy with increase in transactions and productivity.
The economy works as a cycle. Credit decides the trail of events for the future. Studying the economy allows us to understand what is going on today, what is likely to happen tomorrow, and most importantly how we should act now.
We need to understand, that if credit is easily available, it leads to expansion and if it’s not available it causes a recession. But most importantly, it’s critical to keep increasing the productivity and that’s the key to a thriving economy.
This is how it works and keeps rolling.