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Economics 101

Economics 101 Economics 101
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An economy is simply the sum of the transactions that make it up and a transaction is a very simple thing. You make transactions all the time. Every time you buy something, you create a transaction. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. Credit spends just like money, so adding together the money spent and the amount of credit spent, you could know the total spending. The total amount of spending drives the economy. If you divide the amounts spent by the quantity sold, you get the price and that’s it, that’s a transaction. It’s the building block of the economic machine. All cycles and all forces in an economy are driven by transactions. So, if we can understand transactions, we can understand the whole economy. A market consists of all the buyers and all the sellers making all transactions for the same thing. For example, there is a (wheat) market, a farm market, a stock market and markets from millions of things. An economy consists of all of the transactions and all of its markets. If you add up the total spending and the total quantity sold in all of the markets, you have everything you need to know to understand the economy, it’s just that simple.

People, businesses, banks and governments all engage in transactions the way I just described. Exchanging money and credit for goods, services and financial assets. The biggest buyer and seller is the government which consists of two important parts. A central government that collects taxes and spends money and a central bank, which is different from other buyers and sellers because it controls the amount of money and credit in the economy, it does this by influencing interest rates and printing new money. For these reasons as we’ll see, the central bank is an important player in the flow of credit. I want you to pay attention to credit. Credit is the most important part of the economy and probably the least understood. It’s the most important part because it’s the biggest and most volatile part. Just like buyers and sellers go to the market to make transactions, so the lenders and borrowers. Lenders usually want to make their money into more money and borrowers usually want to buy something they can afford, like a house or a car, or they want to invest in something like starting a business.Credit can help both lenders and borrowers get what they want. Borrowers promise to pay the amount they borrow called principal, plus an additional amount called interest. When interest rates are high, there is less borrowing because it’s expensive. When interest rates are low, borrowing increases because it’s cheaper. When borrowers promise to repay and lenders believe them, credit is created. Any two people can agree to create credit out of thin air, that seems simple enough but credit is tricky because it has different names, as soon as credit is created, it immediately turns into debt. Debt is both an asset to the lender and a liability to the borrower. In the future, when the borrower repays the loan plus interest, the asset and the liability disappear and the transaction is settled. So why is credit so important? Because when a borrower receives credit, he is able to increase his spending, and remember, spending drives the economy. This is because one persons spending is another person’s income. Think about it, every dollar you spend, someone else earns and every dollar you earn, someone else’s spend. So when you spend more, someone else earns more. When someone’s income rises, it makes lenders more willing to lend them more money because now he’s more worthy of credit. A credit worthy borrower has two things, the ability to repay and collateral.

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Source : 

Transcript from How The Economic Machine Works by Ray Dalio, September 22, 2013, Youtube

 

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