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A Simple Description of the U.S. Economy (Version 2)

February 11, 2013

The economy is all about people and what they consume. People consume in order to satisfy their needs and desires. A higher level of consumption corresponds to a higher standard of living as well as a higher level of satisfaction by the consumers. Except for the air we breath, everything we consume must be produced by someone who usually requires compensation.

Consumption can be classified as either private or public. Consumption of goods and services provided by private businesses which is paid for by the consumers and is mainly voluntary. This is in contrast to consumption of public goods and services provided by federal, state and local governments which is mostly paid for by taxpayers and taxes are mandatory.

The U.S. economy is built on the legal foundation provided by the Laws and Constitution of the United States. It can be conceptually divided into two distinct parts: the physical part (the real world) and the financial part (the world of pure numbers) as presented in the following diagram along with a simple description of the whole thing.



The physical part of the economy consists of three main physical components: people, the production system and nature.

  • People are the centerpiece of the economy. Everything is done by the people for the people. Every activity in the production system is aimed toward a final product or service to be consumed. At the present time approximately, give or take a few percentage points, one half of the population are engaged in production and the total output of these workers is consumed by all people. This is based on the fact that typically, a person spends roughly half of his/her lifetime working.
  • The production system contains all the physical infrastructures needed to support all production activities, including activities related to the financial part as well as federal, state or local government. Governments at all levels are part of the production system.

The end purpose of the production system is to output goods and services for the people to consume. It also exports/imports anything from raw materials to finished products to/from the global market (other economies from around the world). Trading with foreign economies results in a larger market for U.S. products and a wider range of products for U.S. consumers.

Obviously, one can not consume what is not produced, and the producers will stop producing what cannot be sold. New products are constantly being invented and produced, some are welcomed by consumers and become profitable for the producers, others are rejected. In the absence of government interference, the consumers are the final referee in deciding winners and losers in the marketplace. Free and fair competition has been highly beneficial to the consumers.

  • Nature is where raw materials needed by the production system are extracted and waste from production processes and from consumption is dumped. At the present time nature means part of the earth that could be exploited in accordance with U.S. laws and international agreements. At some future time, it could be extended to the solar system and beyond.


The financial part of the economy contains four elements: accounts, money, financial products and the Federal Reserve System (commonly referred to as the Fed).

  • Accounts are where all the money is kept (recorded). They are owned by individuals, governments, private businesses or organizations. They are maintained by banks and similar financial institutions. The containers of paper money and coins such as pockets, wallets, safes… can be regarded as a kind of self-recording accounts.
  • Money is just numbers recorded in accounts, printed on dollar bills (paper money) or stamped on coins.  Money can be moved from one account to another for any reason such as purchasing, borrowing, tax-paying, gift-giving etc… When money is moved, the amount to be moved is subtracted from the source account and the exact same amount is added to the destination account. You cannot move an amount greater than what’s left in the source account. When a new account is created, it must be empty until it receives money from existing accounts (there is one exception involving bank loans to be described later). The total amount of money that exists in the economy (the money supply) is the sum total of money in all accounts.

One more time, and in italics, because it needs to be perfectly clear: money is just numbers, it can sit still in an account or it can be moved to another account, requiring only simple addition and subtraction. Very few things in life are simpler than that.

The flow of money between all accounts is shown in the diagram as red, blue and green streams (lines with arrows). The red streams represent taxing and spending by governments at all levels. The blue streams represent money flowing among private accounts. The green streams show the flow of money to and from the Federal Reserve System to be described later.

Since consumption is the end purpose of production, the most relevant flow of money is from the personal accounts of the people to various accounts of businesses and governments to pay for all consumption. Obviously, people have to receive income equal to or greater than what they spend. The sources of income are businesses, governments and other individuals in the form of wages/salaries, interest/investment income, borrowing, government benefits, prior savings, pension plans etc… Excess income usually is saved or invested for future consumption.

The value of money is determined by what it can buy which varies with time, location as well as personal needs and desires of the buyer and seller. When I buy a gadget for $5.00 for example, I value the gadget more than $5.00 while the seller values $5.00 more than the gadget.

  • Financial products mostly exist in the form of contracts. They are created for the purpose of channeling money to where it’s needed in anticipation of future profit. Shares in a publicly owned corporation can also be regarded as a type of financial product.

Some financial products cannot be bought or sold. Those that can are usually traded in various financial markets. These trades could result in either profits or losses which may or may not have a direct impact on the physical part of the economy.

  • The Federal Reserve System was created by Congress in 1913 and tasked with the dual mission of controlling inflation and encouraging economic growth. It is both a source and a drain of the total amount of money that exists in all accounts.

We can imagine the Fed as a huge (perhaps infinite) reservoir of money. When the Fed thinks that the economy needs more money to encourage growth, it pumps money from its reservoir into the economy. This is done by the Fed lending money to banks or buying financial products from various sellers. Money flows from the Fed’s reservoir into accounts of the borrowers or of the sellers of those financial products. The total amount of money in the economy increases accordingly. When the Fed thinks that there is too much money in circulation that could cause (or already caused) inflation, it drains money from the economy back into its reservoir. This is done by the Fed selling its loans and financial products to banks and various buyers. Money flows back into the Fed reservoir. The total amount of money in the economy decreases accordingly.

The observation that the Fed’s account appears to be infinite is based on the fact that the Fed has never run out of money even though the total amount of money in circulation has been increasing continuously since the establishment of the Fed. According to data provided by the Ludwig von Mises Institute, the True Money Supply (TMS), which is very close to how money is described here, the total amount of money in circulation was approximately $282 billion in 1959. It is more than $7,500 billion on April 1, 2011.

Banks also have limited ability to generate new money (money that does not come from any existing accounts, which means it comes from nowhere) in the form of loans. The fancy term for this creation of additional money is called fractional banking. The total money in circulation is increased by the amount of the loans. However these loans have to be paid back at which time the principal amount of the loans is removed from circulations. If a bank cannot make up for the loss from bad loans, it may be forced into bankruptcy, and the total amount of unpaid loans remains in the economy indefinitely. Unpaid loans could be one of the reasons why the total money supply keeps increasing over time.

In general, the more outstanding loans there are, the higher the total money supply and vice versa. By setting certain interest rates that it charges banks, the Fed can encourage or discourage borrowing as a means of influencing the money supply of the economy.

Although the financial and the physical parts of the economy are separate and fundamentally different in their nature – one occupies the realm of pure numbers, the other is the world of real stuff – they are intimately connected. With few exceptions, each action in the physical part is accompanied by a transaction in the financial part. The flow of materials and products in the physical part is mirrored with a flow of money in the financial part. Any disruption of flow in one part would cause a disruption of flow in the other. It is this connection that makes numerical wealth in the financial part as real as the physical wealth. If for whatever reason the connection is broken, then the wealth contained in the financial part would simply evaporate and become nothing more than pure, useless numbers. In the United States, the connection between the financial part and the physical part is maintained and protected by U.S. laws and Constitution.


The U.S. Constitution and laws together provide the legal framework and the foundation on which the economy is built. At the most fundamental level, the U.S. Constitution guarantees individual freedom and private property rights which naturally lead to our being a free market economy. In other words, we are not so much followers of Adam Smith or any other economist or economic theory as we are of the U.S. Constitution. It is the Constitution which compels us to adopt a free market economy, one which is also constrained by existing laws and regulations.

In a free market economy, things and money tend to go to where they are needed because there is profit to be made. The stronger the need, the higher the profit potential. And the highest profit goes to the most creative and the most efficient, most of the time. The free market is not perfect, it has its own problems. Attempts to fix problems with new rules, regulations, or policies are not perfect either. They may solve certain problems but more often than not, they also lead to new problems. In short, there are no magic formulas, no guarantees. Sometimes, we just make things up as we go along.

Nevertheless, it is undeniable that the size of the U.S. economy in terms of total consumption – the only relevant measurement – has grown tremendously since the nation was founded until the present time. This can be traced to the fact that throughout history, we keep inventing and reinventing things – physical things, intellectual things, financial things, all kinds of things – for all kinds of different reasons, not just to make money. As a result, new products and services are constantly being created which are not only better but also more abundant and affordable leading to vastly increased consumption and continuous expansion of the economy. Any disruption of growth so far has been only temporary. It is doubtful that any one person can make the whole economy grow, but there seems to be a lot of people who are very good at inventing and making things up.

Last update: July 18, 2013


From → Economics

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