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Economics and the financial system

How households, businesses, institutions, and policy interact.

← All knowledge areas · Glossary

No prior finance knowledge is needed, though this lesson builds on the terms introduced in Money and financial fundamentals, especially interest and inflation. Each new finance term is bold, explained on first use, and linked to its glossary definition. The glossary links back to the section where you can see it in context.

The prices, rates, and figures below are invented teaching examples chosen to make the ideas concrete, not forecasts or current data. Where real institutions and events are mentioned by name, that is noted in the text.

In this lesson

  1. Supply, demand, and incentives
  2. The business cycle
  3. Central banks and monetary policy
  4. Money creation
  5. Growth, employment, and economic indicators
  6. Financial institutions and systemic risk
  7. Check your understanding

Supply, demand, and incentives

A market is any arrangement, physical or online, where buyers and sellers exchange goods, services, or assets. Prices in a market are generally shaped by two forces.

Demand is the quantity of something buyers are willing to purchase at a given price. Supply is the quantity sellers are willing to offer at a given price. As a general pattern, buyers want to purchase more of something at a lower price, and sellers are willing to offer more of it at a higher price.

Suppose a farmers’ market has 100 baskets of strawberries for sale on a Saturday. At $6 a basket, shoppers want to buy only 80 baskets, and 20 go unsold. The seller lowers the price to $4, and shoppers want all 100. This simplified example shows a price doing two jobs at once: rationing a limited supply among interested buyers, and signaling to sellers how much people value what they are offering.

An incentive is something, such as a price, cost, reward, or penalty, that encourages a particular choice. A higher strawberry price is an incentive for farmers to grow more strawberries next season and for shoppers to buy blueberries instead. Incentives operate throughout the financial system: a higher interest rate is an incentive to save rather than spend; a tax deduction is an incentive to contribute to a retirement account.

Real markets are more complicated than one farmers’ stand. Prices can be affected by rules, market power, information gaps, and factors outside a single buyer’s or seller’s control. The Federal Reserve Bank of St. Louis explains supply and demand in more depth.

The business cycle

Economies do not grow at a constant, steady pace. The business cycle describes the recurring, irregular pattern of expansion and contraction in overall economic activity.

During an economic expansion, production, employment, and spending are generally increasing. Businesses often hire more workers and invest in new equipment. During a recession, overall economic activity is generally declining: businesses may sell less, cut costs, and lay off workers. Exact definitions and the official dating of recessions vary by country; in the United States, a nonprofit research organization called the National Bureau of Economic Research determines recession dates after reviewing several measures together, not from a single rule.

Business cycles are irregular in both length and severity. An expansion that lasts several years can be followed by a recession lasting only months, or one that lasts much longer. No two cycles are identical, which is one reason economic forecasting is difficult even for professional economists. The Federal Reserve Bank of St. Louis’s business cycle overview discusses how these turning points are identified.

Central banks and monetary policy

A central bank is a public institution responsible for a country or region’s currency and monetary policy, and often for bank supervision and financial stability. Examples include the Federal Reserve in the United States, the European Central Bank, and the Bank of England.

Monetary policy refers to the actions a central bank takes to influence the availability and cost of money and credit. Its main tool is usually a policy rate: a short-term interest rate the central bank sets or targets, which influences the rates banks charge on loans and pay on deposits throughout the economy.

Suppose inflation is running above a central bank’s target. Raising the policy rate tends to make borrowing more expensive and saving more attractive, which can cool spending and, over time, ease upward pressure on prices. Lowering the policy rate has the opposite intent: cheaper borrowing to encourage spending and investment during a slowdown. These effects work with a lag, often many months, and are not precise or guaranteed; a central bank is balancing multiple goals, commonly including stable prices and full employment, using incomplete and constantly updated information.

Fiscal policy is a separate lever: government decisions about spending and taxation. A government might increase spending or cut taxes to support economic activity during a downturn, independent of what a central bank is doing with interest rates. Monetary and fiscal policy can reinforce or offset each other, and coordinating them is a recurring subject of economic debate. The Federal Reserve’s explainer on monetary policy and the International Monetary Fund’s introduction to fiscal policy cover each in more detail.

Money creation

The money supply is the total amount of money circulating in an economy at a given time. It is larger than just the physical cash in circulation, because most money exists as balances in bank accounts, and measuring it requires choosing which types of accounts to include.

Money is not fixed in the way that, say, the number of collectible coins ever produced is fixed. When a bank makes a loan, it typically credits the borrower’s account with new deposit money, rather than physically handing over money that was sitting idle. That new deposit can then be spent, deposited elsewhere, and lent out again. Banks are required to hold a portion of deposits as reserves and to meet other regulatory requirements, which limits how much lending, and therefore how much new deposit money, the banking system as a whole can create.

This means the amount of money in an economy expands and contracts with lending activity, not only with central bank decisions to print currency. A central bank influences this process indirectly, largely through its policy rate and other tools, rather than by directly deciding the total money supply figure. The Bank of England’s explainer on how money is created walks through this process in a UK context, and the concept applies with local variations in most modern banking systems.

Growth, employment, and economic indicators

Economists and policymakers track a set of economic indicators, which are statistics used to assess the condition or direction of an economy, to make sense of where the business cycle stands.

Gross domestic product (GDP) is the total monetary value of goods and services produced within a country over a stated period, commonly a quarter or a year. Rising GDP generally reflects an expanding economy; falling GDP generally reflects a contracting one. GDP is a broad summary measure: it does not, by itself, describe how growth is distributed across a population, or account for costs like environmental damage.

The unemployment rate is the share of people in the labor force without a job who are available for and actively seeking work. Suppose a labor force of 1,000 people includes 40 people who are actively looking for work but do not currently have a job. The unemployment rate is 40 ÷ 1,000 = 4%. People who are not looking for work at all, such as full-time students or retirees, are generally not counted as part of the labor force, which is one reason the unemployment rate does not capture every form of joblessness.

Inflation, introduced in Money and financial fundamentals as an increase in the general level of prices over time, is itself a key economic indicator, typically tracked using a price index built from a broad basket of goods and services.

These three indicators, along with others such as wage growth and consumer spending, do not always move together or send a consistent signal. GDP can grow while unemployment stays elevated in some sectors; inflation can rise even as growth slows, a combination sometimes called stagflation. Reading indicators well means looking at several together over time rather than reacting to any single report. The US Bureau of Labor Statistics and a country’s national statistics agency are typically the primary sources for indicators like these.

Financial institutions and systemic risk

A financial institution is an organization, such as a bank, credit union, insurer, or investment firm, that provides services like accepting deposits, lending, or managing investments. Banking, credit, and lending covers how individual banks and credit unions serve customers; this section looks at how these institutions connect to one another.

Financial institutions are linked through lending, borrowing, and contracts with each other, not just with individual customers. A bank might borrow from another bank overnight, hold bonds issued by other institutions, or provide insurance-like protection against another firm’s default. Systemic risk is the possibility that the failure or distress of one financial institution or market spreads to others through these connections, threatening the stability of the wider financial system, rather than remaining contained to the institution that first ran into trouble.

A financial crisis is a period of severe disruption to financial institutions or markets, often involving sharp asset price declines, credit shortages, or institution failures. The 2007–2008 global financial crisis is a widely studied example: losses tied to mortgage-related investments spread through interconnected banks and other institutions worldwide, credit became difficult to obtain even for creditworthy borrowers, and the resulting slowdown affected employment and economic activity broadly, not only within the financial sector.

Regulators respond to systemic risk with tools such as capital requirements, which require institutions to fund themselves with a buffer of their own resources rather than only borrowed money, and deposit insurance, introduced in Banking, credit, and lending, which protects depositors if an insured institution fails. No set of safeguards eliminates the possibility of future financial crises; they aim to reduce the likelihood and contain the effects. The Federal Reserve’s explainer on financial stability and the International Monetary Fund’s history of the 2008 financial crisis provide more detail.

Check your understanding

Try these before reading the answers.

  1. A concert venue has 500 seats. At $80 a ticket, 700 people want to attend. What would you expect a promoter to do to the price, and why?
  2. What is the difference between monetary policy and fiscal policy?
  3. A labor force of 2,000 people includes 90 people actively looking for work who do not currently have a job. What is the unemployment rate?
  4. Why can a recession be associated with both falling GDP and a rising unemployment rate at the same time?
  5. Explain, in one or two sentences, why the failure of one financial institution can affect others that had no direct dealings with it.

Answers

  1. Raise the price. At $80, demand (700) exceeds supply (500), so the promoter can likely raise the price and still sell out, rationing the limited seats among the buyers most willing to pay.
  2. Monetary policy is set by a central bank, mainly through interest rates, to influence borrowing, saving, and prices. Fiscal policy is set by a government through spending and taxation decisions. They are controlled by different institutions and can move independently of each other.
  3. 4.5%. 90 ÷ 2,000 = 0.045, or 4.5%.
  4. Because they often result from the same underlying slowdown: businesses producing and selling less (falling GDP) commonly respond by reducing staff or hiring more slowly, which raises the unemployment rate.
  5. Financial institutions are financially connected through lending, investments, and contracts with each other; losses or a failure at one institution can reduce what it can pay or lend to others, spreading stress through those connections even to firms with no direct relationship to the original problem.

Terms introduced in this lesson

Use these links to revisit definitions. Each glossary entry has a link back to its explanation above.

Keep learning

Continue with Banking, credit, and lending to see how individual banks operate and how deposit insurance protects customers. Continue with Investing and portfolio management to see how economic indicators and interest rates connect to investment decisions.