For most of us, an economy is the system of interaction between economic concepts associated with financial management. With respect to economics, an economy is a set of human activity that influences the allocation of scarce resources. An economy is a closed system that encompasses all aspects of economic life; however, there is a crucial aspect of the economy that remains largely unexplored by most people, and that is finance. Finance is the science of understanding, predicting, and managing financial resources.
The modern economy operates on the basis of three core principles: liberty, regulated competition, and free markets. A classical liberal economic system is based on individual freedom, a minimal state, open economy, and freedom of speech and association. Capitalism, by contrast, is a strict competitive economy where the powerful protect and serve the weak through extensive regulation of markets and prices. A socialist economic system is designed around heavy government intervention to ensure that the interests of the masses are protected. Individual freedom, a minimal state, open economy, and protection of the rights of minorities are also important concepts of socialism.
The concept of capitalism is often confused with classical liberal economies such as continental European and Japanase economics. The distinguishing feature of capitalism is its unrestricted pursuit of private investment. Unlike socialism, which restricts access to capital, capitalism encourages entrepreneurial activity and free markets. A classical liberal economy is based on laissez-faire capitalism; free markets, entrepreneurial activity, and laissez faire are essential characteristics of the modern state.
A key feature of a genuine capitalist economy is sound money and credit. In Europe, after the global depression, many countries found themselves in a severe crisis because of the failure of their currency, the Eurozone. In the United States, the gold standard, an alternative to the printing of paper currency during the colonial period, was used to maintain financial liquidity. In both cases, sound money and credit play crucial roles in promoting economic growth.
The limited number of factors determining economic growth are determined by the nature of the economy – capital accumulation, technological development, international trade, government support, and entrepreneurial activity. The role of the state in an economy determines the level of freedom and prosperity of citizens – high taxation and state regulation limit options and reduce opportunities for entrepreneurial risk. Capital, technology, international trade, and government support all have a direct impact on economic growth. The level of government intervention and level of freedom to determine the sustainability of the system – runaway inflation or deflation can destroy the system and make recovery slow and painful.
Economic theories suggest that a market economy relies on the invisible hand of the marketplace for its stabilization. The invisible hand refers to the interaction of forces beyond governmental control. For example, increased demand from buyers raises the cost of goods and discourages sellers who have surplus production; increased demand reduces the rate of interest that sellers pay to consumers and drives up prices; a sudden rise in the price of something causes producers to raise prices until they absorb all of the new demand, resulting in shortages; and a decline in the rate of exchange reduces the rate of interest.
A market economy avoids aspects of this model such as self-interest, because the actions of producers beyond governmental control affect their ability to make profits. However, changes in the structure of the economy may alter self-interest. The existence of monopoly and large companies in some societies limits entrepreneurial risks, which inhibit the rate of economic growth. Entrepreneurs may have greater opportunities to accumulate wealth and spread profits through mergers and acquisitions.
Critics argue that true capitalism is impossible to realize since it is based on an ideology that has no place in modern societies. The left argues that all economies are self-interest driven and thus all must be changed to maximize productivity. There is no place for a central planning authority in today’s world and the left proposes instead a social safety net that would allow people to get assistance when they need it without worrying about being able to repay it. The Soviet Union’s centrally planned economy was notorious for its high level of unemployment and mass starvation. No matter what type of system a society builds, everyone has a stake in the success of the economy, and they will act to increase their profits or reduce their losses to protect the economy.