How does our economic system work

Complex markets, sensitive reactions - how does our economic system work?

What exactly does market economy mean?

The term market economy describes an economic system in which supply and demand meet in the market and regulation is normally based on the price. A product is normally sold at the price at which the highest market turnover is possible.

A small example to clarify:

With the current capacities, the producers of a commodity are able to produce 500,000 units per year. They sell these for 120 euros each and can sell 400,000 of them. Since they have an overproduction of 100,000 units, the first thing they will try is to attract customers with lower prices. At a sale for 110 euros each, sales can suddenly increase to 450,000 units. The higher demand results from the fact that more consumers are willing to buy the product at this price. A further price reduction of 10 euros to 100 euros means that the producers can then sell their full capacity. The market has found a balance.

How do the markets coordinate?

The pricing takes place through the free decisions of the individual market participants. This includes companies on the one hand and households (consumers) on the other. The following decisions are available to market participants:

  1. Households: Consume and Save

A household can plan for itself how much money from its own budget should be spent on consumption and what proportion will be used for saving. Saving is defined as renouncing consumption.

  1. Company: produce and invest

A company can produce (manufacture products and provide services) and also make investments. This involves the replacement of worn-out means of production or expansion investments.

According to the theory, both sides try to maximize their personal benefit and thus make the decisions that are best for them.

What is the role of the state?

In principle, it is up to the state to first determine the framework conditions for the economic activity of the individual market players. Good examples are:

  • Securing rights to private property
  • Guarantee of freedom of contract and liability
  • Creation of good infrastructure and funding of education and basic research
  • Establishing the rights of freedom
  • Maintaining competition

In addition, however, the state is also recognized as having a social responsibility. It should therefore ensure the following aspects within the framework of the social market economy:

  • Establishing minimum social standards
  • Redistribution through the tax and social security system
  • Eliminating excessive injustices caused by market events

What is the role of the central banks?

Basically, the central bank should provide the economy with money. She issues new banknotes. At the same time, it controls the amount of money in circulation and can thus influence the rate of price increases. It therefore makes a major contribution to the stability of a currency's value. The European Central Bank (ECB) is responsible for the euro area and controls the money supply primarily via the key interest rates:

  • Refinancing rate: Banks can borrow money from the ECB at this rate. This is newly created deposit money, which increases the shortage of money in the economy. The higher the interest rate, the less new money will be put into circulation. That is why central banks usually raise the refinancing rate when inflation rises.
  • Deposit facility: This interest rate describes the rate of return commercial banks receive when they park deposits with the central bank. This almost always happens when you do not use the money for other banking transactions (e.g. lending to customers and companies) or hold it in cash (in the safe). If the central bank wants to encourage the banks to increase their lending, it can also set the deposit interest rate negatively and quasi condemn the banks to penalty interest.
  • Marginal Lending Facility: This interest rate basically determines the interest rate at which banks can borrow money via interbank trading at short notice.

In the last 20 years, however, the ECB has increasingly taken on the role of economic watchdog. Extremely low key interest rates and bond purchases are intended to support the economic system and enable economic growth.

The markets are more complex than in theory

The markets are of course always more complex in practice than in theory. This is mainly due to the fact that humans are emotional beings. This can be clearly seen from the example of building interest:

  1. Building interest rates have continued to fall in recent years

Building interest rates have fallen from record low to record low in recent years. This was virtually a side effect of the ECB's interest rate policy. While a building loan cost an average of 4.85% per year at the beginning of 2007, the building interest rate averaged 1.39% per year at the beginning of 2020.

  1. Demand for home loans has increased extremely

The demand for home loans has risen extremely due to the low interest rates. More and more people are financing their dream of owning a home, even if objectively they do not have the financial means to do so. This shows that people act emotionally and do not always weigh everything rationally.

The low interest rates also ensure that special financing offers such as the forward loan are becoming increasingly popular. After all, everyone would like to secure the low interest rates for follow-up financing in a few years' time.

  1. Property prices have skyrocketed

As a normal market reflex, property prices have skyrocketed. For many potential real estate buyers, this price increase eats up the savings from low interest rates.

Complex side effect: The high demand for living space and the high purchase prices have also influenced rental prices. Living in popular locations is becoming more and more expensive. There are other reasons for this as well, but it is also due to the real estate boom.

Interventions in the market often have side effects

Unfortunately, the free market economy without regulatory forces does not only produce winners by far. If the state intervenes here for the common good and cushions hardship, this is certainly desirable. However, decisions should always be carefully weighed here, as they can sometimes have unpleasant side effects. The explosion in real estate prices, for example, is a side effect of the low key interest rates and is certainly not wanted.