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Knowledge Corner

Economics & Financial Markets – 1

Understanding of economics is a key to knowing how the financial markets operate. There are intricate linkages between various economic factors and financial variables. For example, any tax rate changes by a government or a decision to change the amount of money in the system can have both direct and indirect impact on the financial markets.
This module provides in very simple terms various macroeconomic concepts and a glimpse of macroeconomic behavior with frequent references to the Indian economy. This perspective forms an integral part of understanding that discerning finance professionals need to possess, as it would help them identify the causes of different economic developments and issues as well as anticipate the possible impact of changes in economic policies. A successful professional is one who applies this understanding to think ahead and formulate strategies for likely future scenarios. Macroeconomics is a vast and complex subject. The literature is large, the issues diverse, and opinion divided on both diagnosis of the problems and prescriptions for solving them. It is also an evolving subject. Therefore, in preparing a short course material like this module, the author had to be selective. Further, the author had to strike a balance between theory, historical experiences and recent developments, while ensuring that the practical aspects of macroeconomic fundamentals and their impact on the Indian economy are adequately covered. For more advanced material, interested students are requested to refer to various books, websites on the subject.
Microeconomics and Macroeconomics
It is said that Economics is the social science that studies the production, distribution, and consumption of goods and services. Resources are scarce, while human wants are unlimited. Economics is the study of how societies use scarce resources to produce goods and services and distribute them efficiently among different people to satisfy their consumption needs. The essence of Economics is to explore ways to optimize the use of scare resources and to organize the society in a way that leads to the most efficient use of those resources. Economic theory can be broadly divided into two categories: Microeconomics and Macroeconomics.
Microeconomics focuses on the individual level of the economy. It studies the behavior of individual economic agents such as individual consumers or workers or firms. For example, microeconomics studies how a firm attempts to maximize its profits under the constraints of its resources or how an individual makes decisions about his purchases given the income constraint that he or she has. In other words, Microeconomics analyzes and studies decisions of individual economic agents and how they interact in specific markets and allocate their limited resources to optimize their own wellbeing.
Macroeconomics, on the other hand, looks at the economy as a whole. It deals with aggregate economic behavior of a nation, a region or the global economy. In other words, Macroeconomics deals with economy-wide phenomena such as inflation, unemployment, and economic growth. Macroeconomics tells us about what determines level of output in an economy, how are employment and prices determined; how money supply affects rate of interest, how do the monetary and fiscal policies of the government affect the economy etc. Macroeconomics tries to address some key issues which are of great practical importance and are being discussed and debated regularly among the press, media and politicians. Some of the key subjects which are dealt with in macroeconomics include:
Long-term Economic growth
Currently, we see that there is significant divergence of standard of living among different countries. The main reason for this varying standard of living among countries is the different levels of economic growth in the past. Over the past several decades, economies of the currently developed countries have shown moderate to high growth rates for a sustained period, while the economies of developing countries have not. The developing countries may have had occasional periods of high growth; but they have not sustained high growth performance over a long period. In other words, the developed countries have experienced higher long-term economic growth than the developing countries. Macroeconomics analyzes how and why different countries are growing at different rates, and suggests how countries can accelerate their growth rates.
Business Cycles
Growth of most countries—developed as well as developing countries -- go through ups and downs. The term business cycle refers to economy-wide fluctuations in production or economic activity over time between periods of relatively rapid economic growth, and periods of relative stagnation or decline. The duration of a business cycle can be several months or even a few years. Despite being termed cycles, these fluctuations in economic activity usually do not follow a mechanical or predictable periodic pattern. The downward phase of business cycle, when economic activity contracts, is called recession. Recession can lead to job losses and other hardships for the population in the concerned economy. Macroeconomics studies business cycles and suggests policies so that recession can be avoided as far as possible or made short-lived. The upward phase of the business cycle is called economic boom. During this period, many new jobs are created and the unemployment rate in the economy falls.
When prices of goods and services increase in an economy, it is said that the economy is experiencing ‘inflation’. Inflation is thus the rate of increase in general price level over a period of time. Inflation is usually measured over a year and is expressed 7 in percentage terms. When we say that annual inflation on April 1, 2011 is 7 percent, it means that the general price level increased by 7 percent between April 1, 2010 and April 1, 2011. Inflation can be high, moderate or low. If the general price level falls, inflation turns negative; this phenomenon is called ‘deflation’. Deflation is a very rare phenomenon. High inflation and deflation are both not desirable for an economy. High inflation hurts consumers as it reduces their purchasing power. Suppose during a year, an individual’s income goes up by 6 percent, but the inflation during the year is 15 percent. Then the purchasing power of the individual has gone down by 9 percent, even though his income has risen by 6 percent. On the other hand, deflation leads the producers of goods and services to slow down their activities, because they get a lower price for their products than they used to earlier. This reduces their profits or even forces them to incur losses. As a result, the economic growth slows down. The economy may even get into a recession. Study of Macroeconomics gives insights into why inflation rises or falls and what policies help avoid periods of high inflation or deflation.
Global economic linkages:
Currently, most countries of the world trade with each other and experience capital inflows and outflows. Macroeconomics studies the factors which drive movements of goods and services as well as capital across countries. It also studies the impact of such flows on the rest of the economy. Note that foreign capital flows play a very important role in the financial markets of developing countries and hence is becoming an increasingly important aspect of the economy of these countries.
Macroeconomic Policies
Performance of a country’s economy is based on a number of factors like its endowment of resources, its stock of human capital, its technology and so on. In addition to all these, one other factor that plays a key role in determining the economic performance of a country is the economic policy followed by the government of the country. Governments of different countries use different policies to run the economy as efficiently as possible. These policies can be broadly divided into two segments: monetary policy and fiscal policy. Monetary policy involves the use of some monetary tools to influence the money supply in an economy and thereby influence other aspects on the economy. Money supply growth is regulated by the central bank of a country.
The central bank of India is called the Reserve Bank of India. Fiscal policy is the use of government expenditure and taxation to impact the economy. What should be the growth in government expenditures? How much of it should be on creation of assets? What should be taxed and at what rates? What should be the direction and magnitude of change in tax rates? These are some of the questions that fiscal policies, which are part of macroeconomic policies, deal with. Macroeconomics suggests when and how to use these policies and analyzes how these policies can be used for a particular economy in a given set of circumstances.
Why Macroeconomics is important for the financial sector
For people in finance, understanding macroeconomics is very important because each of the major macroeconomic factors mentioned above (such as growth, inflation, business cycles etc.) have strong impact on the financial markets. Macroeconomic factors can have strong impact on the financial sector. For example, when the economy gets into downturn, many firms find it difficult to repay their loans and as a result, the financial health of banks gets affected. Furthermore, changes in macroeconomic policies influence key variables of financial markets such as interest rates, liquidity and capital flows. On the other hand, what is happening in the financial market can have a strong impact on the rest of the economy. Some examples of such transmission can be observed during the financial crises. In the United States, weaknesses in the financial sector stemming from a sudden and substantial decline in the prices of real estate, led to a downturn for the entire economy. In fact, almost all the countries of the world were affected because of this problem in the United States. In many countries across the world, this crisis hit not only the financial markets but also the entire economy, causing major recession and unemployment. The governments of these countries had to undertake serious coordinated policy measures to pull their economies out from recession. As finance and macroeconomics are intimately interlinked, it becomes imperative for finance professional to have at least a working knowledge of macroeconomics, so that they can better predict how the economic agents (firms and individuals) behave in different situations, what risks and opportunities arise in what macroeconomic situation, how changes in policy changes can affect different macroeconomic variables and so on.
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