5. Economic Analysis

Basic Principles of Microeconomics

Microeconomics is the study of the behavior of individuals and their decisions on what to buy and consume based on prevalent prices which in turn signals where the economy has to direct its productive activities. The philosophy of Microeconomics is that prices and production levels of goods and services in an economy are driven by consumer demand.

Microeconomics also deals with the “theory of the firm.” Extending the concept of individuals, here it deals with how firms adopt different strategies to increase their profits. It deals with the decision-making process at the level of inputs, outputs, prices, production levels, profits, and losses of individual firms.

Basic Principles of Macroeconomics

1. Macroeconomics is the study of the economy as a whole, including the interaction of households, businesses, and government.

2. Macroeconomic variables such as GDP, unemployment, and inflation rate are used to measure the performance of an economy.

3. The demand and supply of goods and services are the primary determinants of economic activity in an economy.

4. Fiscal policy, such as government spending and taxation, and monetary policy, such as interest rates and money supply, are used to influence economic activity.

5. Macroeconomic models are used to analyze the effect of policy decisions on the overall economy.

6. Macroeconomic risks, such as external shocks, can have a significant effect on the performance of an economy.

Introduction to Various Macroeconomic Variables

The government and central bankers, in any economy, as policymakers strive to promote economic stability and growth. Their continuous attempt is to implement policies, which ensure a low unemployment rate, price stability with a low inflation rate, and steady growth in economic outputs. However, in spite of the best intentions and efforts of policy makers, economies go through cycles of booms and busts.

National income of an economy is defined through a variety of measures such as gross domestic product (GDP) and gross national product (GNP).

Broadly stated, the national income of an economy can be measured through three methods: (i) Product Method (ii) Income Method, and (iii) Expenditure Method.
1. Product Method- The product method of calculating national income is the most commonly used method. This method calculates national income by summing up the total value of all goods and services produced in an economy over a certain period of time. This value is found by multiplying the total quantity of goods and services produced by the price of each individual good or service.

2. The income method of calculating national income is an alternative to the production method. This method measures national income by adding up all the incomes earned by factors of production, such as wages, rent, interest, and profits. This method is useful for understanding the distribution of income among different groups.

3. Expenditure Method The expenditure method of calculating national income is a third alternative. This method involves adding up all the expenditures made by individuals, businesses, and the government during a certain period of time. This includes spending on final goods and services, as well as investments and transfers. This method is useful for understanding the sources of economic growth.

The level of economic welfare and growth of a country is determined by its total national income. A higher national income means that the average person in the economy has more money to spend, which in turn leads to higher levels of economic welfare. A higher national income also indicates that the economy is growing at a faster rate, which can lead to more job opportunities and higher standards of living.

The distribution of income among the constituents of an economy is also an important factor in determining economic welfare and growth. If the income is distributed evenly, it will lead to greater economic welfare and growth. On the other hand, if the income is concentrated among a few individuals, it will lead to lower economic welfare and slower economic growth. For example, the service sector constitutes 60% of India’s GDP at factor cost.

Support to Fiscal and Monetary policies- National income is also an important factor in supporting fiscal and monetary policies. For example, if a country has a higher national income, this can be used by the government to finance public services and investments, which in turn can lead to higher economic welfare and growth. Similarly, higher national income can provide the resources for the central bank to implement monetary policies such as lowering interest rates, which can stimulate economic activity.

Saving and Investments-
Another way in which national income affects economic welfare and growth is through savings and investments. A higher national income can lead to more savings, which can be used to finance investments. This can lead to higher levels of productivity and faster economic growth.

Inflation (Consume/Wholesale Price Indices) and Interest Rate-
Inflation is defined as the general increase in price levels of goods and services in the economy leading to an erosion of purchasing power of money. If Rs. 1000 was put away in a drawer, what would happen to the money after a year? Yes! It would be the same Rs. 1000 bill after a year, but it would buy lesser goods and services than what it would have fetched a year back as all goods and services would have become more expensive after a year.

inflation is measured in two ways – at the wholesale level in terms of the Wholesale Price Index (WPI) and retail level in terms of the Consumer Price Index (CPI). Typically, economists define a basket of products based on general consumption in the economy and compute its prices based on wholesale prices and retail prices defining WPI and CPI respectively. Statistics on WPI and CPI over several years provides trend in inflation numbers and feeds as an important input for policy measures by both government and central banker.

interest and inflation are closely linked parameters. Higher inflation demands higher rates for people to get motivated to save. As they save more and consume less, consumption goes down. On the other hand, higher rates reduce investments (high cost of capital) and may slow down the overall economy. Higher rates affect some sectors such as real estate and auto more intensely as of most the buying here by the middle-class people happens through loans, which become expensive in higher rates scenarios. Higher inflation reduces the discretionary income that people have and impacts their demand for products and services across the board.

Unemployment Rate
The unemployment rate refers to the eligible and willing-to-work unemployed population of the country in percentage terms. During a slowdown in economies, the unemployment rate rises and during an expansion phase, the unemployment rate falls as more jobs are created as production goes up.

Flows from Foreign Direct Investment (FDI) and Foreign Portfolio Investments (FPI)
FDI is welcomed by all developing economies and has multiple benefits, in addition, to bring in the capital of the country:
Job creation
New technologies
New managerial skills
New products and services
While FDI is long-term in nature and stable money, FPIs money is considered hot money as they can pull out the money at any time which could create systemic risk for the economy.

Fiscal Policies and their Impact on Economy
The fiscal policy contains the measures of the Government which deal with its revenues and expenses. Fiscal measures are important in any economy because when the government changes the measures of its income (primary source being taxation) and expenditure (education, healthcare, police, military forces, interest on borrowing, administrative machinery, welfare benefits, etc.), it influences aggregate demand, supply, savings, investment and the overall economic activity in the country.

Budgeted excess of the Government’s expenditure over its revenues in a specific year is known as fiscal deficit, which is generally defined as a percentage of GDP. The fiscal deficit is bridged by the government through market borrowings, both short-term and long-term. A large fiscal deficit, and consequently a higher borrowing by the government, will push up interest rates in the economy and make it difficult for corporate borrowers to access funds. A high-interest rate environment is detrimental to economic growth.

Expenditure is funded by the Government in multiple ways, mainly through:
P/L measures –
Income from operations: Taxation, interest, and dividend income
B/S measures – Borrowing and Sale of assets

While Government tries to balance between its inflows and outflows, based on its actions, fiscal policy is being categorized as:
Neutral fiscal policy – When governments’ income and expenditure are in equilibrium. No major changes are required in the Fiscal policies.
Expansionary fiscal policy – Fiscal measures when the government’s spending exceeds its income. This policy stance is usually undertaken during recessions/slow-moving economies.
Contractionary fiscal policy – Fiscal measures when the government’s spending is lower than its income. The government uses the excess income to repay its debts/obligations or acquire assets.

Monetary Policies and their Impact on Economy
Monetary policy, similar to Fiscal policy, is referred to as either being expansionary or contractionary depending on policy stance. Expansionary monetary policy is used to push the economy up by increasing the money supply steeply and reduction in interest rates. On the other hand, a Contractionary policy is intended to cool down the heated-up economy through a reduction in the money supply or a slow increase in money supply and an increase in the interest rates.

Central banker controls the money supply and interest rates with tools such as the Repo rate (the rate at which the central bank lends money to commercial banks), Reverse repo rate (the rate at which the central bank borrows money from commercial banks), Cash Reserve Ratio (minimum percentage of the total deposits, which commercial banks have to hold as cash reserves with the central bank) and Statutory liquidity ratio (SLR) (minimum percentage of the total deposits, which commercial banks have to hold in cash equivalents such as gold and government of India securities).

International Trade, Exchange Rate, and Trade Deficit-
If imports are more than exports, then the country will have a current account deficit and if exports are more than imports then it will have a current account surplus.

If a country is running a continuous deficit on its current account, it would need a surplus in capital account to support that or deplete its foreign currency reserves. In both these situations, the country runs the risk of losing the confidence of market participants in the country as the currency of the country would lose value very fast.

Currencies get traded in the world markets like commodities. The exchange rate refers to the value of one unit of a currency with respect to other currency/currencies. For example, if Indian Rupee is quoted against the dollar as $/Rs. 65, it means one dollar is priced at Rs. 65. Currencies can become more expensive and/or lose their value vis a vis other currencies based on the relative strength of the country’s economy.

Globalization – Positives and Negatives
Globalization, simply stated, is the ability of individuals and firms to produce anything anywhere and sell anything anywhere across the world. It also means that resources (people and capital) will flow to the places where they produce best and earn best.

Role of economic analysis in fundamental analysis
Economic analysis helps us understand what is happening to the external environment and how
it is likely to affect a particular business.
Studying the GDP growth rate can help us understand what is happening in the overall
economy of the country. Understanding monetary policy and fiscal policy helps us understand
whether policies support further growth of the economy or otherwise. Tracking metrics such as
interest rates, inflation, public expenditure, and fiscal deficit helps us understand the future
direction of monetary and fiscal policies.

Economic trends can be broadly classified into secular, cyclical, and seasonal trends.
Secular trends are long-term, gradual changes in economic activity that occur over a period of several years. Examples of these trends include changes in employment, wages, inflation, and technology.

Cyclical trends are shorter-term, more volatile changes in economic activity that occur over a period of several months or years. Examples of these trends include business cycles, which can be characterized by periods of expansion and contraction in economic activity.

Seasonal trends are short-term, recurring changes in economic activity that occur over a period of several weeks or months. Examples of these trends include holiday shopping, tourism, and changes in agricultural production.

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Chart Source– Tradingview.com

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