Understanding Economic Concepts: A Comprehensive Guide

Posted on May 12, 2024 in Economy

Why Investment Is Important

Investment is one of the most important aspects of financial planning. The aim is to make sure that the money earned by you does not lie around being unproductive. It is a good and profitable idea to make money from any extra cash that a person might have. Investing in various financial products lends growth to any financial portfolio. One thing that is absolutely clear is that any amount of money is sure to appear less with each passing day. This is because the value of say Rs.1000 will not be the same 5 years down the line as it is today. Same holds true for the value of Rs.100 10 years ago as compared to its value today. Hence, it is important to understand that saving alone is not enough for future financial goals. Any investor or common man needs to ensure that his or her money grows as well. Investment can be defined as any activity that involves using money in a way which offers returns in future. Mentioned below are some of the most important reasons for investing money.

• Investing money in various financial avenues ensures that your money grows instead of just lying there in your bank account
• Investments yield returns which take care of emergency expenses such as medical expenditure etc.
• Investments are a good way to earn income from your accumulated wealth. For example, earning rent from a real estate investment or earning dividends from stock market investment
• Tax minimization is a secondary objective that can be achieved by investing your money in various investment tools
• Fighting inflation can be one of the key reasons to ensure that your money grows. The value attached to a quantum of money depreciates with rising inflation. The effect of inflation in lowering the value of your assets can be tamed by investing and generating returns on your corpus
• Investments lead to a certain amount of corpus that plays a vital role in providing financial security to your loved ones
• Distant financial goals, both log-term as well as short-term can be planned and fulfilled by making intelligent and relevant investments

Inflation

Inflation is the rate at which the prices for goods and services increase. Inflation often affects the buying capacity of consumers. Most Central banks try to limit inflation in order to keep their respective economies functioning efficiently. There are certain advantages as well as disadvantages to inflation.

Inflation refers to the increase in the prices of the goods and services of daily use, such as food, housing, clothing, transport, recreation, consumer staples, etc. Inflation is measured by taking into consideration the average price change in a basket of commodities and services over a period of time.

Inflation is calculated in India by the Ministry of Statistics and Programme Implementation.

A simple example would be, suppose a kg of apple cost Rs.100 in 2019 and it cost Rs.110 in 2020, then there would be a 10% increase in the cost of a kg of apple. In the same way, many commodities and services whose prices have raised over time are put in a group and the percentage is calculated by keeping a year as the base year. The percentage of increase in prices of the group of commodities is the rate of inflation.

Causes of Inflation

Money Supply

National Debt

Demand-Pull Effect

Cost-Push Effect

Exchange Rates

What Is Fiscal Policy?

Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions. These include aggregate demand for goods and services, employment, inflation, and economic growth.

During a recession, the government may lower tax rates or increase spending to encourage demand and spur economic activity. Conversely, to combat inflation, it may raise rates or cut spending to cool down the economy.

Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and not elected government officials.

How does it work?
When policymakers want to influence the economy, they mainly have two tools at their disposal, Monetary policy and Fiscal policy. The monetary policy is regulated by the central banks. Money supply in the market is adjusted by tweaking the interest rates, bank reserve rates, sale and purchase of government securities and foreign exchange.

On the other hand, fiscal policy is influenced by the governments by adjusting the nature and extent of the taxes, government spending and borrowing. A healthy fiscal policy is important to control inflation, increase employment and maintain the value of money. It has a very important role in managing the economy.

The government has two variables to influence fiscal policy, namely

Taxation- regulating which the government increases or decreases the disposable cash in the hands of the public.

Government spending- using which the government invests in public infrastructural works and other social welfare schemes that directly or indirectly influence the state of the economy.

To incentivize spending, the government may announce tax cuts and when the economy faces high inflation, the government may announce new taxes or raise the levels of existing taxes. During a period of negative growth, the public and investors may lose faith in the economy which in turn may result in lower production and lower demand. To counter that the government may increase spending to tide over the falling private sector investment and to create demand in the market.

Keynesian Theory of Employment

It is also referred to as the effective demand theory of employment. Keynes developed this first systematic theory of employment. The Keynesian theory of employment states that the cause of unemployment is the deficiency of effective demand, and unemployment can be removed by raising effective demand. With the increase in effective demand, the production in the economy goes up. The increased production generates more jobs thus increasing the employment and giving a boost to the nation’s economy. With the increase in effective demand, there is also an increase in inflation which is good for the economy if controlled within a limit. Therefore, Keynesian theory of employment has a very positive looking approach for the economy of a nation. It helps in dealing with the situations of economic crisis like the Great Depression and the recession.

Keynes Effect

The principle of effective demand is the foundation of Keynes’ General Theory of Employment. Employment is dependent upon effective demand and is directly proportional to Effective Demand. As Effective Demand increases, employment and output and real income increase.

Keynesian Economics

Keynes developed this theory to deal with the situation of the Great Depression. Keynesian Economists recommend fiscal and monetary policy as the primary tools to manage the economy and fight the menace of unemployment. Keynes’s fiscal stimulus theory states that when the government spends money, it leads to an increase in business activity which generates more income and thus increases the GDP. The growth in GDP can be greater than the stimulus amount spent by the government initially. Keynesian Economists believe in saving less and spending more principle so that full employment and economic growth goes on.

The Classical theory of Employment.
The classical economists believed in the existence of full employment in the economy. To
them, full employment was a normal situation and any deviation from this regarded as
something abnormal. According to Pigou, the tendency of the economic system is to
automatically provide full employment in the labour market when the demand and supply of
labour are equal.
Unemployment results from the rigidity in the wage structure and interference in the working
of free market system in the form of trade union legislation, minimum wage legislation etc.
Full employment exists “when everybody who at the running rate of wages wishes to be
employed.”
Those who are not prepared to work at the existing wage rate are not unemployed because
they are voluntarily unemployed. Thus full employment is a situation where there is no
possibility of involuntary unemployment in the sense that people are prepared to work at the
current wage rate but they do not find work

The classical theory of output and employment is based on the following assumptions:
 There is the existence of full employment without inflation.
 There is a laissez-faire capitalist economy without government interference.
 It is a closed economy without foreign trade.
 There is perfect competition in labour and product markets.
 Labour is homogeneous.
 Total output of the economy is divided between consumption and investment
expenditures.
 The quantity of money is given and money is only the medium of exchange.
 Wages and prices are perfectly flexible.
 There is perfect information on the part of all market participants.
 Money wages and real wages are directly related and proportional.

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.

In the United States, the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary depending on the level of growth or stagnation within the economy.

Contractionary

A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money.2

Expansionary

During times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase.1

Goals of Monetary Policy

Inflation

Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation.

Unemployment

An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market.

Microeconomics

Microeconomics is the study of economics at the individual, group, or firm level. This is considered to be basic economics. Microeconomics may be defined as that branch of economic analysis which studies the economic behaviour of the individual unit, maybe a person, a particular household, or a particular firm. This is a study of specific entities rather than all entities combined. Microeconomics is also known as the theory of prices and values, the theory of households, firms, and industries. Most production and welfare theories are microeconomics in nature. A key role of microeconomics is to study how firms can maximise their production and capacity so that they can lower prices and compete in their industry.

Limitations of Microeconomics

The main limitations of microeconomics are as follows: 

• Microeconomic studies assume that other values ​​are constant, which is not realistic. All factors are subject to change and are not constant. 

• One of the important limitations of Microeconomics is that it assumes full employment. In other words, all resources are fully used in the production process, but this is only an illusion and not true.

• Adopting a laissez-faire policy is unrealistic in the real world, where we see government interference in economic activity.

• Knowledge of the economy as a whole is very important for people as it encompasses all economic factors. But microeconomics only focuses on a small part of the economy as a whole.

• The scope of microeconomics is limited and narrow. It does not include income theory, inflation, monetary policy, etc., which are very important for economic analysis.

Macroeconomics

Macroeconomics may be defined as that branch of economic analysis which studies the behaviour of not one particular unit but all the units combined. Macroeconomics is a study in aggregates. Macroeconomics studies the links between different countries in terms of how the policies of one country affect others. Within that framework, an analysis of the successes and failures of government strategies is presented.

Limitations of Macroeconomics

The limitations of macroeconomics are as follows: 

• Macroeconomics deals with aggregates, which refer to individual totals. However, overall results may differ from individual behaviour. 

• It does not study the different effects of the aggregate on different sectors of the economy.

• It ignores the contribution of Individual units.

• If each data unit is different, it becomes difficult to judge.

• The aggregate tendency may not affect all sectors equally.

• Aggregate values ​​cannot be used when individual items need to be considered separately.

  Business Economics

  Business economics is the application of microeconomics focused on subjects of great importance and interest. Business Economics deals with the organisation and allocation of a company’s scarce resources to achieve desired goals. Thus, it combines the fundamentals of economics and business. The primary concern of business economics is with the company, the environment in which the company is located, and the business decision a company must make. Business Economics seeks to examine and analyse how and why a company behaves. It looks at the impact of actions, the policies of the companies that act, and the economy as a whole.

Understanding Say’s Law of Markets

According to the Law of Markets, a person’s ability to demand goods and services is a direct result of production activities that they’ve undertaken. They earn an income either through the production and sale of physical assets or by supplying labor to capital owners. The productivity of the economic agent will influence the level of income they receive, which will, in turn, influence what goods and services they demand and how much of each good or service they demand.

By choosing to produce a certain good, they are indirectly creating the demand for those goods and services that they intend to buy with their earned income. Conversely, if one did not demand anything, they would not want to work. Thus, Say’s Law describes the unfolding market process, stating that “all purchasers must first be producers, as only production can generate the power to purchase.”

Since the production level drives the ability to demand, the most extensive demand will be found in areas where the maximum value is created. Thus, production comes first, and demand follows the wealth created from production. On this note, Say’s Law infers that it is important to look at the supply side if there is a fall in consumption.  There is no point in encouraging demand if there is nothing to supply.

Keynesian Criticism of Say’s Law

The colloquial expression for Say’s Law is that “supply creates its own demand.” It translates as Say saying that simply producing a good is enough to create a demand for it. Further, aggregate supply will always be equal to the aggregate demand of goods and services, and that we cannot deviate from full employment. John Keynes is one of the most important critics of Say’s Law.

Keynesians claim what Say meant was that if things are produced, the income generated from production is automatically spent to fulfill people’s demand. If it were true, then Say would’ve been wrong as some income is often saved for future consumption. However, Keynes focused on only a part of the complex idea behind Say’s Law and presented it as the whole concept.

The marginal efficiency of capital (MEC) is that rate of discount which would equate the price of a fixed capital asset with its present discounted value of expected income.

The term “marginal efficiency of capital” was introduced by John Maynard Keynes in his General Theory, and defined as “the rate of discount which would make the present value of the series of annuities given by the returns expected from the capital asset during its life just equal its supply price”.[1]

The MEC is the net rate of return that is expected from the purchase of additional capital. It is calculated as the profit that a firm is expected to earn considering the cost of inputs and the depreciation of capital. It is influenced by expectations about future input costs and demand. The MEC and capital outlays are the elements that a firm takes into account when deciding about an investment project.

Scope of Macroeconomists

Economists delve into the theory of national income to understand how an entire country’s economic output is measured and distributed. This theory examines factors such as gross domestic product (GDP), which represents the total value of goods and services produced in a country. Economists analyze how income is generated, earned, and spent by households, businesses, and governments, shedding light on the economic well-being of a nation and the factors influencing its growth. The scope of macroeconomics is wide; let’s understand it in detail.

Theory of Money

The theory of money is crucial in understanding the role of currency in an economy. Economists analyze how money is created and circulated and impacts economic activities. They study concepts like inflation, monetary policy, and the functioning of central banks. By comprehending the dynamics of money, economists contribute to formulating effective monetary policies that maintain price stability and economic growth.

Income method is that method which measures the income of the country as the sum total of factor incomes- compensation of employees, rent, interest, and profit-earned by normal residents of a country during an accounting year.

Average Propensity to Consume (APC)

APC can be equal to one, less than one, and more than one, but can never be zero. According to the formula, APC can be zero when the consumption level is zero, which is not possible at any income level because even at zero income level, there is autonomous consumption

Marginal Propensity to Consume (MPC)

The value of MPC varies between 0 and 1. Besides, the Marginal Propensity to Consume (MPC) of the poor is more than the MPC of the rich. It is because the poor spend most of their increased income on consumption as most of their basic needs are not yet fulfilled. However, rich people spend less of their increased income on consumption as they are already enjoying a high living standard.

What is Secular Stagnation?

The term “secular stagnation” refers to a state of little or no economic growth – in other words, an environment where the economy is essentially stagnant. “Secular” in this context simply means “long term.” The term was coined by Alvin Hansen in the 1930s, during the Great Depression, and was revived largely by Lawrence Summers.

Summers is a Keynesian economist who previously held the position of Chief Economist of the World Bank. He also served as Treasury Secretary under President Bill Clinton and as Director of the National Economic Council under President Barack Obama.

MONETARY

Stability: A good monetary system should ensure internal price stability and external exchange rate stability. Stable internal price level is necessary for the economic growth of the country and stability in the foreign exchange rates is essential for the development of foreign trade.