V. ECONOMIC ANALYSIS
A. Basic Principles of Microeconomics
B. Basic Principles of Macroeconomics
C. Introduction to Various Macroeconomic Variables
D. Role of economic analysis in fundamental analysis
E. Secular, cyclical and seasonal trends
F. Sources of Information for Economic Analysis
Basic Principles of Microeconomics
Microeconomics is the study of the behaviour 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 focuses on individual households and firms,
Basic Principles of Macroeconomics
macroeconomics is on factors that influence
aggregate supply and demand in an economy such as unemployment rates, gross domestic
product (GDP), overall price levels, inflation, savings rate, investment rate etc. Most of these
factors are highly affected by changes in the public policies.
Two major influencers of the public policies in an economy are the government and the central
bank..
govt fiscal policy and actions of the central
bank, known collectively as monetary policy
“General Theory of Employment, Interest and Money” book by John Maynard Keynes.
The importance and uses of macroeconomics in brief are as under:
1. Macroeconomics helps us understand the general state of the economy – Domestic
Production, Domestic Consumption, General Price levels, Growth, Quality of life etc.
2. Macroeconomics helps us understand drivers of income, savings, investments and
employment in an economy.
3. Macroeconomic models help governments and central bankers formulate economic policies
for achieving long run economic growth with stability.
4. Macroeconomics helps us understand various aspects of international trade of goods and
services – exports, imports, balance of payment, exchange rate dynamics etc.
5. Macroeconomics also facilitates understanding on how inter-linkages across the economies
work
gross domestic product (GDP) and gross national product (GNP).
national income
national income of an economy can be measured through three methods: (i) Product Method (ii) Income Method, and
(iii) Expenditure Method
Consumers
in an economy are broadly divided into three categories – individuals, corporates and
government.
Product Method
In this method, national income is measured as an aggregated flow of goods and services in the
economy from the different sectors: agriculture, industry and services. Economists calculate
money value of all final goods and services produced in the economy during a specified period.
Final goods refer to only those goods which are consumed by economy participants and not the
ones used in further production processes (intermediate goods).
Product method deals with the economy sector-wise. The total output in the economy is
computed as the sum of the outputs of various sectors.
Income Method
In this method, national income is measured as the aggregate income of individuals in the
economy. Employees (labour and other employees), Professionals,
Entrepreneurs and Investors. Employees earn wages and salaries, Professionals earn their
income based on their services, Entrepreneurs earn profits (including undistributed corporate
profits) and Investors . Sum of all these incomes
for a specified period is called National Income for the economy.
Expenditure Method
As all the goods and services produced in an economy are bought (consumed) by someone,
National Income may also be calculated from the consumption end. Expenditure method
attempts to undertake the same philosophy while computing the National Income. Consumers
in an economy are broadly divided into three categories – individuals, corporates and
government.
Further, as an economy would also have exports (people of foreign countries spending on goods
and services produced by an economy) and imports (people of an economy spending on goods
and services produced by other economies), necessary adjustments are made for the same by
the economist while arriving at the National Income through this method. The aggregate demand
for goods and services is computed as the sum of private consumption, government spending,
gross capital formation and net exports.
National Income is one of the most important statistics for a country. Following are some of the
uses of national income statistics:
Level of Economic Welfare and growth: per capita income
Distribution of income among constituents of the economy: For example, the service sector constitutes
57% of India’s GDP at factor
Support to Fiscal and Monetary policies – Statistics such as saving, consumption and investment
in the economy help policy makers in taking required measures to accomplish desired goals.
5.3.2 Savings and Investments
As defined above, there are three constituents in an economy – Individuals, Corporates and
Government. Savings, defined as income over expenses, are computed for all three categories
separately. Savings of individuals is called “personal savings”, savings of corporates
(undistributed profits) is called “corporate savings” and savings of government is called public
savings (rarely there; governments generally run budget deficits). Individuals and corporate
entities may be clubbed together as private savings. Economists arrive at National Saving by
summing savings of these three constituents – personal, corporate and public savings.
It is also important to understand that savings does not mean investment. When savings are turned into investments, they take the
shape of some financial instrument – Equity, Bonds, Government Securities and others
Higher levels of savings and higher conversion of those savings in to investments are considered
good for an economy.
5.3.3 Inflation (Consumer/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.
Inflation can be caused by demand pull factors or cost push factors. An increase in the price of
goods and services because demand being in excess of available supply, is called demand pull
inflation. An increase in prices because of an increase in input costs is called cost-push inflation.
To defuse the inflation, policy makers adopt several measures to reduce the demand or increase
the supply or both.
Generally, inflation is measured in two ways – at wholesale level in terms of Wholesale Price Index
(WPI) and retail level in terms of Consumer Price Index (CPI).
Further, 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 the 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,
5.3.4 Unemployment Rate
Unemployment rate refers to the eligible and willing to work unemployed population of the
country in percentage terms. During a slowdown in economies, unemployment rate rises and
during an expansion phase, the unemployment rate falls as more jobs are created as production
goes up. Higher employment means income, which improves the ability of people to spend,
which implies potential growth in the economy. The reverse would be true for economy going
through tough times and high unemployment rates.
5.3.5 Flows from Foreign Direct Investment (FDI) and Foreign Institutional Investors (FIIs)
Foreign capital flows to a country can be either in active form known as Foreign Direct Investment
(FDI) or passive form known as Foreign Portfolio Investment (FPI). In case of FDIs, investing
entities participate in decision making and drive the businesses. However, Portfolio Investment,
as name indicates is investment in markets – equity or bonds by the Foreign Portfolio Investors
(FPIs) without any management participation. There are upper limits on the individual and
combined holding by FPIs in the paid up capital of the Indian companies.
FDI is welcomed by all the developing economies and has multiple benefits in addition to bring
in capital to 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 as hot money as
they can pull out the money at any time which could create systemic risk for the economy.
5.3.6 Fiscal Policies and their Impact on Economy
Fiscal policy contains the measures of the Government which deal with its revenues and
expenses. Fiscal measures are important in any economy because when 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 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 leads to high interest rate.
A country has trade and other contracts with entities abroad which results in receipts and
payment of funds. These include payments for imports and receipts for exports, interest and
dividend received and paid and other transfers from abroad. The current account balance is the
difference between the receipts and the payments. A country may have a current account surplus
(receipts > payments) or deficit (receipts<payments). A high fiscal deficit in proportion to the GDP
caused by lack of competitiveness in trade or excessive consumption is a negative commentary
on the economy. A high Current account deficit or CAD causes the nation’s currency to weaken relative to other currency.
This makes imports more expensive and will affect the productivity of the economy as capital
goods and commodities become expensive. It reduces the credit worthiness of the nation and
makes borrowings more expensive. A depreciating currency makes exports of the nation more
competitive and may help narrow the deficit.
If the country is seen as an attractive investment
destination, the capital inflows in the form of FDI and portfolio inflows will offset the CAD and
protect the currency from devaluation.
Expenditure is funded by the Government through 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 required in the Fiscal policies.
Expansionary fiscal policy – Fiscal measures when government’s spending exceeds its income.
This policy stance is usually undertaken during recessions/slow moving economy.
Contractionary fiscal policy – Fiscal measures when government’s spending is lower than its
income. Government uses excess income to repay its debts/obligations or acquire assets.
5.3.7 General Anti-Avoidance Rules (GAAR)
Entities in an economy adopt various methods to reduce their tax liabilities and the same may be
categorized as: “Tax Evasion”, “Tax avoidance”, “Tax Mitigation” and “Tax Planning“. General
Anti-Avoidance Rules (GAAR) are framed to minimize tax avoidance. Simple example of tax
avoidance is routing of investments by investors through tax havens such as Mauritius. In India,
these rules were proposed by the Union Budget 2012-2013. Initially, GAAR was to be effective
from April 1, 2014, which was subsequently deferred to April 1, 2015 (FY 2015-16). It will apply if
the main purpose of the transaction was to get tax benefits. Investments made before 30th
August 2010 are not to be covered under the rules and investments made under an FII structure
in listed securities will not be covered. GAAR will not apply if the tax benefit is below Rs. 30
million.
General Anti-Avoidance Rules empower the revenue authorities in a country to deny the tax
benefits to the entities on a transaction, which is primarily carried out in a specific manner to
avoid taxes. GAAR provides discretionary powers to revenue authorities to impose taxes on such
transactions.
5.3.8 Monetary Policies and their Impact on Economy
Monetary policies, administered by central bank in an economy, deal with money supply,
inflation, interest rates for the purpose of promoting economic growth and managing price
stability (inflation). Expansionary monetary policy is
used to push the economy up by increasing the money supply steeply and reduction in the
interest rates. On the other hand, Contractionary policy is intended to cool down the heated up
economy through reduction in the money supply or slow increase in money supply and increase
in the interest rates.
Central banker controls the money supply and interest rates with tools such as
- Repo rate (rate at
which the central bank lends money to commercial banks), - Reverse repo rate (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).
5.3.9 International Trade, Exchange Rate and Trade Deficit
International trade refers to the total trade that a country does with all other countries in the
world. A country’s balance of payment is the statement showing transactions of a country with
the rest of the world. Balance of payment statement is broadly divided into two accounts namely
the current account and the capital account. The current account has all the details of
transactions on revenue account viz. imports and exports of goods and services while the capital
account captures all the capital flows like FDI, FII, loans, and grants etc.
If imports are more than exports, then country will have a current account deficit and if exports
are more than imports then it will have current account surplus. Similarly, capital account will be
in surplus if inflows are more than outflows and in deficit if outflows are more than inflows on
capital account. Surplus and/or deficit on both current and capital accounts put together makes
it balance of payment number for a country.
If a country is running continuous deficit on current account, it would need surplus on capital
account to support that or deplete its foreign currency reserves. In both these situations, the
country runs the risk of losing 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. 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. 62, it means one dollar is priced at Rs. 62. Currencies can
become more expensive and/or lose their value vis a vis other currencies based on the relative
strength of the countries’ economy.
5.3.10 Globalization – Positives and Negatives
Globalization, simply stating, is the ability of the 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.
World is becoming flatter with less and less entry barriers with an objective to optimize the
output of resources. Economies are realizing that protective attitude would not take them long
and they need to open up economies to the world to progress and allocate resource to the
maximum output. Accordingly, many countries including the developing ones have embraced
globalization by opening up their economies. However, there is no compulsion for any economy
to do so each country decides on the subject on its own based on its assessment of the perceived
advantages.
Globalization is good or bad for economies has always been a debatable issue. Here is a big
picture on positives and negatives of globalization:
Positives of Globalization:
Best allocation of global resources as they are able to flow where they produce best and earn
best.
Integration of developing economies with the developed world and opportunities for them
to learn and grow, access new products and services, exposure to new technologies etc.
Benefits to end consumers through global competition, which encourages creativity and
innovation and keeps prices for goods and services under check.
Greater access to foreign culture in the form of art, movies, music, food, clothing etc. In other
words, the world has more choices today.
Negative of Globalization:
Increasing divide between the rich and the poor – the rich are getting richer and the poor are
becoming poorer.
Competition results in survival of the fittest. As jobs can move to the most competitive
countries, countries with less competent talent may be left without opportunities.
Integrated economies mean that problem in one part of the world would affect the other
parts of the world. For example, credit crisis in U.S. in 2008 created havoc across the world.
5.4 Sources of Information for Economic Analysis
There are several sources of information on economy and a few prominent among them are:
Government Websites
Websites of Regulators such as SEBI, RBI, MOF etc.
Published Economic Research Reports
Economic Survey
Summary
Economic Analysis includes Microeconomics and Macroeconomics
Microeconomics is the study of the behaviour of individuals and firms in an economy.
Macroeconomics focuses on factors that influence aggregate supply and demand in an
economy such as unemployment rates, gross domestic product (GDP), overall price levels,
inflation, savings rate, investment rate etc.
Government and Central Bank, in any economy, strive to promote economic stability and
growth by focusing on following macroeconomic variables explained in this chapter:
National Income is defined through a variety of measures such as gross domestic
product (GDP), gross national product (GNP) etc. National income of an economy can be
measured broadly through three methods: Product Method, Income Method, and
Expenditure Method.
Savings and Investments: Savings, simply means, income over expenses. It is also important
to understand that savings does not mean investment. Savings are to be channelized towards
productive venues called investment. Higher levels of savings and higher conversion of those
savings in to investments are considered good for an economy.
Inflation (Consumer/Wholesale Price Indices): Inflation is the general increase in price levels
in the economy leading to an erosion of purchasing power of money. Inflation is measured in
two ways – at wholesale level in terms of Wholesale Price Index (WPI) and retail level in terms
of Consumer Price Index (CPI). If demand of products and services is more than supply, prices
will keep rising.
Interest rate and inflation are closely linked parameters. Higher inflation demands higher
rates for people to get motivated to save and consume less. On the other hand, higher rates
reduce the investments (high cost of capital) and may slow down the overall economy.
Unemployment Rate refers to the eligible and willing to work unemployed population of the
country in percentage terms. Higher employment rate will lead to income for people, which
means ability of people to spend, which implies potential growth in the economy and vice
versa.
Foreign Capital flows to a country either through Foreign Direct Investment (FDI) or Foreign
Portfolio Investment (FPI). In case of FDIs, investing institutions participate in decision making
and drive the businesses. However, Portfolio Investment is investment in markets
(Equity/Bonds) by the Foreign Institutional Investors (FIIs) without any management
participation. FDI is long term in nature and stable money, while FIIs money is considered as
hot money as they can pull out the money at any time which could crate systemic risk for the
economy.
Fiscal Policies and their Impact on Economy: Fiscal policy contains policy measures of the
Government which deal with governments’ revenues and expenses. While Government tries
to balance its inflows and outflows, based on its actions, fiscal policy is categorized as: Neutral
fiscal policy, Expansionary fiscal policy, Contractionary fiscal policy.
General Anti-Avoidance Rules (GAAR): Entities in an economy adopt various methods to
reduce their tax liabilities and the same may be categorized as: “Tax Evasion”, “Tax
avoidance”, “Tax Mitigation” and “Tax Planning”. General Anti-Avoidance Rules (GAAR) are
framed to minimize tax avoidance by empowering the Revenue Authorities in a country to
deny the tax benefits to the entities on a transaction, which is primarily carried out in a
specific manner to avoid taxes.
Monetary policies, administered by central bank in an economy, deal with money supply,
inflation, interest rates etc., for the purpose of promoting economic growth and managing
price stability (inflation).
Central banker controls the money supply and interest rates with tools such as repo rate,
reverse repo rates, cash reserve ratio (CRR) and statutory liquidity ratio (SLR).
Monetary policy, similar to Fiscal policy, is referred to as either being expansionary or
contractionary depending on policy stance.
International Trade refers to the total trade that a country does with all other countries in
the world. Country’s Balance of Payment is the statement showing transactions of a country
with the rest of the world.
Balance of payment statement is broadly divided into two accounts namely the current
account and the capital account. The current account has all the details of transactions on
revenue account viz. imports and exports of goods and services while the capital account
captures all the capital flows like FDI, FII, Loans, and Grants etc.
Globalization is the ability of the 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.
Various statistics for the computation of the above macroeconomic variables can be obtained
from the following prominent sources of information: Government Websites, Websites of
Regulators such as SEBI, RBI, MOF etc., Published Economic Research Reports, and Economic
Survey.
