Economics' Perspectives on Modern Finance by Dweej Desai

Macroeconomics

John Maynard Keynes is often referred to as the father of macroeconomics. Keynesian economics is a macroeconomic theory of total spending in the economy and its effects on output and employment. Keynesian economy was developed by the British economist John Maynard Keynes during the 1930s in order to understand the great depression. Keynesian economics is called the demand side economics. Keynes advocated the role of the government through investment expenditure and lower taxes to stimulate the aggregate demand and to pull the global economy out of the depression. Keynesian thoughts emphasized that an optimal economic performance could be achieved by government interventional policies. Fiscal and monetary policies were the primary tools recommended by Keynes to manage the economy and fight unemployment. 

Concept of consumption function – consumption function in economics is the relation between consumption spending and the various factors determining it. These include income, wealth, riskiness of the future, interest rates etc. it is an economic formula that represents the functional relationship between total consumption and gross national income. It describes the relation between consumption and disposable income. Yd = disposable income after taxes and compulsory contributions.

Propensity to consume: - propensity is a term that closely means tendency. Consumption is a function of income, and it is noted that as income levels rise, the propensity to consume diminishes in relative terms. In absolute terms money spent increases. 

Average Propensity to save: - the ratio of total savings to total income is known as average propensity to save (APS). Thus APS = C/Y where C is consumption and Y is income. 

Marginal propensity to save - The ratio of increase in savings due to increase in income is known as marginal propensity to save. Thus MPS = DeltaS / DeltaY. Where S is savings and Y is income.

Average propensity to consume: - the ratio of total consumption to total income is known as average propensity to consume (APC). Thus APC =C/Y (C = consumption & Y = income).

Marginal propensity to consume (MPC): - this is a ratio of increase in consumption due to an increase in income DeltaC/DeltaY

Note: - low income groups have a high propensity to consume and high-income groups have a low propensity to consume.

A major concept in macroeconomics is the multiplier. 

The basic tenet of the concept of multiplier is - One person’s expenditure is another person’s income. Thus, during the depression if the government makes an autonomous investment, the propelling force of the multiplier is MPC. The higher the MPC the higher the value of the multiplier. Let us assume the government makes an investment of 100 million and the MPC is 0.8, this 100 million becomes the income of the economy. The earners of this money will now spend 80 million which will become the income of another set of people and this chain continues.

The symbol for multiplier is K

Thus, the multiplier K = 1/(1-MPC) or 1/MPS

Let us assume the MPC is 0.6. then the multiplier will = 1/1 – 0.6

                                                                                       = 1/0.4

                                                                                       = 2.5

Tax multiplier: - when the government injects money into the economy it multiplies by a factor of the spending multiplier, but the government can also have an impact on aggregate expenditures because of taxes or transfers

TM = MPC x Multiplier = MPC/MPS

Another extremely important part of macroeconomics is Aggregate Demand and Aggregate supply.

Aggregate demand – this is also called domestic final demand and is the total demand for final goods and services in an economy at a given time. It specifies the amount of goods and services that will be purchased at all price levels. Aggregate demand consists of consumer goods and services, capital goods, government spending, and exports and imports. 

AD = C + I + G + (X-M)

AD = aggregate demand 

C = Consumption demand 

I = Investment demand 

G = Government Spending

X = Total Exports 

M = Total Imports

Aggregate demand curve

The aggregate demand curve shows the quantity demanded at each price level. The y axis has price level of all final goods and services. The aggregate price level is measured in terms of CPI, or GDP deflator. On the x axis is the real GDP which is a sum total of all final goods produced in a given year. The aggregate demand curve has a negative slope.

Shape of AD – downward sloping – reasons:

-       Foreign sector substitution effect: - if an economies price level rises foreign goods become relatively cheaper similarly foreigners too will buy less goods of this country. The overall result will be a lesser aggregate demand at higher price levels. Conversely at lower price levels more will be demanded by the consumers of home country and foreigners. 

-       Wealth effect – When the price level is high, the purchasing power of the consumer falls hence less is demanded at higher price levels. Conversely at lower price levels more is demanded due to greater purchasing power.

Changes in AD

Factors affecting change in aggregate demand:

1)    Consumer spending (C):

If consumer incomes rise, so will their consumption and savings more over consumption may also increase if their future is secure

2)    Investment spending (I):

If the expected rate of return is high, firms will invest more since they are optimistic about future profitability, also they may invest more if the rate of interest falls.

3)    Government Spending (G): 

Governments may inject money into the economy through autonomous investments or by reducing taxes or by increasing transfer payments (pensions etc.)

4)    Net exports (X-M): 

o   When we sell more goods and services to foreigners and buy fewer goods from them the AD increases.

o   Foreign incomes – when foreign economies are strong, they buy foreign goods. Therefore, X is greater.

o   Consumer tastes and preferences – when foreigners tastes and preferences are in favor of domestic goods X increases, therefore AD increases.

o   Exchange Rate – If the exchange rate of the home currency falls (rupee becomes weak) exports increase and so does the AD.

 Aggregate supply

Aggregate supply is the total supply of final goods and services that firms in an economy plan on selling in a specific period, usually a year.

Macroeconomic short run aggregate supply

In stage one which is the initial stage we assume that the economy has been in a recession. Therefore, the aggregate demand is weak and so is the price level, up to GDPu. Hence the AS curve is nearly horizontal. In stage 2, AS approaches full unemployment and the price level rises due to increased aggregate demand and higher input cost. (Most of the time an economy operates in this stretch and hence the SRAS {Short run Aggregate supply} is commonly drawn with a positive slope) if the economy grows further and reaches the nations production capacity GDPc firms are left with no resources and no matter how high the price level, the real GDP does not expand, and the SRAS is nearly vertical.

  Macroeconomic Long Run Supply Curve (LRAS)

 Shifts in SRAS

Factors affecting shifts in SRAS

1)    Input prices /cost of production

If COP (cost of production) falls the SRAS will increase

2)    Tax policy

If taxes are reduced or subsidy is given the SRAS will shift to the right

3)    Deregulation

If regulations are removed or lessened the SRAS shifts to the right

4)    Political/ environmental reasons

Wars, Natural disasters will shift the SRAS to the left

Shifts in LRAS (Long run aggregate supply)

The LRAS can shift if:

1)    New natural resources are found.

2)    Improvement in technology increases productivity.

3)    Government policy incentives

Different national policies such as unemployment doles produces the labor supply as then many prefer not to work. Similarly, if government gives tax incentives at greater investment, the LRAS will shift to the right.

Fiscal Policy

Fiscal Policy

The policy of the government as regards taxation, public spending and borrowing, to achieve various objectives of economic policy is called fiscal policy

Objectives of economic policy

1)    Economic/price stability, 

2)    Full employment

3)    Economic growth

4)    Equity 

5)    Equilibrium in the balance of payment

Expansionary fiscal policy

When an economy is deflated and suffering a recession or depression the real GDP is low, unemployment is high the equilibrium between AD and AS is located near the horizontal part of the AS.

To boost the economy the government has to boost the AD which is 

AD = C + I  + G + (X-M).

During a recession consumer demand C is low therefore investment demand I is also low. This is the cause of the recession to counter this the government reduces taxes (both direct and indirect), to boost the C and I. Besides that, government spending is increased. The net result of this moves would be an increase in AD from AD0 to AD1. Thereby, there is an increase in real GDP from GDP0 to GDP1.

Contractionary fiscal policy.

If an economy is operating at/beyond full employment and inflation is a problem government needs to contract the economy. The equilibrium between AD and AS is in the vertical section of the AS curve. To reduce the price level the government need to decrease AD.

AD = C + I  + G + (X-M).

During inflation consumer demand and investment are very high. To counter this govt will raise taxes (direct and indirect) to reduce C and I. Government spending will be reduced. The net result of these moves brings about a fall in AD

Deficits and surpluses 

A budget deficit exists when government spending is greater than government revenue in a given period of time. 

A budget surplus exists when government spending is less than government revenue in a given period of time.

Modern welfare states invariably have a deficit budget.

National Debt – this refers to the borrowing of the government during a deficit budget. It is meant to bridge the gap between expenditure and revenue. When deficits are an annual occurrence the national debt gets accumulated. It is therefore that more borrowing needs to be done to repay old debts. This is called a 

debt trap.

Financing of deficits

1)    Borrowing 

o   From the public

o   From banks

o   From other financial institution

§  E.g., IMF

o   Countries of the rest of the world

2)    Creating money

Creation of new money is done to avoid high interest rates caused by borrowing however it’s disadvantage is the risk of inflation.

Handling of Surplus during Contractionary Policy

1)    The government can pay old debts

2)    To retire bonds

3)    To retain the money

Idle surplus funds can be locked up and be stopped from recirculating

Automatic stabilizers – an automatic stabilizer is an inbuilt mechanism that increases a budget deficit during a recessionary period and increases a budget surplus during an inflationary period, without any change made by the government. These mechanisms are inbuilt into the tax system which automatically regulate and stabilise the economy. 

Progressive taxes and transfers

1)    When an economy is booming the GDP is increasing and more households and firms fall into higher tax brackets.

A strong economy reduces the need for transfer payments such as unemployment doles, old age pensions etc

The progressive tax system therefore has an automatic contractionary mechanism during a boom.

2)    When an economy is in recession and the GDP is falling  more households and firms fall into lower tax brackets 

A weak economy increases the need for transfer payments by way of welfare measures (unemployment dole, old age pension) this softens the recession and automatically leads to a bigger deficit. Therefore this tax system has an automatic inflationary mechanism. 

In the above diagram with the given level of government spending, net taxes rise or fall with GDP. They reduce the negative effects of a recession when the economy is weak and they reduce the negative effects of an inflation when the economy is unduly strong. 

Difficulties of fiscal policy

Crowding out – if the government borrows funds to fuel an expansionary fiscal policy it will have an effect on the market of loanable funds.

It decreases the supply of loanable funds to the private sector and leads to an increase in the interest rate. This reduces capital formation and investment by firms (private sector) and it thwarts national growth. When the interest rate increases firms and households are crowded out of the market of loanable funds.

When the government is fighting inflation with a contractionary fiscal policy we see the opposite of crowding out. There is a budget surplus, the government returns debts, the supply of loanable funds increases and interest rates fall. This is referred to as crowding in. 

Net export effect – if the government is borrowing during an expansionary fiscal policy, the supply of loanable funds reduces, the interest rate rises and there is a crowding out effect. Private sector or private firms are unable to invest and produce, and this has a negative effect on the foreign exchange rate 

Economic growth and productivity

Productivity and its possibilities are graphically represented through a production possibility frontier. The perimeter of the frontier shows the existing limit of production possibilities. If an economy is operating inside the frontier, there is underutilization of resources. Such is the case in developing economies or 

LDC’s (Less Developed Economies). For growth to happen in LDC’s, the point of productivity would move towards the frontier. If greater productivity is to be achieved beyond the frontier, it can happen in the following ways.

-       The quantity of economic resources should increase 

E.g., New minerals, oil and other resources may be discovered

-       The quality of the existing resources improves 

E.g., Human resources improve with better training

-       If the technology in a given economy improves

Monetary Policy 

Fractional Reserve Banking and Money Creation

Fractional reserve banking is a system in which only a fraction of the total money supply is held in reserve as currency. This is done to theoretically expand the economy. It allows the bank to keep only a portion of the consumer deposits while lending out the rest. Banks use customer deposits to create new loans. The process of fractional reserve banking expands the money supply of the economy but not without the risk which the bank may face by depositor withdrawals. 

This system increases the money supply by lending the money multiple times over and helps in economic development. The banks use customer deposits to make new loans and the reserves are held in balances at the central bank.

Money creation – an example of how the fractional reserve system can multiply bank deposits into new created money.

Illustration

If the cash reserve ratio (CRR), then the reserve ratio(RR) = cash reserve/Total deposits = 0.1

Money multiplier: - M=1/RR

If RR = 10% therefore M= 1/RR

                                        =  1/10%

                                        = 10

Central Bank

Each country has one central bank. It is the apex financial authority of the country

Functions: - 

The central bank regulates the economy, fixes interest rates and controls the supply of money. It is a bankers bank. It keeps the mandatory reserves of the commercial banks, it is a lender of the last resort to commercial banks, and it provides clearing house facility to the commercial banks in their role of money creation. It is the governments bank, it keeps governments money such as tax revenue, it gives loans to the government, it is the bank of issue, it is the governments agent and it keeps the governments reserves of gold, foreign currency etc. it controls the supply of money, e.g. during inflation it tries to reduce money supply and during recession it increases money supply. 

Expansionary monetary policy

This occurs when the monetary authority uses its procedures to stimulate the economy. It is used to treat unemployment and recession and promote economic growth. In this case, the supply of money is enhanced to increase the aggregate demand. 

Contractionary monetary policy. 

Here the money supply is restricted to fight inflation. The AD during inflation is high and efforts are made to reduce the money supply due money tools.

Quantitative measures of monetary policy / Quantitative tools

Bank rate  - this is the rate charged by the central bank to the commercial banks for short term loans. This is discounted and hence known as discount rate. During inflation, bank rate is raised. This reflects on the interest rate of commercial banks, increasing it. Due to a high interest rate, deposits increase and loans decrease thereby reducing money supply in circulation. This reduces AD and helps bring prices down. This is termed as contractionary monetary policy.

During recession it is imperative in this case to increase AD. Bank rate is decreased this reflects on interest rate of commercial banks, decreasing it. Due to low interest rates, deposits decrease and loans increase, thereby increasing money supply in circulation. This increases AD and brings up prices. This is termed expansionary monetary policy. 

Credit Reserve Ratio(CRR): The central bank sets a minimum amount of reserve requirement to be held by commercial banks. The minimum reserve is determined by the central bank and no bank can keep less than this. This safeguards the deposits of the customers in commercial banks.

During inflation the central bank raises CRR so that less money is given out by way of loans. This reduces the amount of money in circulation this reduces the AD

During recession the central bank reduces CRR so that more money is given out by way of loans. This increases the amount of money in circulation and thus increases the AD.

Open Market Operations : This is an activity by the central bank wherein it buys and sells securities or treasury bills on the open market in order to regulate the supply of money.

During inflation, the central bank will sell securities or treasury bills on the open market in order to regulate the supply of money. This will reduce AD and help lower prices.

During recession, the central bank will buy back securities on the open market and thereby increase the supply of money. This will increase AD and help increase prices.

Quantitative measures/Tools of monetary policy : - these include customer credit and margin requirements.

Coordination of Monetary and Fiscal Policy / A Monetary Fiscal Mix

During Inflation

Microeconomics

Demand – Is the consumers desire as well as their willingness to pay a price for certain goods and services at a given period of time

Law of demand – all other things being constant, when the price of a good rises, the quantity demanded for those good decreases. Quantity demanded and price have an inverse relationship. 

Demand Curve

Note: - Demand curve is always sloping downwards from left to right.

Determinants of demand (Non price factors affecting demand)

-       Tastes and preferences/Trends and Fashion

-       Income

o   Normal Goods: if income rises, demand for normal goods will rise

o   Inferior goods: if income rises demand for inferior goods will fall

-       Price of substitute goods

E.g., Tea and coffee are substitutes. Price of tea has been fixed for a long time but there is still a fall in the demand for tea due to the decrease in the price of coffee since consumers shifted to consume coffee.

-       Price of complimentary goods

Complimentary goods are jointly consumed e.g., bread and butter. The demand for butter falls if price of bread increases.

-       Future expectations of price

If there is an expectation that price will rise in the future, qty demanded will rise today.

-       Number of buyers in the market/ population

Demand curve shifts when there are changes in the determinants of demand.

Rightward shift = Increase in Demand

Leftward Shift = Decrease in Demand

Market forces – demand and supply

Supply

Law of supply – if price increases, the qty supplied increases; vice versa. Price and supply have a positive correlation. 

Note: the supply curve is sloping upwards from left to right.

Determinants of supply

-       Cost of production: if the cost of production increases, then the supplier will be demotivated to produce/supply more as the profit reduces for the supplier. Therefore, the supply curve will shift to the left. 

-       Technology and productivity: with technological improvement the productivity increases and the cost per unit might also fall. Hence profit will increase, and the supplier would like to sell more. Therefore, the supply curve will shift right.

-       Taxes: tax is an amount charged by the government when a particular product is sold/produced. When the tax increases. The profits reduce for the supplier due to which the supply will decrease, and the supply curve will shift to the left.

-       Subsidy: subsidy is an amount of aid or gift given by the government to the suppliers to help increase the productivity or to boost a particular sector of the economy. Subsidy reduces the cost of production, which motivates the supplier to supply more, hence the supply curve shifts to the right. 

-       Price expectations: if the supplier expects the price to rise in the near future, the qty supplied today would fall, vice versa.

-       Number of suppliers: when more suppliers enter a market, we expect the supply curve to shift to the right. For e.g. During the strawberry season, many farmers try to grow strawberries in their free farmlands and hence supply of strawberries increases.

Market Price

-        Over Supply – Supply>Demand – Price will Decrease

-       Shortage – Demand>Supply – Price will Increase 

Market equilibrium is the point at which demand, and supply curves meet. It is at that point at which price is set and that amount of a good is supplied and demanded. It is the point at which supply and demand of a good are equal at a fixed price level.

Welfare Analysis

Society is typically made up by consumers and producers. Hence in any particular free market when the demand meets the supply there is equilibrium. At equilibrium there is no wastage of resources, and the total welfare is maximized, which means all the producers and the consumers are happy with the situation.  

Free market – no government intervention – no taxes, no minimum wage etc.

Total Welfare/Total Surplus – It is the sum of consumer surplus and producer’s surplus.

Consumer Surplus – the situation in which the consumer benefits by getting the desired quantity of goods or services at the expected price or even lower. E.g., the consumer is willing to pay 5 dollars for an apple, but he gets it at 3 dollars then the consumers surplus is 2 dollars 

Producer Surplus – the situation in which the producer benefits by selling the desired quantity of goods or services at his expected price or even higher. E.g., the producer is willing to sell an apple for 5 dollars, but he gets 8 dollars then the producer’s surplus is 3 dollars.

Consumers choice

Utility

It is the benefit or the satisfaction that the consumers experience by consuming goods and service.

Total Utility

It is the total amount of benefit or satisfaction received from the consumption of certain amount of a good or services.

Marginal Utility 

It is the benefit or satisfaction received by consuming one extra unit of a particular good or service.

e.g., If a person goes from 0 to 1 glass of water, his happiness increases from 0 to 10 points. Similarly, when he drinks 1 more glass of water the additional utility is 8 points.

Diminishing Marginal Utility: in the table above, we can see a relationship between total utility and marginal utility. We can see that total utility increases but at a slower rate, and marginal utility keeps falling. Hence the law of diminishing marginal utility tells us that in a given period of time the marginal utility by consuming 1 extra unit falls (total utility increases at a decreasing rate).

Constrained Utility Maximization

With a fixed daily income and a price attached to consuming each additional unit is a constraint to our consumption pattern. So, we must ask aur self if one additional bottle of water costs me $1, then is it with the additional utility of 8 points. If the answer is yes, then you will consume the additional water bottle. If no, then do not consume it.

Consumers are constrained by two things, price, and fixed income. One will keep consuming apples until a point when the utility of the last apple consumed is equal to the price I pay for that apple. 

Most consumers allocate limited income between many goods and services, each with a price that must be payed.

Conclusion

In this project, I conducted a comprehensive examination of the intricate relationship between economics and finance. The analysis encompassed macroeconomic theories, including the foundational contributions of John Maynard Keynes, emphasizing the essential role of government intervention in economic cycles. Key concepts such as the consumption function, propensity to consume, and the multiplier effect were explored, shedding light on their impact on aggregate demand. Beyond macroeconomics, the project delved into the complexities of aggregate demand and supply, scrutinizing their determinants and the factors influencing their shifts. A detailed exploration of fiscal policy, covering both expansionary and contractionary measures, provided insights into the government's pivotal role in shaping economic outcomes, including the management of budget deficits, surpluses, and the national debt. 

Shifting focus to monetary policy, the project elucidated fractional reserve banking, money creation, and the quantitative tools employed by central banks. The coordination of monetary and fiscal policies, known as a monetary-fiscal mix, was analyzed in the context of effectively managing inflationary and recessionary gaps. Within the microeconomic realm, fundamental principles such as the law of demand and supply, market equilibrium, and welfare analysis were explored. The study of utility maximization theories deepened our understanding of individual consumer choices within the broader economic landscape, especially when faced with constrained decision-making due to limited resources.

Moreover, this project took a holistic approach by addressing critical dimensions of risk management and corporate governance. By emphasizing their significance, it underscored the pivotal role these elements play in maintaining financial stability and fostering ethical business practices. In synthesizing these diverse elements, this research contributes not only to a nuanced understanding of economic systems and policies but also highlights the imperative of prudent financial management and responsible corporate governance in navigating the complexities of the contemporary economic landscape.