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Chapter 5: Economic Analysis

Chapter 5: Economic Analysis – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book 

What are the Basic Principles of Microeconomics

Microeconomics is the study of the behaviour of individuals and their decisions regarding consumption and purchases based on current prices. It investigates how these decisions signal to the economy about where to direct productive activities. Microeconomics believes that consumer demand drives the prices and production levels of goods and services in an economy. It focuses on decision-making drivers and how individual choices impact the overall supply, demand, and pricing of specific goods and services. Additionally, it encompasses the “theory of the firm,” analysing how firms strategize to maximise profits, including decisions about inputs, outputs, prices, production levels, and managing profits and losses.

Topic Pointers:

  1. Study of Individual Behavior: Microeconomics examines how individuals decide what to buy and consume, influenced by current prices.
  2. Consumer Demand as a Driver: Emphasises that consumer demand primarily determines the prices and production levels in an economy.
  3. Focus on Decision Making: Investigates the factors influencing individuals’ choices and how these choices affect supply, demand, and prices.
  4. Theory of the Firm: Extends to firms, studying their strategies for profit maximisation and decision-making regarding production and pricing.
  5. Price Determination: Helps understand how prices for goods and services are set in an economy based on individual and firm behaviour.
  6. Distribution of Goods and Services: Looks at how goods and services are distributed among participants in an economy.
  7. Understanding Free Market Economy: Microeconomics is essential for comprehending the workings of a free market economy.
  8. Economic Distribution Analysis: Analyses how goods and services are allocated among various participants in the economy.

Example: Consider a situation where the price of a popular smartphone decreases. Microeconomics would study how this price change influences consumer choices (more people might buy the phone), affects the supply (manufacturers might produce more phones), and impacts the overall market for smartphones. It would also examine how the smartphone company decides on its production levels and pricing strategy in response to consumer demand.

What are the Basic Principles of Macroeconomics

Macroeconomics is the branch of economics that focuses on the economy as a whole, rather than individual households or firms (as in microeconomics). It concentrates on broad economic factors such as unemployment rates, gross domestic product (GDP), overall price levels, inflation, savings and investment rates. These factors are often influenced significantly by public policies, primarily shaped by the government’s fiscal policy and the central bank’s monetary policy. The discipline was greatly influenced by the work of John Maynard Keynes, particularly his book “General Theory of Employment, Interest and Money.”

Topic Pointers:

  1. Study of the Economy as a Whole: Macroeconomics looks at the “big picture” of the economy, different from microeconomics’ focus on individual entities.
  2. Key Economic Factors: Focuses on aggregate supply and demand, encompassing variables like unemployment, GDP, inflation, savings, and investment rates.
  3. Influence of Public Policies: Highlights how changes in government and central bank policies can significantly affect these macroeconomic factors.
  4. Fiscal and Monetary Policies: Fiscal policy (government decisions) and monetary policy (central bank actions) are major influencers in macroeconomic activity.
  5. Keynesian Contribution: Emphasises the revolutionary impact of John Maynard Keynes’s work on macroeconomic analysis.
  6. Economic State Understanding: Helps in understanding the overall condition of an economy, including production, consumption, price levels, growth, and quality of life.
  7. Income, Savings, and Investment Drivers: Aids in understanding factors driving income, savings, investments, and employment in an economy.
  8. Policy Formulation Aid: Assists in developing economic policies aimed at long-term growth and stability.
  9. International Trade Analysis: Facilitates understanding of international trade aspects like exports, imports, balance of payments, and exchange rate dynamics.
  10. Global Economic Interlinkages: Provides insights into how different economies are interconnected and influence each other.

Example: Consider the impact of a government stimulus package on the national economy. Macroeconomics would analyse how this policy affects overall economic factors like increasing GDP, changing unemployment rates, or influencing inflation levels. It would also look at the broader effects on savings and investment rates across the economy.

Introduction to Various Macroeconomic Variables

In macroeconomics, various variables play a role in shaping the economic stability and growth of a country. Policymakers, such as governments and central bankers, aim to achieve low unemployment rates, price stability, and steady economic growth. However, controlling these variables can be challenging, as economies naturally experience cycles of booms and busts. The effectiveness of policy actions, like adjusting interest rates, can be influenced by uncontrollable factors, leading to varying outcomes in different economic conditions.

Topic Pointers:

  1. Economic Stability and Growth Goals: Governments and central banks aim to promote economic stability and growth through policy decisions.
  2. Challenges in Policy Implementation: Despite good intentions, achieving desired outcomes can be difficult due to the complexity of economic variables.
  3. Key Macroeconomic Goals: These include maintaining low unemployment rates, ensuring price stability with low inflation, and fostering steady growth in economic outputs.
  4. Impact of Uncontrollable Factors: Various uncontrollable variables can affect the success of policy measures, such as interest rate adjustments.
  5. Variability in Economic Conditions: Different countries may adopt different strategies based on their specific economic conditions to achieve common macroeconomic goals.
  6. Example of Policy Limitations: The Reserve Bank of India’s (RBI) efforts to control inflation through interest rate hikes in 2011-2013 were less effective due to persistently high food prices.
  7. Economic Cycles: Recognition that economies naturally go through cycles of expansion (booms) and contraction (busts).
  8. Need for Detailed Study: For an in-depth understanding of macroeconomic variables, consultation of specialised books and literature is recommended, as brief definitions provide only a basic overview.

Example: The example of RBI’s intervention in 2011-2013 to control inflation by raising interest rates illustrates the complexity of macroeconomic variables. Despite the standard policy action of increasing rates to reduce inflation, the continued high prices of food items led to the policy not achieving its intended result. This situation highlights the challenges policymakers face in controlling macroeconomic variables, as external factors can significantly impact the effectiveness of their strategies.

What is National Income

National income of an economy is defined as the total value of all final goods and services produced within a country over a specific period of time. It is calculated through measures such as gross domestic product (GDP) and gross national product (GNP).

Topic Pointers:

  1. National income is measured through three methods:
    • Product method: Calculates national income by finding the total value of all final goods and services produced.
    • Income method: Sums up all incomes earned by factors of production within the economy.
    • Expenditure method: Sums up all expenditures made on final goods and services in the economy.
  2. Computation of national income involves large-scale data collection on production, income, and spending across all sectors of the economy.
  3. Key measures are GDP which measures the value of all final goods and services produced within a country, and GNP which measures the value of all final goods and services produced by domestically owned factors of production irrespective of location.

Example: If the GDP of a country in 2022 was $2 trillion, then the national income of that country for 2022 is $2 trillion. This means the total value of all final goods and services produced within that country in 2022 was $2 trillion.

What are Product Method for National Income

The product method measures national income by calculating the aggregate monetary value of all final goods and services produced in the different sectors of the economy like agriculture, industry, and services over a specific time period.

Topic Pointers:

  1. Final goods refer to goods that reach the end consumers rather than being used in further production processes as intermediate goods.
  2. The product method sums up the money value of all final goods and services produced sector-wise.
  3. The sectors included are – agriculture, industry, and services. Output of each sector is calculated separately.
  4. Intermediate goods which are used up in making final goods are excluded from output calculation to avoid double counting.
  5. The national income is then estimated by aggregating the final output across the three sectors.

Example: If the final output of agriculture sector was $500 billion, industry sector was $900 billion and services sector was $600 billion in 2022. Then the national income by product method is $500 billion + $900 billion + $600 billion = $2,000 billion for the year 2022.

Income Method for National Income

The income method measures national income as the total factor income earned by all individuals in the economy over a specific time period. As per Robert Kiyosaki, the working population can be categorised into – Employees, Professionals, Entrepreneurs, and Investors.

Topic Pointers:

  1. Employees earn wages and salaries as factor payments for their labour.
  2. Professionals like doctors, lawyers etc. earn income by selling their services.
  3. Entrepreneurs earn profits, including undistributed corporate profits.
  4. Investors earn interests, rents, and dividends as return for providing capital.
  5. National income by income method sums up all the above factor payments.
  6. It includes: Wages & Salaries + Rents & Interests + Profits + Dividends

Example: If total wages and salaries paid in 2022 was $500 billion, total rents and interests earned was $600 billion, total profits and dividends was $900 billion. Then, national income by income method is $500 billion + $600 billion + $900 billion = $2,000 billion for 2022.

What are Expenditure Method for National Income

The expenditure method sums up all expenditures made in the economy on final goods and services over a period by the private and public sectors along with net exports (exports – imports) to estimate the national income.

Topic Pointers:

  1. Expenditures are made by:
    • Individuals on consumption goods and services
    • Businesses on investments
    • Government on its expenditures
    • Foreign buyers on exports
  2. Imports by domestic residents are deducted to avoid double counting.
  3. The main components are:
    • Private Final Consumption Expenditure
    • Government Final Consumption Expenditure
    • Gross Fixed Capital Formation (Investments)
    • Change in Stocks
    • Net Exports (Exports – Imports)
  4. National Income = C + I + G + (XM) Where, C = Private Consumption Expenditure I = Gross Domestic Investment G = Government Spending X = Exports M = Imports

Example: If in 2022, C = $700 billion, I = $500 billion, G = $300 billion, X = $250 billion, M = $100 billion Then, National Income = $700 billion + $500 billion + $300 billion + ($250 billion – $100 billion) = $1,650 billion

What are Savings and Investments

Savings refer to income remaining after meeting expenses. There are three categories of savings – personal savings, corporate savings (undistributed profits), and public savings (government budget surplus). Sum of these comprises the national savings. Savings are channelized into investments – which are outlays made by businesses and governments in productive activities to generate future earnings.

Topic Pointers:

  1. Savings arise from three sectors:
    • Individuals (personal savings)
    • Private corporations (corporate savings / undistributed profits)
    • Government (budget surplus)
  2. Savings provide loanable funds to finance investments through financial instruments.
  3. The government and central bank work to facilitate smooth conversion of savings into investments through efficient financial markets and instruments.
  4. Higher levels of savings allow more investments and capital formation.
  5. Higher investments enable businesses to expand capacity and boost future productive capacity and growth.

Example: In 2022, if personal savings is $500 billion, corporate undistributed profit is $350 billion, and government has a budget surplus of $100 billion, then the national savings is $500 billion + $350 billion + $100 billion = $950 billion, which becomes available for investments in the economy.

What are Inflation (Consumer/Wholesale Price Indices) and Interest Rates

General increase in price levels of goods and services in an economy leading to erosion of purchasing power of money over time. Measured by Wholesale Price Index (WPI) at wholesale level and Consumer Price Index (CPI) at retail level.

Topic Pointers:

  1. Inflation reduces purchasing power of money over time e.g. Rs. 1000 will buy fewer goods/services over a year as prices increase.
  2. Caused by:
    • Demand-pull: Excess demand over supply
    • Cost-push: Increase in input costs
  3. Measured by WPI (wholesale prices) and CPI (retail prices) using a defined basket of goods.
  4. Higher inflation demands higher interest rates to motivate saving.
  5. Higher rates reduce investments and slow down the economy.
  6. Impacts sectors like real estate and auto more as purchases often involve loans.
  7. Reduces discretionary spending power of people.

Example: If inflation is 5% per year, Rs. 1000 today will buy goods/services worth only Rs. 950 next year as prices increase 5%. So purchasing power is reduced.

What is Unemployment Rate

Unemployment rate refers to the eligible and willing to work unemployed population of the country expressed as a percentage.

Topic Pointers:

  1. Unemployment rate rises during economic slowdowns as fewer jobs are available and falls during economic expansions as more jobs are created from increased production.
  2. Higher employment leads to more income, enabling increased consumer spending, which contributes to economic growth potential.
  3. Lower employment rates during tough economic times contribute to high unemployment as consumer spending drops.
  4. No formulas, data, or examples were provided in the original definition to include.

The analysis covers the key points from the definition in a study note format with concise explanations for learning the topic quickly. Let me know if you need any clarification or have additional requirements for the analysis.

What is Foreign Capital Flows

Foreign capital flows into a country can be either Foreign Direct Investments (FDI) where investors participate in decision making or Foreign Portfolio Investments (FPI) which is investment in financial markets without participation in management.

Topic Pointers:

  1. FDI involves active participation in business management decisions by foreign investors whereas FPI is passive investment without involvement in operations.
  2. There are limits imposed on the ownership stake FPIs can acquire in Indian companies.
  3. FDI provides long-term stable capital and has additional benefits like job creation, new technologies, and managerial skills.
  4. FPIs involve shorter-term speculative investments and the capital can be pulled out quickly, creating systemic risk.
  5. As FPIs don’t involve active management of companies, they don’t directly provide the ancillary benefits of FDI.

What are the Fiscal Policies and their Impact on Economy

Fiscal policy refers to government revenue (taxes) and spending measures that influence aggregate demand, supply, savings, investment, and overall economic activity.

Topic Pointers:

    1. Fiscal deficit is the budgeted excess of government expenditure over revenue, expressed as % of GDP. Financed through borrowings.
    2. High fiscal deficit → higher interest rates → harder for companies to borrow → lower growth.
    3. Current account is the difference between foreign receipts (exports etc) and payments (imports etc). Surplus if receipts > payments.
    4. High fiscal deficit as % of GDP signals lack of trade competitiveness or excessive consumption.
  • High current account deficit (CAD) weakens currency. Makes imports costly, capital goods expensive. Hurts productivity and creditworthiness.
    1. Depreciating currency makes exports more competitive, helps address CAD.
    2. Foreign investment inflows can offset CAD, preventing currency devaluation.
    3. Government spending funded by: tax revenue, borrowing, sale of assets.
    4. Types of fiscal policy:
  • Neutral – income = expenditure
  • Expansionary – spending > income. Undertaken in recessions.
  • Contractionary – spending < income. Repay debts.

What are the Monetary Policies and their Impact on Economy

Monetary policy refers to central bank policies dealing with money supply, interest rates, and inflation to promote economic growth and price stability.

Topic Pointers:

  1. Expansionary policy increases money supply and lowers interest rates to stimulate the economy.
  2. Contractionary policy reduces money supply or slows its growth and raises interest rates to cool an overheating economy.
  3. Central bank controls money supply and rates using policy tools like:
    • Repo rate
    • Reverse repo rate
    • Cash reserve ratio
    • Statutory liquidity ratio
  4. No standard formula for addressing economic issues due to differences in GDP composition, growth rates, demographics, etc. across economies.
  5. Policy actions have unintended consequences e.g. stimulating a stagnant economy risks higher inflation.
  6. Cooling a heated economy by reducing money supply or spending may slow long-term growth and increase unemployment.

What is International Trade, Exchange Rate, and Trade Deficit

International trade refers to total trade a country conducts with all other countries. Balance of payments covers current account (trade in goods & services) and capital account (financial flows).

Topic Pointers:

  1. Current account – Imports & exports. Deficit if imports > exports, surplus if exports > imports.
  2. Capital account – Inflows & outflows like FDI, loans etc. Surplus if inflows > outflows, deficit otherwise.
  3. Overall balance from current + capital account. Continuous current account deficit needs capital account surplus or drawing down reserves. Risks losing market confidence in currency.
  4. Exchange rate – Value of one currency vs another (e.g., $1 = Rs 65). Currency values depend on relative economic strength.
  5. Trade deficit – Negative balance (more imports than exports) on trade in goods & services. Financed through capital account surplus or reserve drawdown.

What is Globalisation – Positives and Negatives

Globalisation refers to the ability of individuals and firms to produce goods and services anywhere in the world and sell them across countries. It leads to optimal allocation of resources like labour and capital to places where they are most productive. Many economies have embraced globalisation by opening up trade and capital flows. However, globalisation has its share of positives and negatives.

Topic Pointers:

Positives of Globalization:

  1. Efficient allocation of resources: Resources like labor and capital can flow to countries where they are most productive, leading to gains for both source and destination countries.
  2. Learning and growth for developing countries: Integration with developed countries provides opportunities for developing countries to access new technologies and innovation.
  3. Consumer benefits: Global competition encourages innovation and keeps prices of goods and services in check through competitive forces. It also provides greater product choices.

Negatives of Globalization:

  1. Inequality: Globalisation has increased inequality between rich and poor income groups and between developed and developing countries. The rich tend to gain proportionately more from trade and investment opportunities.
  2. Competition and job losses: Jobs tend to flow to more competitive countries leading to structural shifts and concentrated job losses in particular sectors or regions of countries.
  3. Financial contagion risks: Integrated economies increase cross-border spill-over risks, like the 2008 global financial crisis which spread rapidly across borders.

What is the Role of Economic Analysis in Fundamental Analysis

Fundamental analysis aims to assess a company’s intrinsic value and future growth prospects. Economic analysis is crucial to understand the broader environment affecting a company’s business. Key economic indicators like GDP growth, monetary policy, fiscal policy, interest rates, and inflation offer insights into economic growth prospects and government policy stance. These impact industries and companies.

Topic Pointers:

  1. GDP growth rate: Indicates overall economic expansion or contraction. Useful to assess demand trends for companies.
  2. Monetary policy: Interest rates and liquidity measures by central banks. Accommodative policy supports growth while tightening curbs demand.
  3. Fiscal policy: Government taxation, spending, and deficit levels. Expansionary policy aids growth but increases risks of high inflation and deficits.
  4. Interest rates: Cost of capital in an economy. Low rates support business investment and access to cheaper capital.
  5. Inflation: Rising prices indicate overheating economy and risks policy tightening. Moderate inflation encourages consumption.

Example: If an analyst is studying an automobile company, tracking metrics like GDP, interest rates, and inflation will help assess future consumer demand and input costs trends for the sector. This feeds into the overall business outlook.

What is Secular trends

Secular trends refer to long-term gradual shifts or changes over time, often caused by technological, cultural, demographic, or consumer preference disruptions. They can lead to inflections in the business life cycles of industries.

Topic Pointers:

  • Secular trends are long-term, gradual changes rather than seasonal or cyclical changes. They persist over many years or decades.
  • They are often caused by disruptive forces that bring about changes in technology, culture, demographics, or consumer preferences.
  • Examples of secular trends include the digitization of office spaces and the increased use of digital products and reduced paper consumption over time.
  • Secular trends can lead to turning points of inflections in the business life cycles of established industries as new technologies and offerings emerge.
  • They require businesses and industries to adapt to the changing external landscape or environment rather than rely on historical performance.

Example: With the secular trend of digitalization, paper and printing industries have seen falling demand over the last two decades. At the same time, technology companies providing digital solutions and cloud computing have benefited.

What is Cyclical Trends

Cyclical trends refer to short-term booms and busts in economic activity that occur in wave-like patterns over years. They are caused by business cycles of expansion and contraction in an economy. Cyclical trends get reversed periodically unlike long-term secular trends.

Topic Pointers:

  • Economic cycles:
    • Expansion: High growth, confidence, and borrowing, capacity expansion.
    • Slowdown: Lower but rising growth and consumption.
    • Recession: Falling demand, incomes and production, job losses.
    • Recovery: Easing policies boost growth.
  • Commodity cycles:
    • Boom and bust cycles in commodity prices.
    • Driven by demand-supply mismatches.
    • Can happen independently of economic cycles.
  • Inventory cycles:
    • Short term fluctuations caused by inventory adjustments.
    • Oversupply reduces prices, then eventual restocking increases prices.

Example: In April 2020, crude oil prices crashed to $20/barrel due to excess inventories during the pandemic. By June, as inventories stabilised, prices recovered to $40/barrel despite ongoing economic weakness.

What is Seasonal Trends

Seasonal trends refer to predictable short-term fluctuations in production and consumption of goods and services owing to seasonal factors. For example, agricultural output varies based on sowing and harvesting cycles. Analysts use seasonally adjusted data or year-over-year growth rates to smooth out seasonal effects when studying economic trends.

Topic Pointers:

  • Cause: Seasonal factors like weather, holidays, customs that impact production or consumption in predictable way year after year.
  • Impact: Temporary booms and busts around the same time periods each year. For example, peak retail sales around festivals, surge in tourism during suitable weather.
  • Quantification: Economists use seasonally adjusted metrics to smooth seasonal effects. Analysts also use year-over-year growth rates to compare against the same period in the previous year.
  • Importance: Seasonal fluctuations need to be accounted for to accurately understand underlying trends in production, consumption, prices, employment, etc.

Example: Agricultural GDP in India sees a spike during harvest season in second quarter, leading to higher overall GDP growth compared to other quarters. Using seasonally adjusted GDP provides a smoother trend.

What are the Sources of Information for Economic Analysis

Key sources for economic data and analysis include government websites, regulators’ reports, published research reports, and the Economic Survey.

Topic Pointers:

  • Government Websites:
  • Provide macroeconomic indicators data E.g. Ministry of Statistics site
  • Regulators:
  • RBI, SEBI provide data on monetary policy, financial markets E.g. RBI Bulletin
  • Published Research Reports:
  • Banks, rating agencies, brokerages publish research on economies, sectors Provide forecasts, impact assessments etc.
  • Economic Survey:
  • Annual report of India’s economic development Analyses macro environment, fiscal policy Provides outlook and reform roadmap

Example: An analyst can refer to RBI for liquidity data, brokerage reports for GDP growth forecasts, and Economic Survey for the government’s reform priorities.

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