Factors are Important for Efficient Decision Making

Why are the economic analysis and in-depth understanding of economic factors is important for effective decision making in capital market?

Investors always try to formulate best possible portfolio by investing in the capital market for the purpose of getting capital gain and dividend (cash or stock). It is not an easy task to choose best investment alternatives because the proper analysis is required. Only a specialized person would be able to analyze the market and identify the potentials. Many people think that only financial analysis is enough to make an investment but in a real sense, not only financial analysis but also economic analysis is required.

Factors are Important for Efficient Decision Making

In case of financial analysis, we only consider the company and industrial outcome through fundamental and technical analysis. But whenever we go for analysis by considering economics we have to analyze the macroeconomic factors that may have an impact on the capital market. An economist or any other professionals those have knowledge of economics can do this analysis on behalf of investors. But investors also have to have basic ideas of how economic factors can influence the price of the investment securities.

Factors are Important for Efficient Decision MakingFor efficient decision making in the capital market following economic factors should be considered

  • Inflation
  • Market Interest Rate
  • Economic Recession
  • Employment Rate

Effect of Inflation in the Capital Market

In an inflationary economy, investors have less money to invest because investors have to spend more money on their consumption. As because there is a less demand for the stock in the capital market, the price should be lower; we know that lower the demand lower the price. In the other sense in case of a company, for inflation, the production cost of the company is higher than the previous. So company’s income will be lower that stimulate the price of the stock. We know that the stock which provides more dividends to the stockholders, that stock should price higher than the other company which provides lower dividends.

Effect of Market Interest Rate in the Capital Market

If the market interest rate increases then an investor will prefer fixed income securities rather lower earning risky securities. Suppose government bond providing 10% of interest then this bond will get more preference compared with risky investment. On the other hand, if the interest rate is lower in the market then an investor will borrow the money at lower interest and invest in the capital market.

Economic Recession

Because of economic recession, there may have a positive impact on the capital market. Normally at the beginning of recession investor loose but there is always an expectation that in near future there will be positive movement in the stock price in the market, so investor prefers to invest when there is a recession. This will happened only if there is the strong form of efficiency exists in the market.

On the other hand, if there is an economic boom situation exists then there may have a possibility of declining market price movement.

Employment Rate

With the increase of a number of employees in a country per capita, income will also increase. For this people will have extra money after consumption. If people capital market is performing well then an investor will be interested to invest their surplus amount of money. So higher the employment higher the earning and it does increase the investment in the capital market.

Political Condition of a Country

Political condition is one of the main factors which have a huge impact on the overall economy and the capital market. People believe that a positive economic condition is required to maintain a stable capital market. Several financial decisions taken by the government over time to time, so it is also important to know how much preference a capital market gets from the government.

In a capital market investors basically, invest in long-term security so the investor must consider all probable aspects and economic factors before making an investment. A choice of investment in capital market can lead to a huge capital loss, so proper analysis has to done by the professional and select best opportunities.

Finally, one thing is that an investor should consider economic factors which have an impact on the capital market and proper financial and economic analysis must be done before investing in the capital market.

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Determination of Consumption Multiplier

Determination of Consumption Multiplier

aggregate demand function

Marginal Propensity to Consume is the rate of change in consumption for the change in income.

determination of consumption multiplier

In macroeconomics consumption multiplier (CM) is a very old concept but now this is neglected due to more precise National Income Multiplier (NIM). Consumption multiplier helps us to understand other multipliers. It is very simple but it helps us to calculate National Income Multiplier and many other important things in economics.

If autonomous consumption increases when the real gross domestic product (Y) will increase by the amount equal to the increase in autonomous consumption time’s consumption multiplier.

Since MPC is a fraction of small c (0 < c < 1), and consumption multiplier is greater than 1. In other words, if autonomous consumption is increased by $1000 then Y will increase by more than $1000. Smaller MPC will produce a small amount of Y and larger MPC will produce a larger amount of Y.

Similarly, a larger value of autonomous consumption will produce the more real gross domestic product (rGDP of Y) and a small value of autonomous consumption will produce a small amount of Y.

Thus it is important to increase both autonomous consumption and marginal propensity to consume.

consumption multiplier change in autonomous consumption

Initially, the equilibrium point is “a” with autonomous consumption of “C bar zero” and real GDP of “Y zero”. If “C bar” increases then the consumption and real GDP will increase, so the curve will shift parallel above the initial line and we get a new equilibrium point “e”. On the other hand if “C bar” decreases then the curve will shift downward parallel to the original line.

Here the change in “Y” is “a to d” but “C” is changed by only “b to e” so it’s clear that (ad > be) “ad” is greater than “be”

consumption multiplier change in merginal propensity to consume

If there is a change in marginal propensity to consume (small c) then there will be the change in real GDP and the curve will shift, for increase in small c (marginal propensity to consume) curve will shift above the original line but not parallel shift.

Both these cases if there is a change in “C bar” and small “c” real GDP “Y” increase which is good for the economy. So the government should try to increase these.

Circular Flow of Goods and Services

Do you know what is the circular flow of goods and services? If you do not know then this article may help you to understand it clearly.

Different participants involve with the exchange process in an economy and each of the participants is interdependent with one another. There are four major participants in an economy, these are:

  • Business sector
  • Households sector
  • Government sector and
  • Foreigners or the rest of the world

These four groups of participants interact with one another in factor markets (resource markets) and product markets, which ensures the circular flow of goods and services to the economy. This has been shown in the diagram of the circular flow of goods and services with the foreign sector.

Circular Flow of Goods and Services

Circular Flow of Goods and Services

Circular Flow of Goods and Services

Business sector

Businesses incur costs to collect resources from the factor market (resource markets). So resource markets get money from the businesses and in return resource market supply required resources to the business. These resources are used to produce goods and services to deliver to the economy.

On the other hand, a business sells its goods and services to the product market, in return business generate revenue from the product market.

Household Sector

Households provide their labor, land, capital and other human skills to the resource market and in return, they get money income (rent, wage, interest, profit etc) from the resource market.

Households provide goods and services to the product market and in return participants of product, market collect consumption expenditures of the households.

Government Sector

Government sector stay middle in the circular flow of goods and service process, here government collect net taxes (sells and income) from both business and households. As a responsible government provides required goods and services to the business and households. The government also collect resources from the resource market and goods and services from the product markets for this government have to incur expenditures which are got by the resource market participants.

Rest of the World

This application for an open economy where export and import of goods and services are involved. Through export, product markets will supply product and services for profit and for import of goods and services for product market we have to incur expenditures. With export foreign expenditures are involved and with import domestic expenditures are involved.

These all participants exchange their required resources with each other to ensure proper utilization of resources and fluent flow of goods and services.