Magazine article National Forum

What's It All about? (Economics and Finance)

Magazine article National Forum

What's It All about? (Economics and Finance)

Article excerpt

Much of what we know about business comes from our daily newspaper, and it is too often unrelated to our knowledge of economics learned years ago in that introductory course in college. Over the years, I have come to think of the two fields of economics and finance (my specialty piece of the business pie) as interrelated and inseparable. I thought it would be nice to present a brief but broad overview of the two areas, their parallels, and the "big picture" of how finance and economics fit together.

Economics

economics is most simply about resource allocation - how to make the most of what we have. The overall framework is the market (or the nation, when we aggregate as macroeconomists), and the "desired outcome" within that framework is market equilibrium, or more broadly, economic efficiency. The measurable components of the market are price and quantity, which are affected by the actions of two classes of participants - one representing supply, the other demand. Firms are assumed to be maximizing profit, and households or consumers are presumed to be maximizing utility (while we are not quite sure what utility is, we claim to know it when we feel it). Two complex elements that make the subject sometimes intractable and often interesting are dynamics and uncertainty (in other words, time and risk). Never is life as simple, certain, or stationary as it is in Econ 101.

Macroeconomics adds other key ingredients, such as inflation, to the economic brew. Another major area, important to the overall standard-of-living issue, is that of economic growth. The economy also uncaringly provides us with a host of economic signals and statistics, which we humans very caringly collect and analyze; this activity is the least sexy, but perhaps most important, of economic functions. Finance

What does all this have to do with finance, which is all about stocks and options, mutual funds, and what to put in my 401k plan? Initially, finance is about much more than this and is closely related in many ways to economics. The overall framework for finance is value, and the "desired outcome" within this framework is value maximization. The two main classes of actors -- corporations (more generally, firms) and other users of capital, and households and other providers of capital - are supplemented by a host of intermediaries, securities, and markets.

Finance's first function, reallocating the unbalanced capital, comes directly from consumers and firms solving their respective economic-maximization (utility and profit) problems. In a dynamic, uncertain world, this solution results in huge capital imbalances that must be efficiently moved, smoothed, and filled, for the economy to operate effectively. The consumer's solution to the consumption-savings tradeoff (our fancy way of talking about saving for retirement) may result in a large, growing pile of cash that we do not need until we are seventy. A value-maximizing firm may desire to capture more profits through expansion but cannot afford to fund the growth. The role of finance is to bring these two actors together, allowing each a more effective solution to their economic problem.

Investment and Finance Decisions In the business world, corporations put finance into practice by adding value through making good investment decisions, and likewise through making good financing decisions. On the investment side, firms take a stock of capital and convert it into an uncertain flow of goods and services (and resulting cash flows) over time. This process is resource allocation in action. In doing so, firms make use of most of the components of the economic paradigm. …

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