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Definitions of Economics
One of the earliest and most famous definitions of economics was that of Thomas Carlyle, who in the early 19th century termed it the "dismal science." According to a much-repeated (but erroneous) story, what Carlyle had noticed was the anti-utopian implications of economics. Many utopians, people who believe that a society of abundance without conflict is possible, believe that good results come from good motives and good motives lead to good results. Economists have always disputed this, and it was to the forceful statement of this disagreement by early economists such as Thomas Malthus and David Ricardo that Carlyle supposedly reacted.
Another early definition, one which is perhaps more useful, is that of English economist W. Stanley Jevons who, in the late 19th century, wrote that economics was "the mechanics of utility and self interest." One can think of economics as the social science that explores the results of people acting on the basis of self-interest. There is more to man than self-interest, and the other social sciences--such as psychology, sociology, anthropology, and political science--attempt to tell us about those other dimensions of man. As you read further into these pages, you will see that the assumption of self-interest, that a person tries to do the best for himself with what he has, underlies virtually all of economic theory.
At the turn of the century, Alfred Marshall's Principles of Economics was the most influential textbook in economics. Marshall defined economics as
"a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man."
Many other books of the period included in their definitions something about the "study of exchange and production." Definitions of this sort emphasize that the topics with which economics is most closely identified concern those processes involved in meeting man's material needs. Economists today do not use these definitions because the boundaries of economics have expanded since Marshall. Economists do more than study exchange and production, though exchange remains at the heart of economics.
Most contemporary definitions of economics involve the notions of choice and scarcity. Perhaps the earliest of these is by Lionell Robbins in 1935: "Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses." Virtually all textbooks have definitions that are derived from this definition. Though the exact wording differs from author to author, the standard definition is something like this:
"Economics is the social science that examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants."
Scarcity and Choice
Scarcity means that people want more than is available. Scarcity limits us both as individuals and as a society. As individuals, limited income (and time and ability) keep us from doing and having all that we might like. As a society, limited resources (such as manpower, machinery, and natural resources) fix a maximum on the amount of goods and services that can be produced.
Scarcity requires choice. People must choose which of their desires they will satisfy and which they will leave unsatisfied. When we, either as individuals or as a society, choose more of something, scarcity forces us to take less of something else. Economics is sometimes called the study of scarcity because economic activity would not exist if scarcity did not force people to make choices.
When there is scarcity and choice, there are costs. The cost of any choice is the option or options that a person gives up. For example, if you gave up the option of playing a computer game to read this text, the cost of reading this text is the enjoyment you would have received playing the game. Most of economics is based on the simple idea that people make choices by comparing the benefits of option A with the benefits of option B (and all other options that are available) and choosing the one with the highest benefit. Alternatively, one can view the cost of choosing option A as the sacrifice involved in rejecting option B, and then say that one chooses option A when the benefits of A outweigh the costs of choosing A (which are the benefits one loses when one rejects option B).
The widespread use of definitions emphasizing choice and scarcity shows that economists believe that these definitions focus on a central and basic part of the subject. This emphasis on choice represents a relatively recent insight into what economics is all about; the notion of choice is not stressed in older definitions of economics. Sometimes, this insight yields rather clever definitions, as in James Buchanan's observation that an economist is one who disagrees with the statement that whatever is worth doing is worth doing well. What Buchanan is noting is that time is scarce because it is limited and there are many things one can do with one's time. If one wants to do all things well, one must devote considerable time to each, and thus must sacrifice other things one could do. Sometimes, it is wise to choose to do some things poorly so that one has more time for other things.
Positive and Normative
Economists make a distinction between positive and normative that closely parallels Popper's line of demarcation, but which is far older. David Hume explained it well in 1739, and Machiavelli used it two centuries earlier, in 1515. A positive statement is a statement about what is and that contains no indication of approval or disapproval. Notice that a positive statement can be wrong. "The moon is made of green cheese" is incorrect, but it is a positive statement because it is a statement about what exists.
A normative statement expresses a judgment about whether a situation is desirable or undesirable. "The world would be a better place if the moon were made of green cheese" is a normative statement because it expresses a judgment about what ought to be. Notice that there is no way of disproving this statement. If you disagree with it, you have no sure way of convincing someone who believes the statement that he is wrong.
Economists have found the positive-normative distinction useful because it helps people with very different views about what is desirable to communicate with each other. Libertarians and socialists, Christians and atheists may have very different ideas about what is desirable. When they disagree, they can try to learn whether their disagreement stems from different normative views or from different positive views. If their disagreement is on normative grounds, they know that their disagreement lies outside the realm of economics, so economic theory and evidence will not bring them together. However, if their disagreement is on positive grounds, then further discussion, study, and testing may bring them closer together.
Economists can confine themselves to positive statements, but few are willing to do so because such confinement limits what they can say about issues of government policy. Both positive and normative statements must be combined to make a policy statement. One must make a judgment about what goals are desirable (the normative part), and decide on a way of attaining those goals (the positive part). Economists often see cases in which people propose courses of action that will never get them to their intended results. If economists limit themselves to evaluating whether or not proposed actions will achieve intended results, they confine themselves to positive analysis. (You should realize that although economists can speak with special authority on positive issues, even the best can be wrong.) However, virtually all economists prefer a wider role in policy analysis, and include normative judgments as well. On normative issues economists cannot speak with special expertise. Put somewhat differently, addressing most normative issues ultimately depends on how one answers the following question: "What is the meaning of life?" One does not study economics to answer this question.
Most statements are not easily categorized as purely positive or purely normative. Rather, they are like tips of an iceberg, with many invisible assumptions hiding below the surface. Suppose, for example, someone says, "The minimum wage is a bad law." Behind that simple statement are assumptions about how to judge whether a law is good or bad (or normative statements) and also beliefs about what the actual effects of the minimum wage law are (or positive statements).
B.Mohammad Rafee M.A.M.Phil.,(Ph.D) Ph: +919738374981,8951163373 Research Scholar Economics Jamal Mohamed College (Autonomous) Tirchy-20.
Monday, May 31, 2010
Sunday, May 31, 2009
Impact of crude oil prices on Indian Economy since 1971-2005 by Mohammad Rafee
Impact of crude oil prices on Indian Economy since 1971-2005 by Mohammad Rafee
India is the 7th largest country with the land mass of 3.29 million sq.k.m and second largest in population of over one billion. It accounts for 16 percent of the world population. The country has to produce about one trillion worth of GDP to fulfill the needs of its huge population.
In order to produce this one trillion dollar worth of output, India needs 2.5 million of oil per day which is 6.5 percent of total world demand for oil. The share of commercial energy consumption in total energy consumption has increased from 29 percent in 1953-54 to 68.2 percent in 2001-02. These ever exert demand profound influence on the growth and inflation levels in India.
International oil price assumed to affect the domestic prices. However in India’s case the sharp increase in international oil prices has not been fully transmitted in to the domestic prices. The administrative price mechanism had shielded the country from the impact of oil shocks. Now the govt of India has given up the administrated price mechanism in oil sector and linked the domestic oil prices with international oil prices. Oil price is certainly as external factor how it affects the Indian economy. This made me to undertake this research work.
Statement of the problem :- international oil price how it affects whole sale price index of India, exchange rage or rupee to dollar, growth rate of India, forex reserves of India, oil and non-oil trade balance.
Objective of the study:-
To analyse trend in oil price
To study the relationship between oil prices & inflation, exchange rate of rupee to dollar, growth rate of India, forex reserves of India, oil & non-oil trade balance.
To offer policy suggestions.
Hypothesis’:- * there is no difference between explanatory powers of international oil prices per barrel in dollar & annual percentage change in international oil price variation in explaining the change in the selected macro economic impacting variables.
Methodology:- the study relies exclusively on secondary data, pertaining to international oil price, growth rate of India, exchange rate of India, forex reserves of India, inflation & oil and non-oil trade balance. The data of oil downloaded from forbes.com. Data related to other variables were downloaded from RBI website.
Tools used:- annual percentage change has been calculated to analyse the trend behavior. Multiple linear regression models has been fitted to assess the impact of oil prices on the selected variables.
Limitations:-
The impact has been assumed with regard to the selected variables alone. So the impact assessment would be partial. Because oil prices can penetrate all the sectors of the economy.
The public sector oil companies and consumers have shared the burden of oil price increase. Public sector companies, backed by the government support. Ultimate burden shifted to people whole in the form of taxes.
Significance of the study: - Energy is the driver of economic growth. Energy from the oil is the largest source of energy supply. However significance of the oil prices has not been put into through explanation. A study that addresses the nuances of consequences of oil prices hike may guide government of world countries in policy formulation.
Period of study:-
From 1971-72 to 2005 on the study period there was energy crisis in 1973 and in 1979 and a gulf war in 1990. In 1991 India started its reforms Liberalization, privatization & globalization. These are all the major causes to undertake the study on oil prices.
About crude oil:-
Crude oil is a naturally occurring liquid composed mostly of hydrogen and carbon. It is believed to have been formed from very small plants & animals that lived in ancient seas and oceans a very long time ago. As these plants and animals die, they sink to the bottom of the sea. When thy mix with mud, sand and clay.
This mixture of mud & organic (once living) material is rich in hydrogen & carbon. Over millions of years this layer of organic rich mud becomes buried thousands of feet deep in the earth.
The temperature of the earth becomes hotter as you go deeper in to the earth. The combination of increasing temperature & pressure on the organic mixture causes change in to crude oil. If the temperature increases further crude oil can be changed in to natural gas.
Crude oil prices:
Inflation firmed up in the second half of 2005 in a no. of economies with a movement in international crude oil prices with oil price reaching record high of us $ 70.88 $ a barrel in august 2005. With that advanced countries like US, UK & European Union experienced inflation at the rate of 4.7, 2.6, and 2.5 respectively.
Crude oil price rose to US $ 70.88 a barrel on august 30, 2005 in the immediate after math of hurricane Katrina. Prices in the subsequent months moderated to below US $ 60 a barrel during November-December 2005. Reflected supply augmenting efforts by the IEA and the OPEC slowing of oil demand growth and a relative warmer weather in the US. But prices again edged up to US $ 67-68 a barrel in Jan 2006 on disruption of Russian Natural gas deliveries to Ukraine threatened supplies to Western Europe, unrest in Nigeria and tension over Iran’s Nuclear Programme.
OPEC:-
Organization of Petroliam exporting countries. Members include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, and UAE & Venezuela. OPEC was found in Baghdad, Iraq in Sep 1960.
Oil Crisis:-
Price increase of 2004-06 oil price was $ 25 per barrel in sep 2003.but by august 11, 2005 it had rises to over $60 per barrel & a record price of $ 78.40 per barrel on July 14, 2006. Experts attributed spike in prices to a variety of factors, including North Korea’s missile launches, the crisis between Israel & Lebanon, Iranian Nuclear programme & US department showing a decline in petroleum reserves.
Testing of Hypothesis:-
** There is no difference between explanatory powers of international oil prices per barrel in dollar & annual percent change variation in oil price in explaining the change in the selected variables.
In the analysis the relationship between the oil price variation & selected variables has been showing a negative relationship. Therefore the Null hypothesis is rejected.
Findings:-
There is no significant relationship between inflation & oil prices. International oil price behaved more erratically in 1980’s. While inflation was erratic in 1970’s.
Similar behavior is found in case of inflation. The volatility of exchange rate behavior has intensified during the study period. The variance of dollar- rupee exchange rate of 1980’s is higher than 1970’s and in 1990’s.how ever the regression results suggests that international oil prices is not a significant variable in determining the exchange rate of rupee.
Growth rate of India had fluctuated in 1960’s and in 1980’s. The growth rate was stabilized and in 1990’s there was further decline in ups and downs in growth rate of Indian economy as shown in the variance.
There is seemed to prevail negative relation ship between annual percentages in oil price the growth rate reduced to 0.1 percentages.
Every unit increase in annual percentage change of international oil price can deplete 63 million of forex reserves.
The oil price is not significant variable in explaining the change in non oil trade balance of India. Every increase in oil price in dollar the non oil trade balances may be widened by 68 million dollars. Similar with every increase in oil price. The non oil trade balance may be widened by 5.60 percent.
The oil trade balance of India may widened by 12.13 percent with every unit increase in oil prices.
India lost 17.95 percent of trade balance every year during the study period with every percentage increase in international oil prices.
Conclusion:-
The study concludes that international oil price does not affect the domestic prices of a country significantly. Similarly the oil prices do not exert a strong influence on the economic growth of India. Quantity of possessions of forex reserves the exchange rate of rupee in dollar terms and trade balances.
The multiple regression co-efficient of determination R2 in the case of above variables is worked found meager 10 percent of the variation in all the above macro economic impacted variables.
Best Regards,
B.Mohammad Rafee M.A.,M.Phil,
Ph : 919786372115,9177654835
Email: basharafee@gmail.com
Website:www.mohammadrafee.tk
India is the 7th largest country with the land mass of 3.29 million sq.k.m and second largest in population of over one billion. It accounts for 16 percent of the world population. The country has to produce about one trillion worth of GDP to fulfill the needs of its huge population.
In order to produce this one trillion dollar worth of output, India needs 2.5 million of oil per day which is 6.5 percent of total world demand for oil. The share of commercial energy consumption in total energy consumption has increased from 29 percent in 1953-54 to 68.2 percent in 2001-02. These ever exert demand profound influence on the growth and inflation levels in India.
International oil price assumed to affect the domestic prices. However in India’s case the sharp increase in international oil prices has not been fully transmitted in to the domestic prices. The administrative price mechanism had shielded the country from the impact of oil shocks. Now the govt of India has given up the administrated price mechanism in oil sector and linked the domestic oil prices with international oil prices. Oil price is certainly as external factor how it affects the Indian economy. This made me to undertake this research work.
Statement of the problem :- international oil price how it affects whole sale price index of India, exchange rage or rupee to dollar, growth rate of India, forex reserves of India, oil and non-oil trade balance.
Objective of the study:-
To analyse trend in oil price
To study the relationship between oil prices & inflation, exchange rate of rupee to dollar, growth rate of India, forex reserves of India, oil & non-oil trade balance.
To offer policy suggestions.
Hypothesis’:- * there is no difference between explanatory powers of international oil prices per barrel in dollar & annual percentage change in international oil price variation in explaining the change in the selected macro economic impacting variables.
Methodology:- the study relies exclusively on secondary data, pertaining to international oil price, growth rate of India, exchange rate of India, forex reserves of India, inflation & oil and non-oil trade balance. The data of oil downloaded from forbes.com. Data related to other variables were downloaded from RBI website.
Tools used:- annual percentage change has been calculated to analyse the trend behavior. Multiple linear regression models has been fitted to assess the impact of oil prices on the selected variables.
Limitations:-
The impact has been assumed with regard to the selected variables alone. So the impact assessment would be partial. Because oil prices can penetrate all the sectors of the economy.
The public sector oil companies and consumers have shared the burden of oil price increase. Public sector companies, backed by the government support. Ultimate burden shifted to people whole in the form of taxes.
Significance of the study: - Energy is the driver of economic growth. Energy from the oil is the largest source of energy supply. However significance of the oil prices has not been put into through explanation. A study that addresses the nuances of consequences of oil prices hike may guide government of world countries in policy formulation.
Period of study:-
From 1971-72 to 2005 on the study period there was energy crisis in 1973 and in 1979 and a gulf war in 1990. In 1991 India started its reforms Liberalization, privatization & globalization. These are all the major causes to undertake the study on oil prices.
About crude oil:-
Crude oil is a naturally occurring liquid composed mostly of hydrogen and carbon. It is believed to have been formed from very small plants & animals that lived in ancient seas and oceans a very long time ago. As these plants and animals die, they sink to the bottom of the sea. When thy mix with mud, sand and clay.
This mixture of mud & organic (once living) material is rich in hydrogen & carbon. Over millions of years this layer of organic rich mud becomes buried thousands of feet deep in the earth.
The temperature of the earth becomes hotter as you go deeper in to the earth. The combination of increasing temperature & pressure on the organic mixture causes change in to crude oil. If the temperature increases further crude oil can be changed in to natural gas.
Crude oil prices:
Inflation firmed up in the second half of 2005 in a no. of economies with a movement in international crude oil prices with oil price reaching record high of us $ 70.88 $ a barrel in august 2005. With that advanced countries like US, UK & European Union experienced inflation at the rate of 4.7, 2.6, and 2.5 respectively.
Crude oil price rose to US $ 70.88 a barrel on august 30, 2005 in the immediate after math of hurricane Katrina. Prices in the subsequent months moderated to below US $ 60 a barrel during November-December 2005. Reflected supply augmenting efforts by the IEA and the OPEC slowing of oil demand growth and a relative warmer weather in the US. But prices again edged up to US $ 67-68 a barrel in Jan 2006 on disruption of Russian Natural gas deliveries to Ukraine threatened supplies to Western Europe, unrest in Nigeria and tension over Iran’s Nuclear Programme.
OPEC:-
Organization of Petroliam exporting countries. Members include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, and UAE & Venezuela. OPEC was found in Baghdad, Iraq in Sep 1960.
Oil Crisis:-
Price increase of 2004-06 oil price was $ 25 per barrel in sep 2003.but by august 11, 2005 it had rises to over $60 per barrel & a record price of $ 78.40 per barrel on July 14, 2006. Experts attributed spike in prices to a variety of factors, including North Korea’s missile launches, the crisis between Israel & Lebanon, Iranian Nuclear programme & US department showing a decline in petroleum reserves.
Testing of Hypothesis:-
** There is no difference between explanatory powers of international oil prices per barrel in dollar & annual percent change variation in oil price in explaining the change in the selected variables.
In the analysis the relationship between the oil price variation & selected variables has been showing a negative relationship. Therefore the Null hypothesis is rejected.
Findings:-
There is no significant relationship between inflation & oil prices. International oil price behaved more erratically in 1980’s. While inflation was erratic in 1970’s.
Similar behavior is found in case of inflation. The volatility of exchange rate behavior has intensified during the study period. The variance of dollar- rupee exchange rate of 1980’s is higher than 1970’s and in 1990’s.how ever the regression results suggests that international oil prices is not a significant variable in determining the exchange rate of rupee.
Growth rate of India had fluctuated in 1960’s and in 1980’s. The growth rate was stabilized and in 1990’s there was further decline in ups and downs in growth rate of Indian economy as shown in the variance.
There is seemed to prevail negative relation ship between annual percentages in oil price the growth rate reduced to 0.1 percentages.
Every unit increase in annual percentage change of international oil price can deplete 63 million of forex reserves.
The oil price is not significant variable in explaining the change in non oil trade balance of India. Every increase in oil price in dollar the non oil trade balances may be widened by 68 million dollars. Similar with every increase in oil price. The non oil trade balance may be widened by 5.60 percent.
The oil trade balance of India may widened by 12.13 percent with every unit increase in oil prices.
India lost 17.95 percent of trade balance every year during the study period with every percentage increase in international oil prices.
Conclusion:-
The study concludes that international oil price does not affect the domestic prices of a country significantly. Similarly the oil prices do not exert a strong influence on the economic growth of India. Quantity of possessions of forex reserves the exchange rate of rupee in dollar terms and trade balances.
The multiple regression co-efficient of determination R2 in the case of above variables is worked found meager 10 percent of the variation in all the above macro economic impacted variables.
Best Regards,
B.Mohammad Rafee M.A.,M.Phil,
Ph : 919786372115,9177654835
Email: basharafee@gmail.com
Website:www.mohammadrafee.tk
Recession? Depression? What's the difference?
There is an old joke among economists that states:
A recession is when your neighbor loses his job.
A depression is when you lose your job.
The difference between the two terms is not very well understood for one simple reason: There is not a universally agreed upon definition. If you ask 100 different economists to define the terms recession and depression, you would get at least 100 different answers. I will try to summarize both terms and explain the differences between them in a way that almost all economists could agree with.
Recession: The Newspaper Definition
The standard newspaper definition of a recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters.
This definition is unpopular with most economists for two main reasons. First, this definition does not take into consideration changes in other variables. For example this definition ignores any changes in the unemployment rate or consumer confidence. Second, by using quarterly data this definition makes it difficult to pinpoint when a recession begins or ends. This means that a recession that lasts ten months or less may go undetected.
Recession: The BCDC Definition
The Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) provides a better way to find out if there is a recession is taking place. This committee determines the amount of business activity in the economy by looking at things like employment, industrial production, real income and wholesale-retail sales. They define a recession as the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise again it is called an expansionary period. By this definition, the average recession lasts about a year.Depression
Before the Great Depression of the 1930s any downturn in economic activity was referred to as a depression. The term recession was developed in this period to differentiate periods like the 1930s from smaller economic declines that occurred in 1910 and 1913. This leads to the simple definition of a depression as a recession that lasts longer and has a larger decline in business activity.
The Difference
So how can we tell the difference between a recession and a depression? A good rule of thumb for determining the difference between a recession and a depression is to look at the changes in GNP. A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe.
By this yardstick, the last depression in the United States was from May 1937 to June 1938, where real GDP declined by 18.2 percent. If we use this method then the Great Depression of the 1930s can be seen as two separate events: an incredibly severe depression lasting from August 1929 to March 1933 where real GDP declined by almost 33 percent, a period of recovery, then another less severe depression of 1937-38. The United States hasn’t had anything even close to a depression in the post-war period. The worst recession in the last 60 years was from November 1973 to March 1975, where real GDP fell by 4.9 percent. Countries such as Finland and Indonesia have suffered depressions in recent memory using this definition.
Now you should be able to determine the difference between a recession and a depression without resorting to the poor humor of the dismal scientists.
A recession is when your neighbor loses his job.
A depression is when you lose your job.
The difference between the two terms is not very well understood for one simple reason: There is not a universally agreed upon definition. If you ask 100 different economists to define the terms recession and depression, you would get at least 100 different answers. I will try to summarize both terms and explain the differences between them in a way that almost all economists could agree with.
Recession: The Newspaper Definition
The standard newspaper definition of a recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters.
This definition is unpopular with most economists for two main reasons. First, this definition does not take into consideration changes in other variables. For example this definition ignores any changes in the unemployment rate or consumer confidence. Second, by using quarterly data this definition makes it difficult to pinpoint when a recession begins or ends. This means that a recession that lasts ten months or less may go undetected.
Recession: The BCDC Definition
The Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) provides a better way to find out if there is a recession is taking place. This committee determines the amount of business activity in the economy by looking at things like employment, industrial production, real income and wholesale-retail sales. They define a recession as the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise again it is called an expansionary period. By this definition, the average recession lasts about a year.Depression
Before the Great Depression of the 1930s any downturn in economic activity was referred to as a depression. The term recession was developed in this period to differentiate periods like the 1930s from smaller economic declines that occurred in 1910 and 1913. This leads to the simple definition of a depression as a recession that lasts longer and has a larger decline in business activity.
The Difference
So how can we tell the difference between a recession and a depression? A good rule of thumb for determining the difference between a recession and a depression is to look at the changes in GNP. A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe.
By this yardstick, the last depression in the United States was from May 1937 to June 1938, where real GDP declined by 18.2 percent. If we use this method then the Great Depression of the 1930s can be seen as two separate events: an incredibly severe depression lasting from August 1929 to March 1933 where real GDP declined by almost 33 percent, a period of recovery, then another less severe depression of 1937-38. The United States hasn’t had anything even close to a depression in the post-war period. The worst recession in the last 60 years was from November 1973 to March 1975, where real GDP fell by 4.9 percent. Countries such as Finland and Indonesia have suffered depressions in recent memory using this definition.
Now you should be able to determine the difference between a recession and a depression without resorting to the poor humor of the dismal scientists.
Do Changes in Stock Prices Cause Recessions?
The economy and the stock market are closely related. Many people examine the stock market to find out how the economy is doing. It's long been known that if the stock market is in a period of decline, the economy is sure to follow. However there is little evidence that the stock market causes the economy to rise or fall. The stock market does not directly affect the economy. It is simply a mirror of people's generally correct beliefs about what is about to happen in the economy. The best way to understand this is to realize that a stock market index the Dow Jones Industrial Average (DJI) is simply a price. Because the value of index is a price, it only has two determinants: supply and demand.
Supply
Any first year college textbook in Economics states that for most goods if the supply increases in the short run then the price of the good should decline. For example, if the car companies suddenly doubled their supply of cars then we would expect the price of cars to fall.
If we thought that changes in the supply of stocks are the main cause of stock market rises and declines then, according to this rule, when a company issues new stock we would expect the price of stock to decline. If stock prices are largely determined by the supply of stocks and the market declines prior to an economic decline, we should see a flood of new stock issues before a recession. This does not happen in practice, as new stock issues tend to occur as the economy enters a growth period. This is because the money made from a stock issue is used to increase the output of the company, which causes economic growth to rise.Demand
It appears that if we want to understand why the economy tends to move in the same direction as the stock market, we'll have to consider the demand for stocks. To do this, we'll need to understand what motivates an investors decision to buy or sell shares. Many investors such as Warren Buffett evaluate their stock portfolios on their inherent value. The inherent value is the total expected earnings of the company over a time period, discounted by the fact that a dollar today is not worth as much as a dollar tomorrow. If investors believe that a recession is coming, then they will believe that company earnings will be less in the future (since that typically takes place in a recession) which will decrease the inherent value of the stock. When the inherent value of the stock is far below its current price, investors will sell the stock, driving the price of the stock down. If investors believe a boom is coming, they will increase their estimates of the inherent value because future earnings should be higher than they previously expected. Often this will lead to the inherent value being far higher than the current price of the stock, so investors buy the stock. This leads the price of the stock to rise.
The belief that the stock market drives the economy is due to an error in logic. Generally we think that if A came before B that A caused B. Philosophers refer to this as the post hoc, propter hoc fallacy. In this case, the expectation of a decline in the economy causes the stock market to decline today. Or in logical terms, A came before B, because the expectation of B caused A. It's also important to realize that it's not the expectation of future economic changes that is causing changes in stock prices. It's the fact that people are acting on these expectations. If investors bought and sold stocks based on astrological factors or Barry Bonds' current homerun total then these would be causing the price of stocks to change. In a situation like that, it would seem that the stars are causing the price of stocks to change; the economy would have nothing to do with it.
It is because a large number of investors act on this inherent value principle that the economy tends to follow the stock market. Investors are constantly watching macroeconomic variables to try and determine when the next downturn in the economy will happen. Investors are often right when they predict the future growth rate of the economy. As a result, they often sell off their shares before the economy goes into a decline making it look like the stock market is causing a recession. In reality the causality runs the other way because the two things that causes price to change are changes in supply or changes in demand.
Supply
Any first year college textbook in Economics states that for most goods if the supply increases in the short run then the price of the good should decline. For example, if the car companies suddenly doubled their supply of cars then we would expect the price of cars to fall.
If we thought that changes in the supply of stocks are the main cause of stock market rises and declines then, according to this rule, when a company issues new stock we would expect the price of stock to decline. If stock prices are largely determined by the supply of stocks and the market declines prior to an economic decline, we should see a flood of new stock issues before a recession. This does not happen in practice, as new stock issues tend to occur as the economy enters a growth period. This is because the money made from a stock issue is used to increase the output of the company, which causes economic growth to rise.Demand
It appears that if we want to understand why the economy tends to move in the same direction as the stock market, we'll have to consider the demand for stocks. To do this, we'll need to understand what motivates an investors decision to buy or sell shares. Many investors such as Warren Buffett evaluate their stock portfolios on their inherent value. The inherent value is the total expected earnings of the company over a time period, discounted by the fact that a dollar today is not worth as much as a dollar tomorrow. If investors believe that a recession is coming, then they will believe that company earnings will be less in the future (since that typically takes place in a recession) which will decrease the inherent value of the stock. When the inherent value of the stock is far below its current price, investors will sell the stock, driving the price of the stock down. If investors believe a boom is coming, they will increase their estimates of the inherent value because future earnings should be higher than they previously expected. Often this will lead to the inherent value being far higher than the current price of the stock, so investors buy the stock. This leads the price of the stock to rise.
The belief that the stock market drives the economy is due to an error in logic. Generally we think that if A came before B that A caused B. Philosophers refer to this as the post hoc, propter hoc fallacy. In this case, the expectation of a decline in the economy causes the stock market to decline today. Or in logical terms, A came before B, because the expectation of B caused A. It's also important to realize that it's not the expectation of future economic changes that is causing changes in stock prices. It's the fact that people are acting on these expectations. If investors bought and sold stocks based on astrological factors or Barry Bonds' current homerun total then these would be causing the price of stocks to change. In a situation like that, it would seem that the stars are causing the price of stocks to change; the economy would have nothing to do with it.
It is because a large number of investors act on this inherent value principle that the economy tends to follow the stock market. Investors are constantly watching macroeconomic variables to try and determine when the next downturn in the economy will happen. Investors are often right when they predict the future growth rate of the economy. As a result, they often sell off their shares before the economy goes into a decline making it look like the stock market is causing a recession. In reality the causality runs the other way because the two things that causes price to change are changes in supply or changes in demand.
Are recessions good for the economy?
Question from Reader E-mail: I have come to believe that a recession is good for an economy because it culls away weak businesses and teaches the strong to survive by cutting the fat that is not needed. I was wondering, though, do you think a depression is good for an economy and why?
A: I don't agree that even recessions are good for the economy. Joseph Schumpeter passionately argued in his 1942 book Capitalism, Socialism and Democracy that recessions are a necessary evil in capitalist societies. The idea that recessions are a necessary evil is still around today. Mark Rostenko, the editor of the Sovereign Strategist wrote the following in an editorial titled The Dips Don't See a "Double-Dip":
The "job" of a recession is to clean the "fat" out of the system, mop up excess, and pave the way for the next expansion. Until that process is complete, there isn't much from which a legitimate expansion can arise.
Recessions put weak companies out of business. In so doing, resources (skilled workers, capital) are freed up to be deployed more efficiently elsewhere. For example, Wall Street analysts who touted bankrupt Internet stocks are redeployed at local fast food restaurants to serve people in a capacity for which they are much better suited.
Stronger businesses that have used the contraction to firm up their bottom lines and grow more efficient are able to take advantage of these resources during the ensuing expansion. The economy emerges from a recession leaner, more efficient and in good shape for the next wave of growth and progress.
While the logic seems sound, it doesn't seem to match the data. If recessions were necessary to "clean the fat out of the system", we'd expect there to be a lot of bankruptcies and firm closures during recessions and little during booms. The data, however, does not support this as you can see in the table on the bottom of the page.
I have data for five different years, 1990, 1995, 2000, 2001 and 2002. The only year in the chart that overlaps with a recession is 1990, as the National Bureau for Economic Research indicates that the United States had a recession from July 1990 until March 1991. For the five years here, the GDP growth rate was positive in each year, from a high of 3.8% in 2000 to 0.3% in 2001.
Notice how little firm closures differ between these five years. We do not see great differences in firm closures between periods of high growth and periods of low growth. While 1995 was the beginning of a period of exceptional growth, almost 500,000 firms closed shop. The year 2001 saw almost no growth in the economy, but we only had 14% more business closures than in 1995 and fewer businesses filed for bankruptcy in 2001 than 1995.
Rostenko is correct when he claims that firm closures are a necessary part of capitalism since it allows "resources (skilled workers, capital) [to be] freed up to be deployed more efficiently elsewhere." When we look at the data, though, we see that we do not need recessions for this to occur; firms do not close that much more frequently in busts than in booms. So at least in this regard, recessions are not necessary at all.
A: I don't agree that even recessions are good for the economy. Joseph Schumpeter passionately argued in his 1942 book Capitalism, Socialism and Democracy that recessions are a necessary evil in capitalist societies. The idea that recessions are a necessary evil is still around today. Mark Rostenko, the editor of the Sovereign Strategist wrote the following in an editorial titled The Dips Don't See a "Double-Dip":
The "job" of a recession is to clean the "fat" out of the system, mop up excess, and pave the way for the next expansion. Until that process is complete, there isn't much from which a legitimate expansion can arise.
Recessions put weak companies out of business. In so doing, resources (skilled workers, capital) are freed up to be deployed more efficiently elsewhere. For example, Wall Street analysts who touted bankrupt Internet stocks are redeployed at local fast food restaurants to serve people in a capacity for which they are much better suited.
Stronger businesses that have used the contraction to firm up their bottom lines and grow more efficient are able to take advantage of these resources during the ensuing expansion. The economy emerges from a recession leaner, more efficient and in good shape for the next wave of growth and progress.
While the logic seems sound, it doesn't seem to match the data. If recessions were necessary to "clean the fat out of the system", we'd expect there to be a lot of bankruptcies and firm closures during recessions and little during booms. The data, however, does not support this as you can see in the table on the bottom of the page.
I have data for five different years, 1990, 1995, 2000, 2001 and 2002. The only year in the chart that overlaps with a recession is 1990, as the National Bureau for Economic Research indicates that the United States had a recession from July 1990 until March 1991. For the five years here, the GDP growth rate was positive in each year, from a high of 3.8% in 2000 to 0.3% in 2001.
Notice how little firm closures differ between these five years. We do not see great differences in firm closures between periods of high growth and periods of low growth. While 1995 was the beginning of a period of exceptional growth, almost 500,000 firms closed shop. The year 2001 saw almost no growth in the economy, but we only had 14% more business closures than in 1995 and fewer businesses filed for bankruptcy in 2001 than 1995.
Rostenko is correct when he claims that firm closures are a necessary part of capitalism since it allows "resources (skilled workers, capital) [to be] freed up to be deployed more efficiently elsewhere." When we look at the data, though, we see that we do not need recessions for this to occur; firms do not close that much more frequently in busts than in booms. So at least in this regard, recessions are not necessary at all.
Cost-Push Inflation vs. Demand-Pull Inflation
Q:] What do the terms "Cost-Push Inflation" and "Demand-Pull Inflation" mean? What's the difference between the two.
[A:] Thanks for your question!
The terms cost-push inflation and demand-pull inflation are associated with Keynesian Economics. Without going into a primer on Keynesian Economics (a good one can be found at Econlib) we can still understand the difference between two terms.
In articles such as "Why Does Money Have Value?", "The Demand For Money", and "Prices and Recessions" we've seen that inflation is caused by a combination of four factors. Those factors are:
* The supply of money goes up.
* The supply of goods goes down.
* Demand for money goes down.
* Demand for goods goes up.
Let's look at the definition of cost-push and demand-pull inflation and see if we can understand them using our four factors.
Definition of Cost-Push Inflation
The text "Economics" (2nd Edition) by Parkin and Bade gives the following explanation for cost-push inflation:
"Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are
* An increase in wage rates
* An increase in the prices of raw materials
These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation
Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production." (pg. 865)
Aggregate supply is the "the total value of the goods and services produced in a country" or simply factor 2, "The supply of goods". The supply of goods can be influenced by factors other than an increase in the price of inputs (say a natural disaster), so not all factor 2 inflation is cost-push inflation.
Of course, the next question would be "What caused the price of inputs to rise?". Any combinations of the four factors could cause that, but the two most likely are factor 2 (Raw materials such as oil have become more scarce), or factor 4 (The demand for raw materials and labor have risen).
Definition of Demand-Pull Inflation
Parkin and Bade give the following explanation for demand-pull inflation:
"The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such an inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are
1. Increases in the money supply
2. Increases in government purchases
3. Increases in the price level in the rest of the world
"(pg. 862)
Inflation caused by an increase in aggregate demand, is inflation caused by factor 4 (An increase in the demand for goods). The three most likely causes of an increase in aggregate demand will also tend to increase inflation:
1. Increases in the money supply This is simply factor 1 inflation.
2. Increases in government purchases The increased demand for goods by the government causes factor 4 inflation.
3. Increases in the price level in the rest of the world Suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see less Americans buy gum from Canadians and more Canadians purchase the cheaper gum from American sources. From the American perspective the demand for gum has risen causing a price rise in gum; a factor 4 inflation.
Inflation in Summary
Cost-push inflation and demand-pull inflation can be explained using our four inflation factors. Cost-push inflation is inflation caused by rising prices of inputs that causes factor 2 (The supply of goods goes down) inflation. Demand-pull inflation is factor 4 inflation (The demand for goods goes up) which can have many causes.
[A:] Thanks for your question!
The terms cost-push inflation and demand-pull inflation are associated with Keynesian Economics. Without going into a primer on Keynesian Economics (a good one can be found at Econlib) we can still understand the difference between two terms.
In articles such as "Why Does Money Have Value?", "The Demand For Money", and "Prices and Recessions" we've seen that inflation is caused by a combination of four factors. Those factors are:
* The supply of money goes up.
* The supply of goods goes down.
* Demand for money goes down.
* Demand for goods goes up.
Let's look at the definition of cost-push and demand-pull inflation and see if we can understand them using our four factors.
Definition of Cost-Push Inflation
The text "Economics" (2nd Edition) by Parkin and Bade gives the following explanation for cost-push inflation:
"Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are
* An increase in wage rates
* An increase in the prices of raw materials
These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation
Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production." (pg. 865)
Aggregate supply is the "the total value of the goods and services produced in a country" or simply factor 2, "The supply of goods". The supply of goods can be influenced by factors other than an increase in the price of inputs (say a natural disaster), so not all factor 2 inflation is cost-push inflation.
Of course, the next question would be "What caused the price of inputs to rise?". Any combinations of the four factors could cause that, but the two most likely are factor 2 (Raw materials such as oil have become more scarce), or factor 4 (The demand for raw materials and labor have risen).
Definition of Demand-Pull Inflation
Parkin and Bade give the following explanation for demand-pull inflation:
"The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such an inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are
1. Increases in the money supply
2. Increases in government purchases
3. Increases in the price level in the rest of the world
"(pg. 862)
Inflation caused by an increase in aggregate demand, is inflation caused by factor 4 (An increase in the demand for goods). The three most likely causes of an increase in aggregate demand will also tend to increase inflation:
1. Increases in the money supply This is simply factor 1 inflation.
2. Increases in government purchases The increased demand for goods by the government causes factor 4 inflation.
3. Increases in the price level in the rest of the world Suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see less Americans buy gum from Canadians and more Canadians purchase the cheaper gum from American sources. From the American perspective the demand for gum has risen causing a price rise in gum; a factor 4 inflation.
Inflation in Summary
Cost-push inflation and demand-pull inflation can be explained using our four inflation factors. Cost-push inflation is inflation caused by rising prices of inputs that causes factor 2 (The supply of goods goes down) inflation. Demand-pull inflation is factor 4 inflation (The demand for goods goes up) which can have many causes.
Supply & Demand: How They Move Currencies
Supply and Demand
In Forex trading, you will see that technical indicators (charts, moving average lines, etc.) are very important for determining how currency prices move. Of course, fundamental analysis (economic data, current events, etc.) is also useful for predicting how a currency price will change. Underlying the fundamental and technical methods is the basic economic principle of supply and demand. In the free marketplace, prices can change dramatically from changes in the supply of a currency and differences in the demand for a currency. This principle also applies to stocks, bonds, and commodities. Keeping this concept of supply and demand in your mind can keep your forecasting and predictions on track.
The Demand Factor
At the most fundamental level, a currency price will change because there is more or less demand for it. More demand means the currency pair will experience a higher price. Less demand means the currency pair price will fall. An example of increased demand for a currency is economic data suggesting a strong economy while demand for a currency could decline if the central bank lowers interest rates. True price movement is based on the demand for the currency. In fact, currencies rally when demand increases.
The Supply Side
A basic economic principle of supply shows that the value of a currency will change as the levels of supply rise and fall. A larger supply of a currency will diminish its value and price. A lower supply of a currency will increase its value and price. While the supply side is important, look to the demand factor as the primary moving force behind a currency’s value and price.
Focus on the Demand-Supply Model
The trader must remember that real price movements are based on the level of demand for a currency. So currency prices are easy to predict, right? Wrong! A host of factors affect the demand and net supply for a currency. Everything from current events to the weather can affect the supply and demand for a currency. Think back to the Internet boom in 2001. People around the world wanted to participate in this booming industry centered in Silicon Valley. Demand for the US dollar soared. Supplies grew tight. The value of the dollar sharply increased.
Long-term vs. Short-term
Long-term supply and demand usually refers to a time period of a year or more. Short-term is typically thirty days or less. The same factors can affect currency prices in both time periods. The trader should be aware of the time factor in which a trade is placed. Long- and short-term price movements can run parallel. However, they can also diverge, leading to inconsistent price movements. Hence, you should always remember the trading environment and the time frame when making your Forex trade.
Determine which Factors affect Supply and Demand
The next step is to examine the broad categories of factors that can affect supply and demand. Most of these factors are fundamental, but technical factors can also affect supply and demand. Focusing on the factors that affect demand will keep you grounded and eliminate much of the “trading noise” and distractions that can impair your forecasting skills. It will also prepare you to interpret any event and analyze its impact on the long- and short-term price of a currency.
In Forex trading, you will see that technical indicators (charts, moving average lines, etc.) are very important for determining how currency prices move. Of course, fundamental analysis (economic data, current events, etc.) is also useful for predicting how a currency price will change. Underlying the fundamental and technical methods is the basic economic principle of supply and demand. In the free marketplace, prices can change dramatically from changes in the supply of a currency and differences in the demand for a currency. This principle also applies to stocks, bonds, and commodities. Keeping this concept of supply and demand in your mind can keep your forecasting and predictions on track.
The Demand Factor
At the most fundamental level, a currency price will change because there is more or less demand for it. More demand means the currency pair will experience a higher price. Less demand means the currency pair price will fall. An example of increased demand for a currency is economic data suggesting a strong economy while demand for a currency could decline if the central bank lowers interest rates. True price movement is based on the demand for the currency. In fact, currencies rally when demand increases.
The Supply Side
A basic economic principle of supply shows that the value of a currency will change as the levels of supply rise and fall. A larger supply of a currency will diminish its value and price. A lower supply of a currency will increase its value and price. While the supply side is important, look to the demand factor as the primary moving force behind a currency’s value and price.
Focus on the Demand-Supply Model
The trader must remember that real price movements are based on the level of demand for a currency. So currency prices are easy to predict, right? Wrong! A host of factors affect the demand and net supply for a currency. Everything from current events to the weather can affect the supply and demand for a currency. Think back to the Internet boom in 2001. People around the world wanted to participate in this booming industry centered in Silicon Valley. Demand for the US dollar soared. Supplies grew tight. The value of the dollar sharply increased.
Long-term vs. Short-term
Long-term supply and demand usually refers to a time period of a year or more. Short-term is typically thirty days or less. The same factors can affect currency prices in both time periods. The trader should be aware of the time factor in which a trade is placed. Long- and short-term price movements can run parallel. However, they can also diverge, leading to inconsistent price movements. Hence, you should always remember the trading environment and the time frame when making your Forex trade.
Determine which Factors affect Supply and Demand
The next step is to examine the broad categories of factors that can affect supply and demand. Most of these factors are fundamental, but technical factors can also affect supply and demand. Focusing on the factors that affect demand will keep you grounded and eliminate much of the “trading noise” and distractions that can impair your forecasting skills. It will also prepare you to interpret any event and analyze its impact on the long- and short-term price of a currency.
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