Finance is based on economics. Therefore, to properly understand financial markets and their behavior one must first understand economics. Economics at its core is concerned with the production, distribution, trade and consumption of goods and services. To put this in human terms we can say that economics is the science that arises out of the interplay between limited resources and unlimited human wants and needs.
There are two basic ways to view economics. There is the broad and distant view, which attempts to view things in aggregate for a society at large. We call this view “Macroeconomics”. Macroeconomics is concerned with the status of the economy as a whole. Thus, it looks at overall employment of a general population or overall income of a nation as opposed to a more focused view of a population segment or specific industry. This view is helpful because it is only by this kind of analysis that we can see the general trends which a society or nation is following. Macroeconomic theory and analysis is employed most often by governments and institutions, which have a responsibility to make policies and decisions which affect the economy as a whole.
Some terms you may have heard of which concern themselves with the macroeconomic view of the economy are Gross National Product, Inflation, Consumer Price Index and Fiscal Policy. The meaning of each of these is listed below.
Gross National Product – This is the most common measure of economic productivity for an aggregate population. GNP is defined as the total value of all goods and services produced in final form during a specific period of time (usually 1 year).
Inflation – Inflation is defined as a condition of generally increasing prices. The term used for measuring these prices can vary according to the desires of the individual, government or institution doing the evaluation.
Consumer Price Index – The CPI is a measure of how much prices have increased or decreased as compared to a baseline years prices. The prices used in arriving at this figure are standard goods and services determined by the evaluator. Thus, the CPI for the United States might vary greatly as compared the CPI for a country from the Middle East.
Fiscal Policy – Fiscal Policy is essentially the manner in which a government achieves economic objectives through government spending and taxation. Fiscal policy is the alternative to Monetary Policy.
Monetary Policy – Monetary Policy is essentially the practice of a government managing the supply of money to achieve economic objectives. The United States uses the Federal Reserve System to either increase or decrease the supply of money, which in turn effects the overall economic environment as a whole.
The principles of Macroeconomics are important in analyzing and understanding longer-term trends and aggregate market behavior. Therefore, for the individual managing his own portfolio it may be helpful to know the current fiscal policy and how it may affect the value of any government bond holdings. One of the ways the government will manage fiscal policy is to buy back these bonds or issue more depending on their objective. This is just one example of the way in which Macroeconomics affects the individual investor.