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Economic Policy Framework And Markets

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Question:

Discuss about the Economic Policy Framework And Markets.
 
 

Answer:

In the market economy, only earning and saving the money is not sufficient to get the full worth of money. Inflation eats away the value of money in all the economies. To recover the losses that occurred due to inflation, people invest their hard-earned money and earn profits or dividends on them. This is the fundamental logic behind investment (Barro and Ursúa 2017). The stock market is one such channel for investment. Stock market and share market are similar. The only difference is that, in stock market, financial instruments, such as, bonds, derivatives, mutual funds as well as shares of companies are traded, while in share market, only shares of organizations are traded. Stock exchange is the basic platform where the stocks and securities of companies are listed. The buying and selling of a stock only happens if it is listed on the exchange (Li 2014).

Effects of demographic transitions on stock market

Demographic changes have major impacts on the stock market, as well as, risks and returns for investment. The age structure of a nation affects the investment and savings patterns. The basic lifecycle theory says that, young people do not invest as much as the aged people. The middle aged population deposits maximum money in savings and investment in governmental and non-governmental bonds and securities. The senior population tends to invest less money in less risky financial schemes, rather they prefer to enjoy the earnings from the past investments (Merkle and Weber 2014). Demographic changes like increasing or decreasing birth rate, longer life expectancy, have effects on the investment patterns. Firstly, the baby boomer time across the world has major impact on the growing population. The increase in population brings about asset meltdown globally. As this situation is changing globally, there will be more of aged people than young people (Dellavigna and Pollet 2013). In such case, people would likely to convert their investments more into cash for more consumption. At the same time, the reducing number of younger population, who has the tendency to buy more than save more, would reduce the demand for all types of investments. As the number of aged population is increasing, there would be a rapid fall in the asset values, extending from bonds to equities to real estate.

There is declining investment trend in equities. Senior people are moving into retirement and moving out of equities. Migration also plays a role in the stock market. Along with aging population, the investment behavior of the migrated people also determine the condition of the stock market. Hence, the nature of the stock market would be different in a country with more migrated population, than in a country with less migrated population. Migrated people would always choose less risky investment options than the people who have a stable job and stable life (Bodie 2013).

A first time investor in stock market must consider the current demographic condition of the nation. The study about the people, who are buying and selling stocks in the stock market, would help the first time investors to get an idea about the asset value of the market. If people shows the tendency to decrease the investment in the stocks, then the market would be unstable. Hence, the market as well as demographic condition should be monitored closely.

 

Effects of economic growth on stock market

The trends in business cycles are caused by factors, like, technological or investment developments, entrepreneurship. These are also important factors for economic growth. There is a relationship between stock market end economic growth of the country. It influences the confidence of the consumers and financial conditions. When the stocks are in the bull market, there would be optimism in the economy regarding the prospects of various stocks (Dellavigna and Pollet 2013). Higher value of stocks enables the companies to borrow more amount of money at lower rates. It allows them to expand their operations, make investments in new projects, and recruit more labor. These activities boost the GDP of the nation. In such environment, consumers are likely to spend more to make larger purchases and major investments, such as vehicles or houses. When the stock prices are in the bull market, there is more wealth in the economy as well as optimism about the future prospects. This confidence of the people is reflected into increased spending, that results in increased sales and revenues for the organizations and further boosts the GDP (Baker, Bloom and Davis 2015).

When the prices of the stocks are low, it has a negative effect on the GDP via same channels. Companies cut costs and lower the worker force. As the companies cannot find any new sources for financing and the existing debt loads of the company becomes a burden. Due to a pessimistic environment in the economy, investment level would be very low. It also affects the level of consumer spending in the economy due to reduced stock prices (Guillén and Capron 2016). There would be increase in the unemployment rate and more uncertainty about the future. When the stocks are in the bear market, the stockholders loose some wealth and confidence of the customers falls. This also have negative effect on GDP. On the other hand, the stock market also has effects on the economic growth of the nation. When there is a growth in GDP above the consensus or the expectation, the stocks need to be in the bull market for increase in the corporate earnings (Hajilee and Al Nasser 2014). The opposite happens when the GDP falls below the consensus or expectation level. Therefore, it is important for the first time investors to study the stock market if it is in the bull market or in the bear market and take the investment decisions accordingly.

Effects of inflation or deflation on the stock market

There is a strong relationship between the rising or depreciating value of money and stock prices. Inflation is the overall rise in the price level of the economy, and the opposite is called deflation. When there is a rise in the prices of goods and services in the country, it results in the fall in the purchasing power of the currency. Consumers’ disposable income reduces, input prices go up, profits and revenue decrease, and the economy slows down for some time until a new equilibrium is reached (Giesecke et al. 2014). The studies on this subject show that expected inflation can have positive or negative impact on the stock prices depending on the monetary policy of the government and the ability of the companies to hedge. However, the unexpected inflation has strong positive correlation with returns on stock during the contraction of the economy. Hence, the investors, especially the first timers, must gauge the phase of the economic cycle before investing in the stocks. At the same time, high rate of inflation is also correlated with greater volatility of the movements of the stocks. Hence, inflation has very strong volatile effects on the stock market (Rogers, Scotti and Wright 2014).

Deflation is the opposite of inflation. It helps to increase the disposable income as well as the purchasing power of the consumers. It helps in the short run but has an adverse effect on the stock market. While in deflation, the organizations have to decrease their prices, and due to this, they earn less profit. It also affects the demand for lending by banks and investors negatively. Finance for the investors suffers from deflationary effects in the economy and lower value of money (Rey 2015). Therefore, the first time investors must study the inflation or deflation situation of the economy before investing.

Effects of monetary and fiscal policy

Monetary policy improves the financial conditions than the aggregate demand in the economy. If the cost of money is lowered then, it would increase the supply of money, reduce the rate of interest and cost of borrowing. Since, the stock prices reflect the developments in the economic sector; it also shows the expectation of the private sector. As the interest rates influences the capital costs, it influences the current value of the future net cash flow of a company (Bodie 2013). Higher rates would lead to high rate of interest, and low current value of future net cash flow. That decreases the stock prices. In case of fiscal policy, it leads to increase in the aggregate demand and employment in the economy. Hence, there is higher spending and higher confidence of the consumers. Stock prices increase as this leads to increased sales and revenues for the organizations (Chatziantoniou, Duffy and Filis 2013).

 

References:

Baker, S.R., Bloom, N. and Davis, S.J., 2015. Measuring economic policy uncertainty (No. w21633). National Bureau of Economic Research.

Barro, R.J. and Ursúa, J.F., 2017. Stock-market crashes and depressions. Research in Economics.

Bodie, Z., 2013. Investments. McGraw-Hill.

Chatziantoniou, I., Duffy, D. and Filis, G., 2013. Stock market response to monetary and fiscal policy shocks: Multi-country evidence. Economic Modelling, 30, pp.754-769.

Dellavigna, S. and Pollet, J.M., 2013. Capital budgeting versus market timing: An evaluation using demographics. The Journal of Finance, 68(1), pp.237-270.

Giesecke, K., Longstaff, F.A., Schaefer, S. and Strebulaev, I.A., 2014. Macroeconomic effects of corporate default crisis: A long-term perspective. Journal of Financial Economics, 111(2), pp.297-310.

Guillén, M.F. and Capron, L., 2016. State capacity, minority shareholder protections, and stock market development. Administrative Science Quarterly, 61(1), pp.125-160.

Hajilee, M. and Al Nasser, O.M., 2014. Exchange rate volatility and stock market development in emerging economies. Journal of Post Keynesian Economics, 37(1), pp.163-180.

Li, G., 2014. Information sharing and stock market participation: Evidence from extended families. Review of Economics and Statistics, 96(1), pp.151-160.

Merkle, C. and Weber, M., 2014. Do investors put their money where their mouth is? Stock market expectations and investing behavior. Journal of Banking & Finance, 46, pp.372-386.

Rey, H., 2015. Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Rogers, J.H., Scotti, C. and Wright, J.H., 2014. Evaluating asset-market effects of unconventional monetary policy: a multi-country review. Economic Policy, 29(80), pp.749-799
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