Financial Markets and the Real Economy - Essay Example

Financial Markets and the Real Economy Introduction For a long time there have been debates on the possible link betweenreal economy and financial markets. What’s more, financial scholars and economists have attempted to conduct studies that evaluate and describe the correlation between financial markets, otherwise known as stock markets and the real economy. Nonetheless, all these have taken place without reaching a conclusive decision or fact on the correlation between financial markets and the real economy (Bailey 56). Adding to the numerous debates, articles, and studies on the link between financial markets and real economy is the following discussion. Based on previously conducted studies and articles, the following discussion attempts to create an understanding of the link between real economy and financial markets. Overview of Real Economy Economics is a social science that equips learners with knowledge on production, distribution, and consumption of products, which are basically goods and services. There are two main branches of economics; macro and micro economics. Whereas macroeconomics deals with behavior of nations, microeconomics deals with behavior of individuals and firms. Each of the branches of economics has definite principles and strategies. For instance, microeconomics is guided by the need to attain the highest level of utility amongst individuals and higher profits for firms (Cochrane 23). Macroeconomics on the other hand attempts to find out how nations can have economic growth through increasing GDP, attaining full employment, stability of prices, and having a favorable balance of payments. These are the principles that economics under its branches attempts to answer. Real economy is part of economy concerned with actual production of goods and service within a country. Real economy in most cases is referred to as the total economy, which encompasses all the economic components such as economic activities, both monetized and non-monetized transactions, official and unofficial, and all transactions or activities that take place between rural and urban areas (Levinson 77). The real economy of a given nation consists of various aspects of the total economy including recorded economy, non-monetized economy, and the remaining bit of economic aspects. In this perspective, recorded economy includes all economic activities within a country that are recordable and reported through gathering of appropriate statistics (Bailey 78). Non-monetized economy on a different perspective refers to all economic activities that are linked to self-consumption. Therefore, real economy is a composition of all the aspects of economic activities within a given nation. Overview of Financial Markets Financial market on the other hand refers to a place where buyers and sellers (individuals and entities) meet to trade on assets that include equities, currencies, derivatives, and bonds. In most cases financial markets are referred to as stock markets. Amazingly, financial markets are as old as humanity. Financial markets started the moment mankind settled down to engaging in serious activities of growing crops and exchanging them with other crops. Despite this aspect of trade was known as barter, there were some financial markets aspects within the trade. For instance, there are possibilities that some people due to one reason or another attain bad harvest (Levinson 99). However, with the bad harvest such individuals had to struggle and obtain a way of farming and obtaining food for their families. In so doing, there was the aspect of obtaining credit hence the assertion that financial markets are as old as humankind. With advancements and developments, financial markets in the contemporary business environment have taken a totally different shape. There are many forms of financial markets currently all of which have their specific purposes to accomplish. In addition, financial markets developments and advancements have led to formation of highly organized markets like the London Stock Exchange and other markets that are highly informal, for instance, the exchange of money across the streets of various cities and towns in the global world especially in African (Wessels 205). Nevertheless, all financial markets whether highly organized or highly informal serve the same functions. Functions of Financial Markets Financial markets serve functions in which they are formed or mandated to within a given economy. The first fundamental function that financial markets perform is that of setting price. Through determining the exchange rates, financial markets have the vista of providing price discovery whilst creating opportunity to determine relative values of products and services within a given economy. The second fundamental function of financial markets is the valuation of assets (Bailey 123). Through determining market prices, financial markets are in a position of valuing assets since most assets are usually valued or sold at prevailing market prices. Valuation of assets is not only important to buyers and sellers but also to regulators and other interested parties such as governing bodies and institutions of a given economy. Arbitrage is another basic function that financial markets perform not only within an economy but throughout the global economy. Countries having highly informal or poorly developed financial markets always experience the idea of same commodities and currencies trading at different prices within varied locations in the same nation. In order to caution buyers against advantages taken by sellers in this perspective, financial markets are highly needed to arbitrage in a bid to harmonizing the concept of differing pricing of commodities and currencies (Davidson 125). Therefore, this is a fundamental function performed by financial markets thus explaining why they are very vital within a given nation or economy. Financial markets are also effective in creating opportunity for investment. Stock, bond, and money markets, which are forms of financial markets, provide a perfect opportunity for individuals and entities to invest their funds. Investments in these financial markets are effective given the return obtained on funds employed by investors (Wessels 210). Financial markets provide accumulation of assets that provides future income for investors. In this regards, financial markets can be considered as store of wealth. What’s more, financial markets provide opportunities to business entities through investors to raise capital required for business operations (Cochrane 45). Financial markets also provide capital for individuals who wish to enter into real estate investment or other assets through selling their shares. Commercial transactions also occur within financial markets. Therefore, through commercial transactions, financial markets are able to provide grease to business entities to acquire long-term capital. The commercial transactions may include arranging for payment of sale of a product or giving the working capital required for meeting daily operations of a firm. In addition to commercial transactions, financial markets are the foundations for managing risk through futures, options, and other derivative contracts (Bailey 135). Financial markets through such tools have helped traders to identify scenarios of boom and recession thereby providing a room to trade in risky business without any fear. Therefore, financial markets are essential features within the economy. Link between Financial Markets and Real Economy Having identified the core aspects of real economy as well as financial markets, it is now important to focus on the hotly debated topic of correlation between financial markets and real economy. In this concept, there are two sides of the coin. Firstly, financial markets are known to be affecting real economy either positively or negative. On the other side of the coin, real economy affects financial markets either positively or negatively. All the same, it should be noted that financial markets fall under the broad aspect of economy and any activity conducted within the financial markets is meant to boost the economic growth and prosperity of a given nation (Levinson 109). Therefore, there is need to identify, evaluate, and discuss both sides of the coin in respect to correlation between financial markets and real economy. Impact of Real Economy on Financial Markets Economists believe that the understanding of marginal value of various wealth within a given nation is the basis of developing insight into macroeconomics. Economics rely on the epicenter of savings and investments, marginal rates of substitutions, marginal rates of transformation, as well as various allocations of individual and nation’s consumption on one hand and investment on the other hand across specified time and states of the economy. From the economists’ point of view, assets markets are responsible for all these economic aspects, principles, and theories (Levinson 106). From this point of argument, economists believe that a powerful measurement of economic performance is only attainable through obtaining a marginal value of wealth from asset markets. Such measurement will definitely provide dynamic, modern, and inter temporal aspects of macroeconomics. Inflation: There is no doubt from such evaluations and description that both real economy and financial institution borrow significantly from each. However, a question that many people continuing asking is, “what impact does real economy play on financial markets?” Real economy plays a significant role in financial markets just as in the case of other aspects of the economy (Davidson 89). Financial markets require certain aspects of the economy to thrive well. Financial markets significantly rely on the principles and theories of investment. For individuals and business entities to invest in the financial market, there is need to have high marginal propensity to save than the marginal propensity to consume. Marginal propensity to save or invest is highly determined by economic situations within a given nation (Bailey 157). One such economic situation is the general rising and falling or prices within an economy otherwise know as inflation. Marginal propensity to save and consume is determined by prices of commodities. General prices of commodities affect significantly the power of consumers to save or consume. The power to save is the one referred to as marginal propensity to save while the power to consume is the marginal propensity to consume. The higher the marginal propensity to save the lower the marginal propensity to consume and the lower the marginal propensity to save the higher the marginal propensity to save (Cochrane 67). For instance, in scenarios where there is high inflation then consumers will have a higher marginal propensity to consumer than save given that their purchasing power decreases with increasing inflations. On the other hand, if there is decreased or low inflation rate then the marginal propensity to save is likely to be higher than marginal propensity to consume hence aiding in financial markets investments. In this case, the real economy has impacted significantly on the financial markets. The link therefore between financial markets and real economy in this case is the fact that real economy through macroeconomic principles struggle to attain stability in prices while inflation (instability) in prices affect the financial markets negatively. Income: Savings and investments are all components of income. Income is therefore a determinant of consumption and investments (savings). A nation that has its citizens with higher income means that there is higher purchasing power. In this respect, after buying the necessities such individuals will have extra income to save that forms the investing component of the income (Davidson 109). Income is determined by the real economy that is, various economic activities that are undertaken within a given nation. When a nation is experiencing increased production it means that most of its citizens are likely to have increased per capita income associated within increased GDP. Through enhanced or increased per capita income arising from increasing GDP due to higher economic activities, there is likely to be higher propensity to save as compared to marginal propensity to consume (Bailey 159). Therefore, this has the implication that there will be increased savings as opposed to consumption. From the savings it becomes easy to invest in financial markets. Therefore, investments within financial markets are highly determined by the amount of income or per capita income that individuals within a given nation have. Notably, per capital income is determined by economic activities within the country in question. Hence, real economy has significantly affected investment within financial markets in as far as the income to be invested is concerned. Unemployment and Employment: Increasing unemployment due to economic activities such as closure of industries as a result of competition thereby leading to laying off works is likely to affect financial markets adversely. The retrenched workers will be forced to look for avenues of getting additional income to sustain their basic needs (Wessels 256). One of the options for such an income would be to retrieve income from the initial investments. Consequently, this may lead to such workers withdrawing their investments. Earlier on it was identified that one of the functions of financial markets is to aid in acquisition of capital by both individuals and entities. In this respect individuals will seek for additional capital or income to sustain their basic needs (Cochrane 89). As a result, this may lead to a few owning shares or bond within the financial markets hence affecting the operations of the same due to over dominance of a give group of investors. Financial markets in this way have been affected adversely by the real economy. On a different perspective increasing the employment rate through creation of job opportunities as in the case of increased production is likely to affect financial markets negatively. With increased employment the per capita income of individuals or citizens within a country is likely to increase thereby creating an opportunity to have higher marginal propensity to save as compared to that of consumption. (Levinson 78). With reduced consumption and increased savings, individuals are likely to go into financial markets in order to invest their extra income. Such investments will definitely boost the financial markets within the country in question. Therefore, financial markets will significantly gain from increased per capita income associated with increased employment rate. Real economy’s macroeconomic principle is to attain full employment (Davidson 98). While real economy struggles to attain full employment through macroeconomic principles, financial markets take advantage to reap from the increasing employment hence the correlation between financial markets and real economy. Balance of Payments: Another aspect of real economy that affects performance of financial markets is the balance of payments. Balance of payments refers to the difference between exports and imports arising from trading activities between the country in question and other countries that form trading partners. The amount of exports and imports included in the balance of payments include financial imports and exports as well. There are three forms of balance of payments; favorable (surplus), balanced, and unfavorable (deficit). Each of these forms has an implication to the economy of a given nation thereby their ability invest within the financial markets (Bailey 198). Favorable and unfavorable balance of payment is also called imbalances within a country’s exports and imports. Imbalances where payments made are below the payments received by an economy in question is known as favorable. In this case, since financial payments outside the country for purposes of importation are less than financial receipts from other countries for purposes of exportations. Therefore, favorable balance of payments arises when exports are more than imports. Favorable balance of payment enhances more entry of currencies into an economy as opposed to currencies that are going out of the economy. The supply of money in the economy in question is likely to increase consequently causing a reduction in exchange rate in relation to other currencies (Cochrane 93). Implications of favorable balance of payments are inflation and unemployment increase. With increased inflations and unemployment rates it is unlikely that financial markets will significantly gain from this idea. Therefore favorable balance of payments will affect financial markets adversely despite the increased flow of currencies into the economy in question. On a different perspective imbalances where payments made to other countries are more than payments received from an economy indicate an unfavorable balance of payments. Financial payments to other countries are for the imports while financial receipts are for exports (Wessels 298). Unfavorable (deficit) balance of payment therefore arises when the imports are more than exports. Few currencies with then flow into the economy under question thereby making their exchange rate against other currencies to rise. The implication is reduction in inflation and increased employment through creation of more opportunities. Once the unemployment rate is reduced as well as the inflation rate, citizens are likely to have higher per capita income hence higher marginal propensity to save. This will positively affect financial markets (Davidson 201). The link between real economy and financial markets in this case is that since real economy aims at attaining a balanced balance of payments, financial markets are affected negatively by favorable balance of payments on one hand and positively by unfavorable balance of payments on the other hand. In the above discussion, the link between real economy and financial markets has been identified and evaluated. It is true from the discussion that from the various aspects of real economy, financial markets are either positively or negatively affected. Impact of Financial Markets on Real Economy Other than the fact that real economy impacts positively and negatively on financial markets, it is inevitable that financial markets also affect real economy either positively or negatively. Various functions of financial markets have been identified. In most cases, real economy benefits or is disadvantaged from the various functions of financial markets. Fundamentally, financial scholars purport that the use of stock prices and various models such as the Discount Cash Flow (DCF) model are meant to give a reflection on the future real economy activities that investors should expect. Therefore, in this perspective, financial markets concepts are used as tools for predicting expected scenarios within the real economy arena (Bailey 210). Basing arguments on this fact there is no doubt that financial markets have significant impact on the real economies of nations. The following discussion attempts to provide an overview of the impact of financial markets on real economy. Setting of Prices: Most economic activities within the real economy are influenced by prices of both inputs and outputs. Since real economy encompasses activities of production, distribution, and consumption it therefore follows that inputs and outputs employed and realized from production process are likely to influence the whole real economy (Levinson 145). Setting prices through price discovery, provision of vistas for determination of relative values, and identifying prices at which individuals are willing to transact business explicitly affect the prices of inputs and outputs. If the prices are negatively affected (there is an increase in prices) then the amount of inputs likely to be used will reduced thus causing a reduction in the amount of inputs as well. As a result, there will be reduced economic activities within an economy hence affecting real economy adversely (Cochrane 99). On the other hand, if prices are affected positively (prices reduce) then there is likely to be increased used of inputs thus producing higher outputs within increased economic activities hence affecting real economy positively. Investing; Investing is another way through which financial markets influence real economy. Investors who have money or funds that they do not intend to put to immediate use may opt to invest in any of the forms of financial markets such as stock, bonds, or money markets. Such investments accumulate assets thereby acting as future income (Davidson 212). There are various aspects through which this will affect the real economy. The first way is tying of the funds to such investments. Once an investor places funds in stock, bond, or money market it means that such an individual is not intending to use the money or fund in the nearest future. With such funds or money tied in the stock, bond, or money, the amount of money in circulation is likely to reduce hence causing reduced economic activities. On the other hand, the company that receives the funds from the investors may use the same to increase inputs for further production (Cochrane 123). Increase inputs and productions lead to increased economic activities hence impacting positively on real economy. The growth of stock, bond, and money markets through investment may be seen as avenues for economic growth and prosperity given that financial markets are aspects and part of real economy. Therefore, looking at investment in different categories indicate that there is a link between financial markets and real economy. Raising Capital; Firms within different economies are faced with insufficiency of funds especially with respect to building new facilities, expanding business, or replacing new machines. Through financial markets, such firms may opt to use various instruments such as shares, bonds, or other types of instruments recognized within financial markets to raise capital. Once such capital is raised, the firm involved will be in a better position to increase its operations through expansion, replacement of obsolete machines, or building new firms. These activities have direct positive impact on the economic activities that determine real economy (Levinson 157). In addition, financial markets have provided capital to individuals for further investments. Additional capitals for more investments have enhanced economic activities within a given economy hence impacting positively on the real economy. As a matter of fact, through raising more capital, financial markets positively impact on the real economy through provision of more funds to encourage increased operations of both individuals and business entities (Cochrane 127). There is a link between financial markets and real economy on the basis of the raising capital component. Commercial Transactions; In addition to providing additional long-term capital, financial markets provide avenue for commercial activities. Surprisingly, such commercial transactions may include arrangement of funds or payment for sale of any product or service of a firm in a foreign country. Through such arrangements it becomes easier for business entities to enhance economic activities where they sell and cause an inflow of currency into the country in question (Davidson 279). What’s more, such commercial transactions involve increasing working capital, which increases the capacity of the firm in question hence possibility of engaging many inputs to have high number of outputs. From this preposition it is undisputable that financial markets will be useful in increasing economic activities within the country (Bailey 234). Increasing economic activities within a country is an effective way of increasing real economy of the same country. No doubt therefore that all financial markets, through enhancement of commercial transactions have impacted positively on real economy. Asset valuation: Setting of prices helps in valuation of assets. Production process highly depends on the inputs used in production. Most inputs within production are mainly assets. Increasing the prices of assets therefore is likely to affect the prices of inputs. When the prices of inputs increase then firms will tend to shy off from buying such inputs. Consequently, there will be reduced production activities hence causing reduced economic activities. Fewer economic activities are characteristic of poor real economy. On other hand, valuation of prices that lowers prices of assets will affect increase of assets and inputs favorable thereby enhancing the production process (Cochrane 234). More production activities in this case are characteristic of increased economic activities and higher real economy. Assets valuation therefore, affects the prices of assets; inputs of production process inclusive will affect the economic activities hence real economy of a country. Size of the Financial Markets: Other than the above aspects of financial markets that affect real economy, the size of financial markets affect real economy significantly as well. Despite the fact that estimating the size of financial markets is difficult, there is no doubt that the bigger the size the higher the possibility of having increased economic activities taking place in the market. Transactions within financial markets are usually added up to come up with the final figure for real economy. In this perspective, a bigger financial market is likely to have higher financial transactions, which translate into economic activities and increased real economy (Bailey 278). On the other perspective, when the financial market is small there is likely to be fewer transactions hence translating into fewer economic activities and real economy. Size of financial markets has direct impact on the economic activities of a given nation hence the real economy of the same. Rise of Formal Markets: Formal financial markets will impact directly on the real economy of a give economy or country. Like the size of financial markets, increase in formal financial markets means that there are increases in authentic transactions that revolve around investment. Increased investment transaction is a sure way of measuring the economic activities of a country hence the real economy (Cochrane 345). In this case, if the formal financial markets continue to rise then it means that there are increasing economic activities through higher investment transactions hence linked to economic activities and real economy. The reverse of collapse of formal financial markets will indicate that there is a reduction in the economic activities hence real economy. From the above discussion it is undisputable that financial markets impact on real economy either negative or positively. Undeniably, there is a link between financial markets and real economy. Conclusion Since classical period, there have been debates on the possible link between real economy and financial markets. Whereas economics is a social science that equips learners with knowledge on production, distribution, and consumption of products, which are basically goods and services, financial market on the other hand refers to a place where buyers and sellers (individuals and entities) meet to trade on assets that include equities, currencies, derivatives, and bonds. Real economy on the other hand is part of economy concerned with actual production of goods and service within a country. Real economy through inflation, income, unemployment, employment, and balance of payments affects the operations of financial markets. Financial markets on the other hand affect real economy through setting of prices, investing, raising Capital, commercial transactions, asset valuation, size of the financial markets, and rise or fall of formal financial markets. These affect cause either a positive of a negative impact. The above discussions have identified and evaluated the link between real economy and financial markets. It is true from the discussion that from the various aspects of real economy, financial markets are either positively or negatively affected. In addition, it is undisputable that financial markets impact on real economy either negative or positively. Undeniably, there is a link between financial markets and real economy. It is therefore high time that debate surrounding link between financial markets and real economy on one hand and the impact each aspect plays on the other hand ended. This is after explicitly explaining from previous studies that there is both positive and negative correlation between financial markets and real economy. Works Cited Bailey, Roy. The Economics of Financial Markets. Cambridge, UK: Cambridge University Press, 2005. Print. Cochrane, John. Financial Markets and the Real Economy. Hanover, MA” Now Publishers, Inc., 2005. Print. Davidson, Paul. Financial Markets, Money, and the Real World. Northampton, MA: Edward Elgar Publishing, Inc., 2002. Print. Levinson, Marc. Guide to Financial Markets. Hoboken, NJ: John Wiley and Sons, 2010. Print. Wessels, Walter. Economics. Hauppauge, NY: Barron's Educational Series, 2006. Print. Read More