WORKING OF AN ECONOMY

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VINEESH KHANNA (Querist)
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13 April 2009
Hi everyone,

Can any one tell me how the economy of an country like India moves on, what are the factors determining growth of an economy, how the economy affects with rise or steep in share prices etc.

Does any of you have any material to share for the same.

Sachidanand Singh

Sachidanand Singh (Expert)
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13 April 2009 It is an involved topic. I am attempting a short and simple summary, hoping that there will not be any error because of over-simplification. First the background:

Economy moves on production of goods and services. Clearly these will not be produced unless there is a market for their consumption. Thus it is equally valid to say that economy moves on consumption of goods and services. Size of an economy is measured in terms of aggregate earnings of every person / organization in that economy taking care not to count the same earning twice.

Production and consumption cannot take place unless resources are invested in production and distribution facilities. (In this context please keep in mind that investment means investment in real assets such as a lathe and a truck rather than in financial assets such as a share or a debenture)

The earnings of an economy get partly consumed and partly saved. The savings, if the financial system of the economy is efficient get invested in those assets which will contribute to maximum growth of the economy. This is how market driven economy works. In planned economy, a body of wise men decides where these savings are to be invested.

If there are not enough savings to invest the economy will falter unless it attracts capital from abroad (savings of other economies) for investment. To increase production (i.e. to expand economy) we need either more capital investment or more efficient utilization of existing investments. Since efficiency cannot go on increasing indefinitely, for sustained growth the economy must keep on reinvesting in itself.

Stock markets play a crucial role in allocation of savings to the most attractive investment avenues. If IT firms are expected to earn better than other firms, the shares of IT firms go up and it becomes easier for a new IT firm to raise money. Thus stock market directs the society’s savings to IT sector which is expected to perform better, which is the same thing as saying that it contributes better towards growth of the economy.

Stock markets cannot perform this work properly unless there is free flow of information, transaction costs are reasonably low and there is no group(s) that can influence the asset prices. A market with these traits is said to be an efficient market and it allocates the savings efficiently contributing to the economic growth.

Now your specific questions:
What are the factors determining growth of an economy: Investment and efficiency, efficiency is measured in terms of how much value is generated with one unit of investment

How the economy affects with rise or steep in share prices etc. The question is not clear. It can be interpreted as how does economy affect the asset prices or how does the economy get affected by share prices: The answers to both questions are interwoven. Markets are forward looking. It means that they price assets not on the basis of what benefits the assets are giving today but on the basis of the benefits they are expected to give in future. Collective expectation of the market men gives a sense of direction to the economic activities as illustrated with the IT example earlier. Present condition of the economy affects the expectations of the market and thus what is popularly called the “mood” of the market.

Was it helpful? I am afraid I do not have any ready material to share on it. But I can refer some books of economics and finance that deal with, among others, these issues. You can try Samuelson for economics and Brealey & Myers or Damodaran for market efficiency. Trouble is both books are thick tomes and you would need to refer to rather small parts.