Economic Analysis — the weather above the company

Economics starts with scarcity

The workbook opens with a definition worth memorising word for word:

Three ideas are packed into it. Scarcity — resources, material and human, are limited. Trade-offs — because they are limited, making one choice would generally mean letting go of something else, so economics is about prioritisation of needs and wants and allocation of limited resources to the desired goals. And rationality — economic analysis of human behaviour begins with the assumption that people are rational: they have well-defined goals and try to achieve them as best they can. Note the word assumption. It is the model's starting point, not a claim about every shopper in every mandi.

Two branches of economics are famous, and this chapter is built on both.

5.1 Microeconomics — the behaviour of the individual and the firm

Microeconomics studies the behaviour of individuals and their decisions on what to buy and consume based on prevalent prices — decisions that signal where the economy will direct its productive activities. Its philosophy, in the workbook's own words, is that prices and production levels of goods and services in an economy are driven by consumer demand. Consumers are upstream; production follows them.

Microeconomics also deals with the "theory of the firm" — how firms adopt different strategies to increase profits, covering decision-making at the level of inputs, outputs, prices, production levels, profits and losses of individual firms.

Two uses are listed:

1. It helps us understand the working of consumers, producers, resource markets and humans, under various assumptions of market structures.
2. It helps us understand how prices get determined, how individuals and firms behave in relation to those prices, and how goods and services are distributed among the various participants in an economy.

5.2 Macroeconomics — the big picture

Macroeconomics deals with the economy as a whole. Its focus is on factors that influence aggregate supply and demand — unemployment rates, gross domestic product, overall price levels, inflation, savings rate, investment rate, and so on.

Then comes the sentence that decides half the questions from this chapter: most of these factors are affected by changes in public policies, and the two major influencers of public policy in an economy are the government and the central bank.

• Government decisions, collectively, are fiscal policy.
• Central bank actions, collectively, are monetary policy.

The workbook credits John Maynard Keynes with laying great emphasis on macroeconomic analysis, through his book "General Theory of Employment, Interest and Money", which it calls quite revolutionary. Know the man and the title — NISM has asked exactly this.

Five uses of macroeconomics, as listed:

1. Understanding the general state of the economy — domestic production, domestic consumption, general price levels, growth, quality of life.
2. Understanding the drivers of income, savings, investments and employment.
3. Macroeconomic models help governments and central bankers formulate policies for long-run economic growth with stability.
4. Understanding international trade — exports, imports, balance of payments, exchange rate dynamics.
5. Understanding how inter-linkages across economies work.

Policy makers do not have a control panel

Policy makers strive for low unemployment, price stability with low inflation, and steady growth in economic outputs. Yet economies still go through cycles of booms and busts, because multiple variables influence an outcome and it may not be possible to control all of them.

The workbook's example is Indian and specific: the RBI's attempt to tame high inflation in India in 2011, 2012 and 2013 by increasing interest rates — the standard policy action against inflation — did not get the desired results because food prices remained high. Interest rates work on demand for credit. They do not make onions cheaper.

Hence: policy makers in different countries may take different routes to arrive at the same common goal, depending on the economic conditions prevalent there.

5.3.1 National income — GDP and GNP

National income is measured through several yardsticks. Two matter here.

• GDP (Gross Domestic Product) — the market value of goods and services produced within a country's frontiers, irrespective of the nationality of the owner who produces.
• GNP (Gross National Product) — the market value of goods and services produced by a country's residents (nationals), irrespective of wherever they are in the world.

The bridge between them is Net Factor Income from Abroad (NFIA) — income received by residents minus income paid to non-residents. So the difference between GDP and GNP is NFIA.

Boundary versus passport. GDP follows the boundary. GNP follows the passport.

The three methods of measuring GDP

The workbook is explicit that GDP can be measured through three methods, and that in practice all three produce similar results with minor differences, for several reasons including errors in the statistics.

(i) Product Method. GDP as an aggregated flow of goods and services from different sectors — agriculture, industry and services. Economists calculate the money value of all final goods and services produced in a specified period. Final goods are only those consumed by economy participants, not those used in further production (intermediate goods). This method is sector-wise: total output is the sum of the outputs of various sectors.

(ii) Income Method. National income as the aggregate income of individuals. The workbook borrows Robert Kiyosaki's four categories of the working population:

Sum all of those for a specified period and you have national income.

(iii) Expenditure Method. Everything produced is bought by someone, so you can count from the consumption end. Consumers are broadly three — individuals, corporates and government. Adjustments are made for exports (foreigners spending on our goods) and imports (us spending on theirs).

The identity to remember:

And note the workbook's own aside: aggregate demand is also sometimes referred to as GNP.

What national income statistics are used for

Level of economic welfare and growth. From national income you get per capita income = National Income ÷ total population.

Here is the sharp point the exam likes: per capita income, not national income, is the better measure of the standard of living. Why? Because national income may rise while population rises faster — and then per capita income falls, meaning the standard of living has gone down. Higher per capita income means a higher standard of living. Looking at national income over several years tells you whether an economy is growing or declining.

Distribution of income. The income method shows how national income is split among Employees, Professionals, Entrepreneurs and Investors. The product method identifies which sector is the primary contributor to GDP and the growth rate of each sector. The workbook's own illustration: the service sector constitutes 60% of India's GDP at factor cost.

Support to fiscal and monetary policies. Statistics on saving, consumption and investment guide policy makers. National income computation is, in the workbook's phrase, a valuable guide to policy makers.

5.3.2 Savings and investments

The three constituents of an economy again — individuals, corporates and government — and savings, defined as income over expenses, are computed for each separately.

Individuals and corporates clubbed together are private savings. National saving is the sum of personal + corporate + public savings.

Then the line that gets tested: savings does not mean investment. Savings must be channelised towards productive avenues — handed to corporates or government to invest and generate further earnings. When savings turn into investments they take the shape of a financial instrument — equity, bonds, government securities and others — which transfers funds from savers to users (the issuers of securities).

That is precisely why governments and central bankers work on efficient and effective financial markets: a wide range of products, ease of conversion, simplicity in transactions, safety in dealing, low cost, and transparency in operations.

Higher levels of savings, and higher conversion of those savings into investments, are considered good for an economy. Both halves matter.

5.3.3 Inflation and interest rates

Inflation is the general increase in price levels of goods and services in the economy, leading to an erosion of the purchasing power of money.

The workbook's illustration: put ₹1,000 in a drawer. A year later it is still the same ₹1,000 note, but it buys fewer goods and services than it would have a year ago. How much less is a function of the prevailing inflation rate.

Two causes:

To defuse inflation, policy makers reduce demand, increase supply, or both.

Two measures:

Economists define a basket of products based on general consumption in the economy and price that basket at wholesale prices (WPI) and retail prices (CPI). The series over several years gives the trend in inflation, which feeds policy decisions by both government and the central banker.

The inflation–interest rate chain

This is the transmission mechanism the exam wants you to be able to walk through in order:

1. Higher inflation demands higher rates for people to be motivated to save.
2. As people save more, they consume less — consumption goes down.
3. Higher rates reduce investment, because the cost of capital is high, and that may slow the overall economy.
4. Higher rates hit real estate and auto more intensely, because most of the buying there by middle-class people happens through loans, which become expensive.
5. Higher inflation reduces discretionary income, which hits demand for products and services across the board.

Note what this gives an equity analyst. A rate hike is not one effect — it is a sequence, and it lands hardest on rate-sensitive sectors: banks, real estate, autos and anything sold on EMI.

5.3.4 Unemployment rate

The unemployment rate refers to the eligible and willing to work unemployed population of the country, in percentage terms.

Read it slowly. It does not count everyone without a job — a person who is neither eligible nor willing to work is outside the calculation altogether.

The cycle logic: during a slowdown unemployment rises; during an expansion it falls as more jobs are created and production goes up. Higher employment means income, which improves the ability of people to spend, which implies potential growth in the economy — and the reverse in bad times.

5.3.5 FDI and FPI — the two kinds of foreign money

There are upper limits on the individual and combined holding by FPIs in the paid-up capital of Indian companies.

FDI is welcomed by all developing economies because, beyond the capital itself, it brings:

• Job creation
• New technologies
• New managerial skills
• New products and services

5.3.6 Fiscal policy — the government's side

Fiscal policy contains the measures of the Government which deal with its revenues and expenses.

• Income — primary source being taxation.
• Expenditure — education, healthcare, police, military forces, interest on borrowing, administrative machinery, welfare benefits, and so on.

When the government changes either side, it influences aggregate demand, supply, savings, investment and overall economic activity.

The fiscal deficit and why an analyst cares

Three details in that one sentence: it is budgeted, it is for a specific year, and it is expressed as a percentage of GDP.

The fiscal deficit is bridged by the government through market borrowings, both short-term and long-term. And now the chain that matters to a research analyst:

Large fiscal deficit → higher government borrowing → pushes up interest rates in the economy → makes it difficult for corporate borrowers to access funds → a high interest rate environment, which is detrimental to economic growth.

The government is the largest and safest borrower in the market. Borrow more and it absorbs the pool of savings, leaving everyone else to pay more for what is left.

How government expenditure is funded

The three fiscal stances

The Balance of Payments and the Current Account Deficit

A country has trade and other contracts with entities abroad, producing receipts and payments. These are captured in a countrywide statement called the Balance of Payments (BOP) — payments for imports, receipts for exports, interest and dividend received and paid, and other transfers from abroad.

The current account balance is the difference between such recurring revenue receipts and the payments. A country may have a current account surplus (receipts greater than payments) or a current account deficit (receipts less than payments).

The workbook then spells out, step by step, what a high CAD does. Learn the chain in order, because this is the most testable transmission mechanism in the chapter:

1. A high Current Account Deficit causes the nation's currency to weaken relative to other currencies.
2. A weaker currency makes imports more expensive.
3. That affects the productivity of the economy, because capital goods and commodities become expensive.
4. It reduces the creditworthiness of the nation.
5. Which makes foreign currency borrowings more expensive.

And then the two self-correcting valves:

• A depreciating currency makes the nation's exports more competitive and may help narrow the deficit.
• If the country is seen as an attractive investment destination, capital inflows in the form of FDI and portfolio inflows will offset the CAD and protect the currency from devaluation.

That second point is why Indian markets watch FPI flow data daily: the flows are not just demand for shares, they are the counterweight holding up the rupee.

A note on the workbook's wording. In this paragraph the workbook writes "A high fiscal deficit in proportion to the GDP caused by lack of competitiveness in trade or excessive consumption is a negative commentary on the economy." The causes named — trade competitiveness and excessive consumption — are the causes of a current account deficit, and the sentences on either side are about the current account. Read it in context, and do not let it confuse the two deficits in your head: the fiscal deficit is government spending over government revenue, and the current account deficit is national payments over national receipts.

5.3.7 Monetary policy — the central bank's side

Monetary policy, administered by the central bank, deals with money supply, inflation and interest rates, for the purpose of promoting economic growth and managing price stability.

Like fiscal policy, it is either expansionary or contractionary:

The toolkit — five instruments, exact definitions

Repo transactions are repurchasing obligations, where the central bank buys approved securities with a promise to resell them when required. In this way it places money in the hands of financial institutions for a very short term.

Three separations to keep clean:

• Repo = lending, Reverse Repo = borrowing. Both are against securities. The direction of the money is the whole difference.
• Bank Rate is the one without collateral, and it is for medium to long term or emergencies — not overnight.
• CRR is held with the central bank in cash. SLR is held by the bank itself in cash equivalents like gold and G-secs. Both are a minimum percentage of total deposits. Raise either one and less money is available to lend.

There is no formula

The workbook is unusually humble here, and the humility is examinable:

Because of variations in the composition of GDP, growth rate and demographic features of different economies, the same policy action may have different outcomes in different economies. Worse, a policy action taken to correct one economic problem may have unintended consequences:

• Stimulating a stagnant economy by increasing money supply, increasing spending and lowering taxes runs the risk of causing inflation to rise.
• Cooling a heated economy by increasing taxes or cutting spending can, in the long run, produce a slow-moving economy and high unemployment levels.

Every policy lever has a cost on the other side.

5.3.8 International trade, exchange rate and trade deficit

International trade is the total trade a country does with all other countries. The balance of payment is the statement showing a country's transactions with the rest of the world.

Under the old structure, BOP had two accounts:

• Imports more than exports → current account deficit. Exports more than imports → current account surplus.
• Capital account in surplus if inflows (FDI, PFI, loans, grants) exceed outflows; in deficit if outflows exceed inflows.
• Surplus and deficit on the two accounts are ideally expected to square off each other, keeping the overall BOP in equilibrium. The workbook's dry comment: "Seldom does it happen."

Under the new IMF BPM6 structure, which is now in vogue, the layout changed:

So under BPM6:

And those changes in reserve asset position are either a drain-out of forex reserves or an increase in forex reserves.

Finally, the sentence that links it all back to the market: if a country runs continuous deficits on the current account, it needs surpluses on the capital account to support that. Otherwise it depletes its foreign currency reserves. In both situations the country risks losing the confidence of market participants, because the currency would depreciate sooner.

5.3.9 Globalisation

Globalisation is the ability of individuals and firms to produce anything anywhere and sell anything anywhere across the world. It also means resources — people and capital — flow to where they are utilised best and generate the best returns.

During a stable phase the world appears flatter, with fewer entry barriers. But note the qualifier: there is no compulsion for any economy to open up — each country decides on its own, based on its assessment of the perceived advantages.

5.4 Why an analyst does any of this

One of the key focus areas of fundamental analysis is whether and how much a business is likely to grow or shrink. That depends heavily on execution by the company and its management — but the overall external environment is also a critical factor. Economic analysis is how you read that environment.

Concretely:

• GDP growth rate tells you what is happening in the overall economy.
• Monetary and fiscal policy tell you whether policy supports further growth or otherwise.
• Interest rates, inflation, public expenditure and fiscal deficit tell you the future direction of monetary and fiscal policy.

And the two forward-looking judgements the workbook draws out:

• If the economy is shrinking, the level of inflation tells you whether the central bank has room to increase liquidity by cutting interest rates. High inflation removes that room.
• The fiscal deficit number tells you whether the government has room to increase public expenditure to aid growth. A stretched deficit removes that room.

Once an analyst has that view, he or she can work out how the future trajectory of the economy is likely to affect the specific industry being analysed. Economy first, then industry, then company.

5.5 Secular, cyclical and seasonal trends

Secular trends. The workbook's example is the digitalisation of office space — consumption of paper and ink falls while spending on digital products rises. Secular trends are driven by disruptions from technology, culture, demography and consumer preferences, are long term, and often cause an inflection in the business lifecycle of an industry.

Cyclical trends are observed at three levels: economic cycle, commodity cycle and inventory cycle.

The economic cycle — four phases

Although the economy keeps going through these phases, the length of these phases is unpredictable. Understanding the economic cycle helps an analyst arrive at a medium-term outlook on sales volume and prices for an industry.

Commodity cycle

Prices of many hard commodities move in cycles, most often driven by economic cycles — up in expansion, down in recession. But at times the commodity cycle occurs independent of the economic cycle.

Its own self-correcting loop: prices rise → suppliers add production capacity → too much capacity → prices fall → high-cost producers find operations uneconomical and abandon capacity → supply decreases → prices rise again.

Inventory cycle

Inventory cycles are short-term cycles that occur within a commodity cycle, caused by inventory adjustments by producers and customers.

• Customers holding huge inventory temporarily reduce procurement → inventory piles up at the suppliers' end → prices fall.
• During a downturn, cautious customers cut procurement sharply. If demand then improves marginally, they do not have adequate inventory and must procure immediately → prices increase.

The workbook's live example: in April 2020, huge inventory of crude oil in Oklahoma caused crude oil futures to crash to around USD 20 per barrel, and the futures price temporarily went negative. As the inventory situation improved, prices recovered and the futures contract traded at around USD 40 per barrel in June 2020.

Understanding the inventory cycle helps an analyst forecast near-term demand and prices for a business's inputs or outputs.

Seasonal trends

Highly predictable fluctuations owing to the nature of the goods. The workbook's example: GDP contribution from agriculture is likely to be higher around the period of harvest, so agricultural income varies quarter over quarter based on the sowing and harvest cycle — but predictably.

Two tools: the seasonally adjusted growth rate, used by economists, which factors in seasonal fluctuation; and year-over-year growth, comparing the current period with the same period in the previous year. The assumption behind the second is that the same observable or unobservable factors influencing a metric during a particular part of the financial year remain the same across years.

This is why an Indian analyst compares Q3 FY26 with Q3 FY25 and not with Q2 FY26. Q3 contains the festive season. Q2 does not.

5.6 Sources of information for economic analysis

The workbook lists four:

• Government websites
• Websites of regulators such as SEBI, RBI, MOF etc.
• Published economic research reports
• Economic Survey

Beyond the book — who actually publishes what

The workbook stops at that four-item list. In practice an analyst needs to know which body releases which series. These are well-documented public facts, not workbook statements — background, not quotable exam answers:

If a question names a source the workbook itself listed — government websites, regulator websites, research reports, Economic Survey — answer from the four-item list. That is what NISM tests.