ECONOMICS VS FINANCES — WHY IT’S IMPORTANT TO KNOW THE DIFFERENCE

Economics and finances are often confused and many times they are taught as either one or separate disciplines. These topics are interrelated and influence each other. What is important about both disciplines is that they can influence the markets and generate volatility. One of the key elements of finances is interest rates which can have a direct effect on economic growth.

What is the difference between finance and economics?

Economics as a discipline is generally considered on a macro level and involves the study of production and the consumption of goods and services. Metrics such as growth and inflation generally describe the performance of a country or a union.

Finance focuses on capital and how it flows through the market. Finances include governmental money flows as well as institutional and personal finances. This includes interest rates, borrowing, and capital flows. Finance also focuses on the performance of individual companies and the risks to performance.

Historically, economics is more theoretical but since both are used to gauge future performance, there is not a great distinction.

How do finance and economics affect each other?

Finance and economics affect one another. Finance focuses on the performance of entities such as a company. It can describe the management, banking, investments, assets, and liabilities that are the backbone of a financial system. All of these are influenced by economic performance.

Alternatively, when finances are driving positive or negative performance, it will either increase or decrease investment, which will influence the economic performance of a country or region. Many view finances as the study of price action, as well as money flows and interest rates which both affect the performance of a broader economy.

What types of finances are there?

There are three general types of finances: Public finances which include municipalities and government entities. Corporate finances which are focused on companies and businesses. Lastly, there are personal finances, which focuses on the individual.

Public finance includes expenditures, budgets, and revenues such as taxes and debt. It can describe how a government borrows money through bonds and loans, as well as driving revenues through taxes and tolls.

Corporate financials involve managing assets and liabilities. It describes how a company generates revenues and how they borrow funds. Finances also describe the capital structure, so you can see how they break down their equity.

Personal finance defines the financial activity of an individual or a household. This will include all the revenue produced from employment and investment displacements. It evaluates investments for retirement or college savings and analyses expenses such as rent, utilities, insurance, and discretionary spending. 

How can finances and economics help with trading opportunities?

Both economics and finances will help determine the future movements of asset prices. Whether you are trading an exchange rate or a share of a company, you need to understand the inter-relationship between economics and finances.

One of the most important financial instruments is interest rates. These are rates that are charged for a loan and fall under the finance umbrella. Interest rates will flow down through an economy and can affect all economic activity.

A central bank of a nation or union will determine the interest rates that banks lend to one another. For example, in the United States, the benchmark interest rate is the Fed Fund rate. This is the rate where commercial banks lend overnight money to each other. A central bank will also control the interest rate that they will lend to other banks, but most banks lend to each other and do not borrow directly from the central bank.

How do finances flow during an economic cycle?

As economic growth contracts, the central bank will begin to increase financial accommodation by reducing the interest rate target that banks lend to one another. That should provide additional lending as banks look for corporations and individuals that will borrow capital. The capital might be used for investments, which will increase business activity. As a business expands, companies hire more employees, generating more consumption which boosts economic growth. The reverse happens when growth expands too quickly, and inflation begins to rise. Interest rates will move higher, reducing loans and business expansion. Companies will then begin to reduce employment which in turn will assist in decreasing consumption, eroding economic growth.

Summary

Most of the interest rates that are used by municipalities, businesses, and individuals are driven by market forces. While the central bank controls the target lending rate between commercial banks, the markets control nearly everything else. The US 10-year yield is the benchmark yield in the US and drives several different markets including the mortgage market, the corporate finance market, and the auto loan market. Trading in government securities will influence how economic factors such as housing and borrowing expand or contract. Understanding the interrelationship between finances and economics is important to your trading success. Learn more about economics, finances, and trading by working through One Financial Market’s free trading academy.

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