Understanding the Economy

What is the Economy?

 “Economics is a study of Mankind in the ordinary business of life.” – Alfred Marshall

The economy is simply the state of a country or region in terms of the production, consumption of goods and services as well as the supply of money. In other words, it’s the system of how money is made and used within a particular country or region.  

The government employs monetary and fiscal policies in managing the economy, these policies ensure equitable distribution of resources, monetary and price stability, economic growth, full employment, and a sound financial system. The result/lack of such sustainable policies impacts the economy either positively or negatively.

Monetary policy is a financial policy of the government implemented through the Central Bank aimed at controlling the volume, direction and flow of money & credit in the economy; through the use of tools such as Bank lending rates, Open Market Operations (OMO) and Cash & Liquidity Reserve Ratio requirements. Fiscal policy is carried out by the executive arm of government and its objective is to stimulate or curtail economic growth in the economy by increasing or decreasing tax and the government’s level of spending (budget deficit/surplus).

Both policies could be contractionary or expansionary in nature, depending on the objective the policymakers are seeking to achieve. For example, an expansive policy involves the reduction of tax rates (fiscal policy) and cash reserve ratio requirements for banks (monetary policy) to increase money supply and promote growth. A contractive policy would lead to an increase tax rates and reserve ratio.

Foreign exchange (FX) policies and exchange rate of a country relative to other currencies of the world is a major determinant of the purchasing power parity which can be used to gauge economic productivity and measure the standard of living across countries. For example, if an import dependent country’s exchange rate in relation to the US dollar moves from 0.66/$1 in the 70’s to about 82/$1 in the late 90’s and to 360/$1 in 2019, it indicates that the standard of living of the people and economy has declined.

To get a better understanding of how the Nigerian economy is faring with respect to the purchasing power parity of its currency; the cost of a ‘brand new’ Peugeot 504 car which was N3,420 in 1974 is valued today at N6.5million as a result of the devaluation of the Naira and inflation.

Economic Indicators

An economic indicator measures the level of economic activities in a country or region and aids in forecasting economic performance over a period of time. The indicators are divided into three broad categories; Leading, Lagging & Co-incidental economic indicators.

Leading Indicators predict future economic direction; examples are the Monetary Policy Rate and stock market performance etc. Lagging indicators informs us on changes in the economy that have already taken place, examples include inflation rate and unemployment rate. Co-incidental indicators shows the current state of economic activity within a particular period; examples include the Gross Domestic Product and Per Capita Income.

Some economic indicators include-:

  • Gross Domestic Product (GDP): is the broadest quantitative measure of a nation’s total economic activity and represents the monetary value of all goods and services produced within a nation’s geographic borders over a specified period of time.
  • Consumer Price Index (Inflation): measures the average change in prices over time that consumers pay for a basket of goods and services. Higher inflation rate decrease the purchasing power of the currency due to a rise in prices across the economy.
  • FX Policies: are the set of rules designed & implemented to minimise the impact of adverse exchange rate fluctuations on a country’s currency. In Nigeria, some objectives of the exchange rate policy include preserving the value of the domestic currency, maintain a favourable external reserve position and the overall goal of macroeconomic stability. FX regime could be floating, fixed or a hybrid of both (as practiced by China).
  • Monetary Policy Rate (MPR): is set by the Central Bank to influence the evolution of the main monetary variables in the economy (e.g. cost of borrowing & lending, exchange rate or credit expansion, among others).The MPR determines the  cost of borrowing in an economy, since it is the price at which Deposit Money Banks obtain money from the Central Bank. A rise in MPR (contractionary monetary policy) is commonly used to curb inflation, currency depreciation, excessive credit growth or capital outflows. On the contrary, a decline in MPR (expansionary monetary policy), should boost economic activities by fostering credit expansion or currency depreciation in order to gain competitiveness.

Impact of Indicators on Investments:

 Finance experts/Investors are interested in economic indicators because they impact the value of the assets and investments as a whole. Reading or predicting a change in trend or point of inflection in economy activity; invariably business cycles, will aid sound and effective investment decisions.

A typical business cycle is comprised of the five phases which are, initial recovery, early upswing, late upswing, slow down and recession. An investor who has the ability to identify or predict economic variables relevant to the current economic environment is considered to have a competitive advantage and an ability to take advantage of unique investment opportunities.

Understanding the relationship between different business cycles and various asset classes, their risk profiles and objectives (as depicted below) should also aid sound investment decisions;

Asset Class  Mutual Funds Investment Objectives Risk Profile Investment Decisions
Money Market Instruments Money Market Funds Capital Preservation Low Contractive cycles (Invest), Expansive cycles (sell out)
Bonds Fixed Income Funds and Bond Funds             Income Generation Medium Contractivecycles (Invest), Expansive cycles (sell out)
Equities Equity Funds and Smart Beta Funds Capital Appreciation & Income Generation High Contractive cycles (sell out), Expansive cycles (Invest)

In conclusion, asides from seeking professional financial advice, a smart investor should develop the skill of carefully interpreting economic data/ indicators and business cycles before investing.

By Fund Mangers Association of Nigeria

smestudio.xyz@gmail.com
Author: smestudio.xyz@gmail.com

FMAN aim to address all the issues affecting the industry’s development and represent its members at levels in ongoing discussion about the regulatory framework for the industry.

smestudio.xyz@gmail.com

FMAN aim to address all the issues affecting the industry’s development and represent its members at levels in ongoing discussion about the regulatory framework for the industry.

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