A Background to Financial Assets

Financial markets essentially revolve around the buying and selling of assets, intangible assets to be precise. An intangible asset is an asset that's physical properties are irrelevant to its value - it tends to just be a piece of paper.  The relevant part is the future claim to some income or benefit that the asset legally entitles the owner to. The owner of the asset would be referred to as the investor, whereas the person/institution that is agreeing to pay out in the future is known as the issuer. Examples of these intangible, also known as financial, assets would be common stock, bonds, loans or mortgages to name but a few. These differ from tangible assets. The value of a tangible asset is derived directly from its physical properties. Examples of these would be a house or a car.

The return the investor receives on these financial assets depends on what sort of asset they've purchased. It could be an equity instrument or a debt instrument. If the investor has purchased an equity instrument then the issuer will be paying an amount out depending on the earnings of the asset. So, for example, an equity instrument could be a partnership share in a business. The issuer would then pay the investor an amount depending on the profits earned by the business. In contrast to this, a debt instrument involves fixed payments to the investor. These would be loans or bonds, when a fixed interest rate is paid out. One exception to the rule would be a convertible bond - these allow the investor to switch between debt and equity if certain conditions are met.

Financial assets play two key roles in the economy. They are a method of transferring funds to those who need them to purchase tangible assets from those who have excess funds. They also act as a method of redistributing the risk that comes with the cash flow generated by tangible assets among those seeking and those providing the funds.  

The price of an asset is the most important factor - this is essentially what determines whether people will buy and/or sell. The basic principle to follow is that the price of the asset is equal to the current value of its expected cash flow. The certainty of that cash flow is what causes variations in the price of the asset. The assets are all subject to risk, and it's this risk that can cause price fluctuations, allowing investors to potentially profit. The three main risks that financial assets are subject to are the following:

• Purchasing Power Risk - This is to do with the rate of inflation. The rate of inflation will affect the real value of the financial asset and thus cause the price to fluctuate.
• Credit/Default risk - This is the risk that the issuer will default on their obligation. Or, in Lehman's terms, the risk that the person agreeing to pay up cannot pay up, causing the investor to lose money.
• Foreign Exchange Risk - The risk associated with the value of the currency changing and potentially being worth less.

There is a relationship between tangible and financial assets. Financial assets tend to be used to finance tangible assets. So a debt instrument may be issued to generate funds to buy some delivery vehicles, for example.

There's a simple introduction to financial assets.  An intangible asset that legally obliges the issuer to pay the investor an agreed amount in the future. The play a pivotal role in the economy - moving funds around from those with an excess to those that need them. The price is determined by how much the asset is expected to bring in at a future date, this value is subject to fluctuations caused by different types of risk. Hope that all makes sense 

The Thatcher and Major Years

In 1979 Margaret Thatcher came to power in Britain - the first female Prime Minister. It was seen as a turning point for Britain, not just for this reason, but because of the effect it could have on economic policy. She was a radical woman, and her policies echoed her personality. Brutal. Defeating inflation was the key to her policies. In the run up to the election the Conservatives rethink their philosophy and come up with their "New Approach". They'd place greater emphasis on market forces, preferring small government intervention in the economy. This wouldn't be possible with the inflation problem, however. This needed to be defeated because it was distorting price signals and angering voters.

This period saw the rise of the Monetarists. They were born out of the "Chicago School" with Milton Friedman a figurehead of sorts. Their argument was fairly simple. They felt using demand management would be shooting ourselves in the foot - more demand meant more inflation and not higher output. Inflation was a monetary phenomenon, the money supply had to be cut to control it - tight financial policy was needed. In 1980, the Conservatives follow this line of thought. They raise interest rates and VAT while lowering their public borrowing. What's the result?

Well, in 1981 the economy is in recession - yet the Budget of this year sees policy tightened even further. It was a bold move, it showed that the Conservatives were really trying to tackle inflation. And it works. Inflation falls rapidly from 18% to a more acceptable 4.3% from 1980-1983. Interest rates are increased further after this and growth starts to pick up. It was a step in the right direction, but unemployment was remaining high and inflation was still higher and more volatile than other major economies.

The policy still struggled, however. They know that responding to the headline inflation rate was pointless because of the time lags in policy taking effect. They somehow needed to find an effective framework that could predict inflation in the future and respond to that level now. This indicator for when to change policy came in the form of the Medium Term Financial Strategy (1980). It was a framework that targeted the money supply - targets would be made and the broad money supply would not be allowed to rise above them. Interest rates and lower public borrowing would be used to control the money supply and keep it within the desired range. It had risks, tightening policy always carried the risk of bringing a recession.

It could have worked, but it had its problems. The targets weren't met - the money supply consistently grew faster than it was meant to and public borrowing wasn't cut enough. The policy wasn't tight enough, yet the real economy suggested the policy was too tight - domestic demand was being curbed by the interest rates and the pound soared. Britain entered a bad recession not long after. Why does this happen? A recession shouldn't really mean the money supply rises. Yet it did. This is the same period that the banks are being deregulated and firms were struggling and needing to borrow more to stay afloat. Lending controls were abolished, which means more loans were now showing on the official statistics. Overall, the money supply figures weren't an accurate guide to the economic conditions.

The Medium Term Financial Strategy is gradually abandoned because of its weaknesses - the government starts to slowly target the exchange rate by keeping the pound steady with the German mark. The pound starts at too low a level against the mark and the economy overheats in 1988. The government try and raise interest rates but it's too late as we enter recession again and end the 1980s with rising inflation. Britain needed help - and this came in the form of the European Exchange Rate Mechanism. This mechanism pinned the pound to the strong Mark allowing it to fluctuate 6% either side - Britain joined at a rate of 2.95 DM. The advantages were that it would supposedly improve fiscal discipline and therefore curb the inflation problem. It didn't. In 1992, on a day known as 'Black Wednesday' we see that it didn't. Britain finds it needing to lower its interest rates because the initial rate it joined the ERM with was over-valued. Other countries in the ERM had high interest rates which meant Britain couldn't realistically lower theirs. Speculators begin to see the pound falling and start to sell, a run on the pound starts. The aftermath of this was that the pound had to be devalued in 1992 and the credibility of the John Major government was ruined. Improvements do follow, but they can't restore the governments political position. An inflation target rate is set and interest rate decisions are given to the Bank of England who based their changes on a range of economic variables and not just the one. 

Battling Against Inflation, 1970-79

The 70s were a bad decade for the British economy. 'Failure' is probably the most fitting word for the period. From 1974 to 1979 unemployment had crept up to pushing on 5%, growth had fallen to 2% but the real issue was inflation at 16%. Part of the rise in prices can be attributed to the collapse of the Bretton Woods system, this led to a global commodity price rise which saw oil rise four fold in a 2 year period. Domestically, though, the supply side issues discussed in a previous post weren't helping and a lot of errors were made in macroeconomic policy cause partly by confusion over the actual cause of inflation.

The confusion was theorists thinking they understood the tradeoffs between economic objectives, such as inflation and unemployment. Stagflation occurred in the early 70s which shocked theorists - inflation and unemployment was rife at the same time, the government were struggling to achieve any of their objectives.

The government needed to re-think. They put the priority on targeting unemployment in the early 70s. During this period the Barber Boom took place. The chancellor at the time (Barber) injected a large monetary and fiscal stimulus to raise output but not inflation because of the spare capacity in the economy. Sterling was also allowed to float freely to stop a balance of payments crisis choking the growth. Did it work? In the short term - yes. Growth peaks at 7% in 1973. But, over the longer term, the balance of payments deficit soars, inflation starts to runaway and smaller financial institutions collapsed - the three things that really weren't wanted.

Because of the soaring inflation the government makes controlling this the main priority as the 1970s progress. Unemployment falls down the pecking order. Revised Keynesian theory defined the inflation as cost-push. Wages were rising faster than productivity forcing up the prices. Pay rises needed to be checked - were income policies the solution to this? Income policies worked like so: pay rises would be limited by setting a norm that everyone should follow. Some would be voluntary, some would be forced, others would be more complex. It worked for small periods of time, but it always failed eventually as people became dissatisfied and it defied the point of trade unions.

The monetarists attacked the income policies claiming they didn't curb inflation at all they just distorted the labour market. Tighter financial policy was required. This was true, public spending was high and still increasing. It rose faster than national income from 1970-75 and reached 9% of GDP during 1975. This high spending was crowding out private sector investment by pushing up interest rates. In 1976, Labour realise the problem and agree to a deflationary package. Their new budget regime centred around cash limits. 60% of their spending would now be subject to 'cash limits'  and different programmes received a fixed cash sum year on year regardless of inflation. In real terms, this change meant public spending fell and brought inflation down to some extent.

What can we conclude from this then? Was this the end of the Keynesian era? The government were still trying their hardest to adapt Keynesian demand management policies rather than find a new, improved framework. This just resulted in what seemed like aimless policies that didn't solve any problems. Real living standards on the whole were hit, especially the middle income people, which led to a lot of resentment. 

Macro-Economic Issues

The macro-economy refers to the wider economy - it's looking at an economy as a whole as opposed to individual firms or operators within an economy that micro-economics refers to. We come across macroeconomics on a daily basis: inflation and unemployment for example. The topic gets a lot of media attention and is the main cause of a lot of the criticism that politicians receive. The importance placed on macroeconomics by politicians can never be understated - they fully understand that voters want a thriving economy and therefore they strive to achieve this.

The four major economic issues are ones we will all have heard of: Economic growth, unemployment, inflation and the Balance of Payments/Exchange rate. The government aims to keep all four of these in check as part of their policy objectives. They want economic growth to be at a high, stable level. They aim to reduce unemployment because not only is it a drain on their finances in the form of unemployment benefits but it is a waste of resources. Inflation needs to be kept low and stable to make decision making easier on individuals and firms. The balance of payments wants to be in surplus, or at least balanced, so that the exchange rate isn't pushed upwards (this can fuel inflation as import prices will rise). The problem the government faces is that these policy objectives can conflict. If there's one thing you learn from this post, make it be this: The government are in a difficult position - they will struggle to achieve all four of these objectives at the same time.

At this point I am going to direct you to a previous post I've written about the circular flow of income as this will come in handy when looking at the next part. Click here to be linked to that post.

So, the macroeconomic goals of the government have a close relationship with the circular flow of income. If the withdrawals from the flow exceed the injections into the flow then we will see a case of aggregate demand falling. This subsequently will lead to a fall in economic growth, a rise in unemployment, lower inflation and a potential improvement of the balance of payments. With injections exceeding withdrawals we expect the opposite to happen. Here is a perfect example of the difficulties the government faces. A rise in aggregate demand has the potential to push the government closer to two of its goals (economic growth and a fall in unemployment) but at the same time it also pushes them further away from the other two goals (rise in inflation and a worsening balance of payments). The dilemmas of a politician. 

Inflation (Macroeconomics)

Inflation is a term that is thrown around a lot, so therefore it's a well known term. However, i'll still write this post to add some details and other information.

Inflation is defined as a rise in the general level of prices over a period of time. It is measured using The Harmonized Index of Consumer Prices (HICP). It measures the average weighted increase in the prices of a typical basket of goods. Inflation was previously measured using the Retail Price Index (RPI).

Inflation can be caused by either demand-pull or cost-push factors. Demand-pull inflation occurs when there has been an increase in the level of demand in an economy - basically there are too many people chasing too few goods. This is illustrated by a rightward shift of the AD curve on an aggregate demand/supply graph.

The other type of inflation, cost-push inflation, is caused by firms raising their prices because of increased wage costs, cost of raw materials or components. Basically, anything that makes production more expensive and causes the firms to raise prices. This type of inflation may be down to imported inflation, which is when we import from abroad a good that's price has risen because of inflation in the country it came from.

To summarize: Inflation is when prices of goods rise over time, caused by either demand-pull or cost-push factors. That is all, in brief.

Thanks for reading.

Aggregate Demand & Supply (Macroeconomics)

A classic AD/AS diagram has two axis. On the y axis (vertical one) we have price levels. Reading of this axis we will be able to see if the price levels in the economy have increased or decreased, thus seeing if there's been inflation or deflation in the economy. On the x axis (horizontal one) we have real GDP. The real part just means the figure has been adjusted slightly so it's in line with inflation. From the axis we will be able to read off the GDP of the economy so we can determine whether the economy has grown or shrunk. Also, we can determine from this axis whether unemployment has risen or fallen.

When we bring both aggregate demand and aggregate supply together and model them on the same diagram the two curves cross. This point is know as the macroeconomic equilibrium. This means both aggregate demand and aggregate supply are equal. 3 of the Governments's main objectives are to achieve full employment, low and stable inflation and to achieve steady economic growth. All of these can be viewed on an AD/AS diagram. Here is a standard AD/AS diagram:

As you can see, the AD curve hits the LRAS curve at the point where the LRAS curve begins to become vertical. This means that full employment has been achieved, or thereabouts. If AD was to shift to the left, it would mean unemployment has increased and the government would have to attempt to stimulate aggregate demand again to increase employment. It would do this by increasing any of the factors... (AD = C+I+G+(X-M)).

The government set the Bank of England the objective of stable prices (a target of 2% inflation). For this to be achieved, aggregate demand must not exceed the point of full employment on the diagram. If this would happen, you can see that price levels would increase dramatically and price levels rising is inflation.

To achieve economic growth, the AD curve would need to shift to the right - meaning Real GDP will have increased. To achieve this growth without inflation, the LRAS curve would need to shift to the right as well as the AD curve if the economy was operating at full employment. This would create some extra capacity for the economy to expand into.

There you have the three government objectives displayed and explained on a diagram. That's it for AD/AS diagrams.. Refer back to the individual posts about aggregate demand or aggregate supply if you're confused. Next up will be a short introduction to the multiplier effect. Thanks.