ECON130 Week 9: Finance

This week was a topic that a lot of students take the course for – finance.

Finance seems like an exciting topic, with a lot of the economic metrics we see flashed around day to day related to financial markets rather than the abstract markets we’ve been talking about so far.

However, what do we mean when we talk about finance here, and how does it fit into what we’ve talked about so far? For the murky details of how we “do” finance I will leave you to work through the lectures (and slides here and here) – this post is just about motivating why we do those calculations.

What are we talking about with finance?

Lets not fixate on stock markets, interest rates, and some of the exciting financial gambles you see in movies. Lets not use some of the common definition of “financing an expenditure” or “dealing with large sums of money. And instead lets start at the beginning and work out what this term means for us in economics.

So far in the course we’ve been fixated on the amount of stuff we have the opportunity to consume – the real things. Ice creams, cars, coffees – all the good stuff. And in week three we described how we may want to think about these intertemporally – namely our consumption at different points in time.

With that we needed a way to magically shift consumption through time – we needed saving and borrowing.

Finance describes how we transfer and value monetary flows through time, which are then used to shift when these consumption opportunities occur.

Finance is the study of financial markets, where financial markets define how we can shift monetary sums through time and how they translate – where the translation is complicated by i) the fact we value things differently through time, ii) the payment of a nominal interest rate, iii) the change in prices [eg giving the idea that a dollar now is valued differently to a dollar in the future].

What’s this got to do with microeconomics?

Everything.

A lot of what we’ve discussed so far in class was static. There was one period of time, there was an amount of income, and we used that for consumption.

But once we admit that:

  • there are multiple periods of time – some where we would really like to borrow from the future or past, and some where we don’t value additional consumption all that much,
  • that we don’t necessarily have information about what will happen in the future (and so there is risk associated with a choice that uses or allocates funds that would have been available in the future),
  • and that there are a variety of ways of allocating these funds through time (holding cash, holding bonds, holding other assets).

We can see that this is an important issue to explicitly think about. Once we start working in this space this expands what we can do when using our microeconomic tools.

In this way, finance is an application of microeconomics that explicitly models time and the intertemporal consumption choice – or trying to understand the dynamic process behind people’s choices about when to consume and save.

Furthermore, these choices are important for macroeconomists – as they look at this behaviour when trying to understand the dynamics of the economy at large. In this way, finance is a central subject for both microeconomists and macroeconomists.