Finance vs. Economics: An Overview
Although they are often taught and presented as separate disciplines, economics and finance are interrelated and inform and influence each other. Investors care about these studies because they also influence the markets to a great degree. It'simportant for investors to avoid "either/or" arguments regarding economics and finance; both are importantand havevalidapplications.
As a general social science, the focus of economics is more on the big picture, or general questions about human behavior around the allocation of real resources. The focus of finance is more on the techniques and tools of managing money. Both economic and finance also focus onhow companies and investors evaluaterisk and return. Historically, economics has been more theoretical and finance more practical, but in the last 20 years, the distinction has become much less pronounced.
In fact, the two disciplines seem to be converging in some respects. Both economists and finance professionals are being employed in governments, corporations, and financial markets.At some fundamental level, there will always be a separation, but both are likely to remain very important to the economy, investors, and themarkets for years to come.
Key Takeaways
- Economics and finance are interrelated disciplines that inform each other, even if the specifics are distinct.
- Finance, as a discipline, is derived from economics; it involves assessing money, banking, credit, investments, and other aspects of the financial systems.
- Finance can be further broken down into three related but separate categories—public finance, corporate finance, and personal finance.
- Economics looks at how goods and services are made, distributed, and used, as well as how the economy overall functions, along with the people who drive economic activity.
- The two main branches of economics are macroeconomics, which looks at the overall economy, and microeconomics, which looks at specific factors within the economy.
Finance
Finance in many respects is an offshoot of economics.Finance describes the management, creation, and study of money, banking, credit, investments, assets, and liabilities that make up financial systems, as well as the study of thosefinancial instruments. Finance can bedividedinto three categories: public finance,corporate finance,andpersonal finance.
Finance typicallyfocuses on the study of prices, interest rates, money flows, and the financial markets. Thinking more broadly, finance tends to center around topics that includethe time value of money, rates of return, cost of capital, optimal financial structures, and the quantification of risk.
Finance, as in the case ofcorporate finance,involves managing assets, liabilities, revenues, and debt for a business.Businesses obtainfinancingthrough a variety of means, ranging from equity investments to credit arrangements. A firm might take out aloanfrom a bank or arrange for aline of credit—acquiring and managing debt properly can help a company expand and ultimately become more profitable.
Personal finance defines all financial decisions and activities of an individual or household, includingbudgeting,insurance,mortgageplanning, savings,andretirement planning.
Public finance includes tax systems, government expenditures, budget procedures,stabilization policyand instruments, debt issues, and other government concerns.
Special Considerations
A degree in finance is a common denominator among many of those who work on Wall Streetasanalysts, bankers, or fund managers. Likewise, many of those employed bycommercial banks, insurance companies, and other financial service providers have college backgrounds in finance. Apart from the finance industry itself, a degree in finance can be a pathway to senior management of companies and corporations.
Finance involves assessing the value of financial instruments,such asthe determination of fair value for a wide range of investment products. Finance includes the use of stock-pricing models like the capital asset pricing model(CAPM) andoption models like Black-Scholes.Finance also includes determiningthe optimal dividend or debt policy for a corporation or the proper asset allocation strategy for an investor.
It can also be argued that finance affects the markets with a seemingly constant stream of new products. Although many derivatives and advanced financial products have been maligned in the wake of the Great Recession, many of these instruments were designed to address and solve market demands and needs. For example, derivatives can be used to hedge risk forinvestors, hedge funds, or large banks, thus protecting the financial system from harm in the event of a recession.
Economics takes a more theoretical look, while finance is more applied, however, both are connected disciplines, with some overlap.
Economics
Economics is a social science that studies the production, consumption, and distribution of goods and services, with theaim of explaining how economies work and how people interact. Although labeled a "social science" and often treated as one of the liberal arts, modern economics is in fact often very quantitative and heavily math-oriented in practice. There are two main branches of economics:macroeconomicsand microeconomics.
Macroeconomicsis a branch of economicsthat studies how the aggregate economy behaves. In macroeconomics, a variety of economy-wide phenomena arethoroughly examined, such asinflation, national income,gross domestic product (GDP),and changes in unemployment.
Microeconomics is the study of economic tendencies, or what'slikely to happen when individuals make certain choices or when the factors of production change. Just as macroeconomics focuses on how the aggregate economy behaves, microeconomics focuses on the smaller factors that affect choices made by individuals and companies.
Microeconomics alsoexplains what to expect if certain conditions change. If a manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer than before. If a major copper mine collapses in South America, the price of copper will tend to increase, because supply is restricted.
Macroeconomics can be applied intrackingGDP, inflation, and deficits to help investorsmake more informeddecisions.Microeconomics could help an investor see why Apple Inc. stock prices might fall if consumers buy fewer iPhones. Microeconomics could also explain why a higher minimum wage might force a company to hire fewer workers.
Special Considerations
When economists succeed in their aims to understand how consumers and producers react to changing conditions, economics can provide powerful guidance and influence to policy-making at the national level. In other words, there arereal consequences to how governmentsapproachtaxation, regulation, and government spending; economics can offer insightand analysis regarding these decisions.
Economics can also help investors understand the potential ramifications of national policy and events on business conditions. Understanding economics can give investors the tools to predict macroeconomicconditions and understand the implications of those predictions on companies, stocks, and financial markets.
For those who choose to pursue a career ineconomics,academia is anoption. Academics spend their time not only teaching students the principles of economicsbut also researching within the field and formulating new theories and explanations of how markets work and how their agents interact.
Economists are also employedininvestment banks, consulting firms, and other corporations. Therole of economistscan includeforecasting growth such asGDP, interest rates, inflation, and overall market conditions.Economists provide analysis andprojections that might assist with thesale of a company's productor be used asinput for managers and other decision-makers within the company.
Economics can be used by market participants to help understand the causes and likely outcomes of market events and the impact on various sectors, companies,and the overallbusiness cycle.
The applications include understanding how changes innational income,inflation,long-termeconomic growth, and interest rates impact the markets and ultimately stocks. An important area of focus for economists is determining how changes inmonetarypolicy by central banks like the U.S.Federal Reservecan impact the economy, both in the U.S. and globally.
