Financial Economics

Macro Investment Analysis is part of the field generally known as Financial Economics, which is, in turn, a specialty within the broader field of Economics. To provide a context for what will follow, it is useful to consider (if only briefly) the domain of the financial economist.

One of the fundamental aspects of economic activity is a trade in which one party provides another party something, in return for which the second party provides the first something else. In many such trades, or transactions, one or both parties are human beings. If Mr. A gives Ms. B an orange and Ms. B gives Mr. A two apples, it is a trade between two people. In other cases, only one is a human being. If a fisherman throws a fish back in the water to get more fish a year hence, it is a trade between a person and nature. Often the first type of trade is called an exchange, while the second is called production.

Economists generally (but not always) concern themselves with exchanges in which one of the items traded is money. To facilitate trade, most societies establish a convention in which a particular item serves as numeraire. Thus if dollars serve as money, one typically trades oranges for apples by (1) trading oranges for dollars ("selling oranges"), then (2) trading dollars for apples ("buying apples"). The terms of the first trade (e.g. $1 for 1 orange) determine the price of an orange (e.g. $1); the terms of the second trade (e.g. $0.50 for one apple) determine the price of an apple (e.g. $0.50). Together, these prices determine the terms of trade for an exchange of oranges for apples (e.g. 1 orange for 2 apples).

The use of money greatly simplifies trading, thus lowering transactions costs. If a society produces 100 different goods, there are 4,950 different possible "good-for-good" trades ([100x100-100]/2). With money, only 100 prices are needed to establish all possible trading ratios.

Traditional economics focuses on exchanges in which money is one, but only one, of the items traded. Financial economics concentrates on exchanges in which money of one type or another is likely to appear on both sides of a trade.

In a single society with only one form of money, there would be no role for financial economics were it not for time and uncertainty. In fact, however, both of these aspects are crucial elements in the lives of individuals and economies.

Many decisions involve trading money now for money in the future. Such trades, be they between people or with nature, fall in the domain of financial economics.

In many such cases, the amount of money to be transferred in the future is uncertain. Financial economists thus deal with both time and uncertainty. Often the latter is called risk.

In many situations, agreements allow one party to make decisions at later times that can affect subsequent transfers of money. Thus financial economists deal with contracts involving options.

Often, information can reduce or possibly eliminate the uncertainty associated with future outcomes. Thus financial economists study the impact of information on trades involving money.

In sum, the financial economist can be distinguished from more traditional economists by his or her concentration on monetary activities in which time, uncertainty, options and/or information play roles. Not surprisingly, Macro Investment Analysis requires careful attention to all four of these key elements.