Chapter 5 · Economics & Investment Analysis

Microeconomics studies the decisions of individual consumers, workers and firms in single markets. Macroeconomics aggregates these decisions to study the whole economy — national output, employment, inflation, money supply.

For ICWIM, macro questions tend to be about GDP/GNP, the business cycle, monetary & fiscal policy, inflation. Micro questions are usually about supply & demand curves and elasticity.

Classical economics identified three factors: land, labour, capital. Modern (neoclassical) economics adds a fourth: enterprise (also called organisation — the entrepreneurial input that combines the other three).

Exam trick: if you see "money" listed as a factor of production, it's wrong. Money is a medium of exchange, not a productive input itself.

GDP measures the total output produced within a country's borders, regardless of who produced it. It's the most-watched indicator of an economy's health.

Where C = consumption, I = investment, G = government spending, X = exports, M = imports. This is the expenditure approach; GDP can equally be calculated by income (wages, profits, rents) or by output (value-added at each stage of production) — and all three should agree.

GNP measures output/income generated by a country's nationals, wherever they are in the world. The crucial difference vs GDP:

Net property income from abroad = income nationals earn overseas minus income foreigners earn domestically.

• Country with many nationals working abroad (eg, Philippines, Ireland) → GNP > GDP
• Country with lots of inbound foreign investment (eg, where multinationals operate) → GNP < GDP

Economies move through repeating phases:

1. Recovery (acceleration) — coming out of a trough, growth picks up
2. Boom / peak — strong growth, high employment, often rising inflation
3. Deceleration — growth slows from the peak
4. Recession — two consecutive quarters of negative real GDP growth (the technical definition)

The cycle is repeating, but its length and depth are unpredictable.

The balance of payments (BoP) records all economic transactions between residents of a country and the rest of the world. It has two main parts:

• Current account — trade in goods (visibles), trade in services (invisibles), primary income (income on investments), secondary income (transfers like aid)
• Capital and financial account — cross-border investment flows (FDI, portfolio investment, reserves)

By accounting identity, the BoP nets to zero — surpluses in one account are matched by deficits in another.

Invisibles = trade in services (tourism, banking, royalties). Visibles = trade in physical goods.

Fiscal policy = the government's tax and spending decisions. Two stances:

• Expansionary fiscal — government spends more and/or cuts taxes. Boosts aggregate demand. Tends to widen the budget deficit. Used to fight recessions.
• Contractionary fiscal — government spends less and/or raises taxes. Slows demand. Narrows the deficit. Used to cool an overheating economy or repair public finances.

A budget deficit = spending > revenue in a period, financed by borrowing (gilts/bonds) or money creation.

Monetary policy = the central bank's control of money and credit conditions. Main tools:

• Policy interest rate — the rate at which the central bank lends to commercial banks (Bank Rate, Fed Funds rate, etc.)
• Open market operations — buying/selling government securities to influence reserves
• Reserve requirements — % of deposits banks must hold as reserves
• Quantitative easing (QE) — large-scale asset purchases funded by creating reserves, used when rates are already at zero

To fight inflation: raise rates / do quantitative tightening (QT). To stimulate: cut rates / do QE.

QE: the central bank creates new reserves and uses them to buy long-dated government bonds (and sometimes corporate bonds). The intent is to push down long-term yields, raise asset prices, and ease financial conditions — used when the policy rate is already at or near zero.

QT: the reverse — letting bonds mature without reinvesting, or actively selling them. Withdraws liquidity from the system, raising long-term yields.

Inflation = a sustained rise in the general price level. Two main causes:

• Demand-pull inflation — aggregate demand exceeds the economy's productive capacity. "Too much money chasing too few goods."
• Cost-push inflation — production costs rise (oil shock, wage shock, supply chain breakdown), pushing prices up across the economy.

Inflation is measured by the CPI (Consumer Price Index — what consumers pay) and the PPI (Producer Price Index — what producers receive).

Deflation = falling prices — can be dangerous because consumers defer purchases (waiting for lower prices), real debt burdens rise, and policy tools (rate cuts) become less effective at the zero bound.

A nominal return ignores inflation. A real return adjusts for inflation, telling you the change in purchasing power.

Exact (Fisher) formula:

Use the approximation in the exam unless precision is asked for.

A weaker domestic currency makes exports cheaper abroad (good for exporters) and imports more expensive (raises domestic prices, hurts import-reliant industries). Over time, this typically improves the trade balance — but with a lag (the J-curve).

A stronger currency does the reverse: makes exports less competitive, makes imports cheaper.

Purchasing Power Parity (PPP): in the long run, exchange rates should adjust so identical baskets of goods cost the same across countries when expressed in a common currency. The Big Mac Index is a famous (if imperfect) illustration.

MMT argues that a country issuing its own fiat currency cannot involuntarily default on debt in that currency — it can always create more. The real constraint on government spending is not financing, but inflation and real productive capacity.

Critics warn that this logic — pushed too far — can entrench inflation and undermine currency credibility. MMT is included in the ICWIM syllabus as a conceptual framework, not as an endorsement.

Typical central bank functions:

1. Set monetary policy (rates, QE/QT, reserves)
2. Issue legal tender (banknotes)
3. Act as banker to the government and the banking system
4. Lender of last resort — provide emergency liquidity at penalty rates against good collateral (Bagehot's dictum)
5. Supervise the banking system (in many jurisdictions; some delegate to a separate regulator)
6. Manage foreign-exchange reserves

What they do NOT do: provide retail mortgages, issue corporate debt, operate stock exchanges.

Most modern central banks have operational independence: they set policy free from short-term political direction, in pursuit of statutory objectives (typically price stability). They remain accountable to government.

Independence is valued because politically-controlled rate setting tends to be biased toward easier policy (lower rates) before elections — entrenching inflation expectations over time.

Commercial banks must hold a fraction of deposits as reserves (cash plus central-bank balances). The rest can be lent out.

With a 10% reserve requirement, $1 of new reserves can theoretically support up to $10 of broad money. Real multipliers are usually lower because banks hold excess reserves and the public holds cash.

Raising reserve requirements → tightens credit (less can be lent per deposit) → reduces money supply.
Lowering reserve requirements → eases credit → expands money supply.

The demand curve slopes downward: as price falls, consumers want more.
The supply curve slopes upward: as price rises, producers offer more.
Where they meet = equilibrium price and quantity.

Movement ALONG a curve vs shift OF a curve — this is the most-tested distinction:

• A change in the price of the good itself → movement along the curve
• A change in anything else (income, tastes, prices of substitutes/complements, technology, input costs) → shift of the whole curve

Demand curve shifts RIGHT (more demanded at every price) when:

• Consumer income rises (for a normal good)
• Price of a substitute rises (eg, butter ↑ → margarine demand ↑)
• Price of a complement falls (eg, printers cheaper → ink demand ↑)
• The good becomes fashionable / advertising effects

Supply curve shifts RIGHT (more supplied at every price) when:

• Production technology improves
• Input costs fall
• More producers enter the market
• Subsidies are introduced

• |PED| > 1 → elastic. Quantity responds proportionately more than price (luxuries, products with many substitutes)
• |PED| < 1 → inelastic. Quantity responds less than proportionately (necessities like petrol, prescription drugs)
• |PED| = 1 → unit elastic

PED is usually expressed in absolute terms (ignoring the negative sign).

A firm maximises profit at the output level where marginal cost = marginal revenue (MC = MR). Produce one more unit and the cost exceeds the revenue; produce one less and you forgo profit.

Economies of scale: average cost falls as output rises (bulk purchasing, fixed-cost spreading, specialisation). Eventually diseconomies of scale set in (bureaucracy, coordination cost), so the long-run average cost curve is typically U-shaped.

Law of diminishing returns: in the short run, holding some inputs fixed, the marginal output from each extra unit of a variable input eventually falls.

Sum all values, divide by count. Sensitive to outliers.

Median = the middle value of an ordered series. For an even count, take the mean of the two middle values.

Mode = the most frequently occurring value. A series can have no mode, one mode, or multiple modes.

The median is more robust than the mean — outliers don't drag it around.

For investment returns over multiple periods, the geometric mean is more accurate than the arithmetic mean because it accounts for compounding.

The geometric mean is always ≤ arithmetic mean for the same series (equal only if all returns are identical).

Range = max − min. Simplest measure of dispersion, but very sensitive to outliers.

Variance = average of squared deviations from the mean. Why squared? So positive and negative deviations don't cancel out.

Standard deviation = √variance. Reported in the same units as the data (so easier to interpret than variance).

For a sample (rather than the full population), divide by (n−1) instead of n (Bessel's correction) to get an unbiased estimator.

In finance, standard deviation is the standard measure of total volatility of returns.

Covariance measures the joint variability of two variables. Positive covariance = they tend to move together; negative = opposite.

Correlation standardises covariance to a value between −1 and +1:

• ρ = +1 → perfect positive (move identically)
• ρ = 0 → no linear relationship
• ρ = −1 → perfect negative (move opposite)

Key portfolio insight: diversification is most powerful when combining assets with low or negative correlation. Combining two highly correlated assets gives little diversification benefit.

For data that's approximately normally distributed:

• ~68% of observations lie within ±1 standard deviation of the mean
• ~95% lie within ±2 standard deviations
• ~99.7% lie within ±3 standard deviations

So if an investment returns 8% on average with a standard deviation of 15%, in any given year you'd expect:

• ~68% chance of return between −7% and +23%
• ~95% chance of return between −22% and +38%

Real financial returns are not perfectly normal — they have fat tails (extreme events happen more often than the normal distribution predicts). But the rule still helps frame expectations.

A dollar today is worth more than a dollar tomorrow — because today's dollar can be invested and earn a return. This is the core insight behind almost every financial maths question.

Two directions:

• Future Value (FV) — grow today's amount forward by some rate of return
• Present Value (PV) — discount a future amount back to today's terms

Simple interest earns interest on the original principal only:

Compound interest earns interest on the accumulated amount (interest on interest):

Compound returns dominate over long horizons. This is the engine behind why patient investing wins.

How much do you need today to have FV in the future?

Just the compound interest formula rearranged.

Approximate doubling time at a compound rate:

• At 6% → ~12 years to double
• At 9% → ~8 years to double
• At 4% → ~18 years to double

Use it for quick exam-room sanity checks. Accurate enough to confirm your answer is in the right ballpark.

An annuity = a series of equal periodic payments. The PV is what that whole stream is worth today.

(Where PMT = payment per period, r = discount rate per period, n = number of periods. This is for an "ordinary" annuity — payments at end of period. For an annuity due, paid at start, multiply by (1+r).)

A perpetuity pays the same amount forever. Cleanest formula in finance:

For a perpetuity with constant growth g (the Gordon Growth Model — also shows up in valuation):

(Only valid if g < r.)

A common exam scenario: client needs an income in the future, in today's purchasing power. You must (1) inflate the income to its future nominal value, (2) capitalise that as a perpetuity at the expected return.

Under the weak form of EMH, past prices already reflect available information — so technical analysis shouldn't work consistently. Many academics agree; many practitioners still use it.

Dow Theory categorises price movements into three durations:

• Primary trend — months to years (the main bull or bear market)
• Secondary trend — weeks to months (corrections / rallies within the primary)
• Minor trend — days (noise within the secondary)

A moving average (MA) smooths out short-term noise. Common: 50-day, 200-day.

• Golden cross — short-term MA crosses ABOVE long-term MA (eg, 50-day above 200-day). Bullish signal.
• Death cross — short-term MA crosses BELOW long-term MA. Bearish signal.

Other technical tools: momentum oscillators (RSI, MACD), Bollinger Bands, support/resistance levels.

Measures how efficiently a company turns its total long-term capital base into operating profit. Higher = more efficient.

Use ROCE to compare companies in the same industry. A ROCE above the company's cost of capital indicates value creation; below it signals value destruction.

• Gross profit margin = (Sales − COGS) / Sales. Product-level profitability before operating costs.
• Operating margin = Operating profit / Sales. After deducting operating expenses.
• Net profit margin = Net profit / Sales. After all costs including tax and interest.
• Asset turnover = Sales / Total assets. How efficiently assets generate revenue.

Financial gearing (leverage) measures how reliant a company is on debt:

Interest cover measures how comfortably operating profit covers interest payments:

Higher interest cover = safer. Below 1× means the company isn't earning enough to pay its interest — major distress signal.

Measure the company's ability to meet short-term obligations:

The quick ratio is stricter — it excludes inventory, the least-liquid current asset.

Working capital = Current assets − Current liabilities. Working capital available to fund day-to-day operations.

The Altman Z-score combines several financial ratios (working capital, retained earnings, EBIT, market value of equity, sales — all relative to total assets) into a single score predicting bankruptcy risk.

• Z > 2.99 → "safe zone", low bankruptcy risk
• 1.81 < Z < 2.99 → "grey zone", uncertain
• Z < 1.81 → "distress zone", high probability of bankruptcy within 2 years

A negative Z-score signals imminent insolvency risk.

A high P/E typically signals investors expect above-average growth (paying more per unit of current earnings). A low P/E can signal undervaluation OR weak prospects.

Dividend cover ≥ 2 is considered safe — earnings comfortably cover the dividend.

EBIT = Earnings Before Interest and Tax = operating profit. Profit from operations, before financing costs and tax.

EBITDA = Earnings Before Interest, Tax, Depreciation and Amortisation. A rough "cash-like" measure of operating performance, popular because it strips out non-cash items.

Beware: EBITDA flatters companies with heavy capex. Charlie Munger famously called it "BS earnings" because real businesses do need to replace assets.

Where NOPAT = Net Operating Profit After Tax, WACC = Weighted Average Cost of Capital.

EVA measures whether a company is generating profits above and beyond what it costs to finance the capital it uses. Positive EVA = value created. Negative EVA = value destroyed — even if accounting profit is positive.

Why this matters: a company can show a healthy accounting profit and still be destroying value if the cost of its capital is higher than its return.

MVA = the market's verdict on whether management will continue creating value above the cost of capital. Mathematically, MVA is the present value of all future EVA.

A positive MVA means the market expects continued value creation; negative means the market expects continued destruction.

Values a share as the present value of its expected dividend stream, assuming dividends grow at a constant rate forever:

Where D₁ = next year's dividend, k = required return on equity, g = constant growth rate of dividends.

Critical condition: only valid if g < k. If g ≥ k, the formula produces infinite or negative values — the model breaks down.

The most general valuation technique: sum the present value of all expected future free cash flows.

The discount rate r is typically the WACC (Weighted Average Cost of Capital):

DCF is powerful but very sensitive to assumptions about growth rates and the discount rate. Small changes in inputs can produce wildly different valuations.