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Investment - Elasticities of Demand
Although supply and demand curves are vital to an understanding of price and quantity changes, they are less effective in determining the magnitude of these changes. To gauge the change in amounts required by consumers and provided by producers, we employ elasticity metrics.
In economics, elasticity refers to how the quantity required or supplied fluctuates in reaction to tiny changes in a relevant element, such as price, income, or the price of a substitute or complementary product. If we understand that the demand for items rises dramatically as incomes increase, investors and analysts may be able to identify the companies and industries that will develop the quickest as the economy grows. Elasticity of demand so has relevance as we estimate which companies and industries will be successful in the future.
Price Elasticity of Demand
Price elasticity of demand allows for the comparison of the responsiveness of quantity sought with changes in pricing. Two extensively used measurements are own price elasticity of demand and cross-price elasticity of demand.
Own Price Elasticity of Demand
The own price elasticity of demand is the percentage change in the quantity requested of a product as a function of the percentage price change of that product. It is computed as the percentage change in the amount required of a product divided by the percentage change in the price of that product.
Own price elasticity of demand explains the change in the quantity requested of a product as a result of a price change in the same product.
But investors and analysts are especially interested in the changes when more than one product is involved.
This is cross-price elasticity of demand, the percentage change in the quantity requested of a product in response to a percentage change in the price of another product.
Own Price Elasticity of Demand
Although supply and demand curves are vital to an understanding of price and quantity changes, they are less effective in determining the magnitude of these changes. To gauge the change in amounts required by consumers and provided by producers, we employ elasticity metrics.
In economics, elasticity refers to how the quantity required or supplied fluctuates in reaction to tiny changes in a relevant element, such as price, income, or the price of a substitute or complementary product. If we understand that the demand for items rises dramatically as incomes increase, investors and analysts may be able to identify the companies and industries that will develop the quickest as the economy grows. Elasticity of demand so has relevance as we estimate which companies and industries will be successful in the future.
Price Elasticity of Demand
Price elasticity of demand allows for the comparison of the responsiveness of quantity sought with changes in pricing. Two extensively used measurements are own price elasticity of demand and cross-price elasticity of demand.
Own Price Elasticity of Demand
The own price elasticity of demand is the percentage change in the quantity requested of a product as a function of the percentage price change of that product. It is computed as the percentage change in the amount required of a product divided by the percentage change in the price of that product.
Own price elasticity of demand explains the change in the quantity requested of a product as a result of a price change in the same product.
But investors and analysts are especially interested in the changes when more than one product is involved.
This is cross-price elasticity of demand, the percentage change in the quantity requested of a product in response to a percentage change in the price of another product.
Own Price Elasticity of Demand
If a 10% fall in the price of automobiles leads to a 15% increase in the quantity of cars wanted, then the own price elasticity of demand for cars is
If a 10% increase in the price of hotel rooms leads to a 20% drop in the amount of hotel rooms required, then the own price elasticity of demand for hotel rooms is
When looking at elasticities, two elements matter: the sign and the magnitude. The sign of price elasticity of demand offers information on how the amount demanded changes related to a change in price.
The degree of price elasticity of demand offers information on the strength of the relationship between quantity sought and changes in price.
When price elasticity is less than –1, such as in the automobile and hotel room cases, the price elasticity of demand is strong, or elastic. This suggests that a minor change in price creates a disproportionally bigger change in demand.
Conversely, if price elasticity is between –1 and 0, the price elasticity is low, or inelastic. Changes in prices for inelastic products are accompanied by less than proportional changes in the quantity demanded, which suggests demand is not extremely price sensitive.
If the price elasticity of demand is exactly –1, it is said that demand is unit elastic. In this situation, a percentage change in price is matched by a similar, but opposite, percentage change in the amount demanded.
Products for which demand increases as price increases have positive own price elasticities. This result usually suggests that the product is a luxury goods. For luxury products, such as expensive vehicles, watches, and jewelry, an increase in price may lead to an increase in quantity demanded.
The sign and amount of the own price elasticity helps a corporation define its pricing strategy. A corporation wants to know whether a minor percentage increase in pricing will lead to a loss in sales and if it does whether it is a large or small percentage decrease in sales. Cutting the price of a commodity with strongly negative elastic demand, such as coffee or butter, tends to lead to an increase in overall revenue.
Total revenue is normally measured as the quantity of things sold times their price. When elasticity is highly negative, the fall in price is more than countered by a higher rise in quantity demanded. By contrast, decreasing the price of a product with inelastic demand results to a drop in total income since the % rise in quantity is less than the percentage decrease in price.
Uniform, non-differentiated products, such as natural resources (e.g., petroleum and iron ore) and supermarket staples (e.g., bagged ice and lentils), are often products with significantly negative own price elasticities of demand. Companies with multiple competitors providing identical products may find that increasing pricing leads to a drop in income.
Perfectly inelastic demand suggests that amount demanded will not change at all, even in the face of substantial price increases or declines. Perfectly inelastic demand may emerge with things that have no substitutes and are requirements, such as pharmaceuticals under patent. If the drug is useful and under patent protection, the company should be able to charge a higher price without losing sales. Once the patent expires and cheaper generic pharmaceuticals become available, the producer may have to lower its price to maintain sales.
Interpreting Price Elasticities of Demand
If a product is easy to substitute because similar products exist, then the own price elasticity will be significant and negative, which is to imply that demand is elastic. If a product offers no immediate substitutes, such as a new drug, or if usage of the product is strongly entrenched by habit, such as tobacco, demand is inelastic.
Another example of a price-inelastic product is one that has a well-defined identity, such as the Apple iPad.
The reason is because, in the view of many consumers, other items do not compare with the iPad, and the demand for the brand means many people are willing to pay a premium for Apple products.
As a result, the quantity sold may be insensitive to price increases and an increase in price of the iPad may lead to higher revenues for Apple.
Elasticity of demand lets market participants assess the consequences of price changes. Investors and analysts use elasticity of demand to analyze a company’s potential as an investment.
As described in the preceding section, whether a firm will see its sales increase or fall as a result of a change in prices, and by how much, helps investors and analysts understand what drives a company’s profit, which, in turn, affects its stock valuation.
Income Elasticity of Demand
Income elasticity of demand is the percentage change in the quantity requested of a product divided by the corresponding percentage change in income. It quantifies the influence of changes in income on quantity required of a product when other parameters, like as the price of the product and the prices of similar products, remain the same.
Most products have positive income elasticities, meaning that when consumers’ income improves, they purchase a bigger quantity of the commodity.
Products having positive income elasticities are called normal products. In contrast, if people purchase less of a product as their income increases, the income elasticity is negative and the products are dubbed inferior goods. Consumers desire less inferior commodities when their income improves and they replace more expensive and desirable things, such as meat instead of potatoes or rice.
Income elasticity of demand also enables investors to discern between luxuries and requirements.
A luxury product usually has an income elasticity of larger than one.
A need product may have an income elasticity of almost zero; the quantity demanded will not change with a change in income.
Luxury purchases may include foreign vacation, spa treatments, and golf club memberships.
What is considered as a luxury item may alter over time since income elasticities will change as a society’s income improves.
Although a smartphone may be a luxury product at a specific income level, it may become a need at another.
The degree of price elasticity of demand offers information on the strength of the relationship between quantity sought and changes in price.
When price elasticity is less than –1, such as in the automobile and hotel room cases, the price elasticity of demand is strong, or elastic. This suggests that a minor change in price creates a disproportionally bigger change in demand.
Conversely, if price elasticity is between –1 and 0, the price elasticity is low, or inelastic. Changes in prices for inelastic products are accompanied by less than proportional changes in the quantity demanded, which suggests demand is not extremely price sensitive.
If the price elasticity of demand is exactly –1, it is said that demand is unit elastic. In this situation, a percentage change in price is matched by a similar, but opposite, percentage change in the amount demanded.
Products for which demand increases as price increases have positive own price elasticities. This result usually suggests that the product is a luxury goods. For luxury products, such as expensive vehicles, watches, and jewelry, an increase in price may lead to an increase in quantity demanded.
The sign and amount of the own price elasticity helps a corporation define its pricing strategy. A corporation wants to know whether a minor percentage increase in pricing will lead to a loss in sales and if it does whether it is a large or small percentage decrease in sales. Cutting the price of a commodity with strongly negative elastic demand, such as coffee or butter, tends to lead to an increase in overall revenue.
Total revenue is normally measured as the quantity of things sold times their price. When elasticity is highly negative, the fall in price is more than countered by a higher rise in quantity demanded. By contrast, decreasing the price of a product with inelastic demand results to a drop in total income since the % rise in quantity is less than the percentage decrease in price.
Uniform, non-differentiated products, such as natural resources (e.g., petroleum and iron ore) and supermarket staples (e.g., bagged ice and lentils), are often products with significantly negative own price elasticities of demand. Companies with multiple competitors providing identical products may find that increasing pricing leads to a drop in income.
Perfectly inelastic demand suggests that amount demanded will not change at all, even in the face of substantial price increases or declines. Perfectly inelastic demand may emerge with things that have no substitutes and are requirements, such as pharmaceuticals under patent. If the drug is useful and under patent protection, the company should be able to charge a higher price without losing sales. Once the patent expires and cheaper generic pharmaceuticals become available, the producer may have to lower its price to maintain sales.
Interpreting Price Elasticities of Demand
If a product is easy to substitute because similar products exist, then the own price elasticity will be significant and negative, which is to imply that demand is elastic. If a product offers no immediate substitutes, such as a new drug, or if usage of the product is strongly entrenched by habit, such as tobacco, demand is inelastic.
Another example of a price-inelastic product is one that has a well-defined identity, such as the Apple iPad.
The reason is because, in the view of many consumers, other items do not compare with the iPad, and the demand for the brand means many people are willing to pay a premium for Apple products.
As a result, the quantity sold may be insensitive to price increases and an increase in price of the iPad may lead to higher revenues for Apple.
Elasticity of demand lets market participants assess the consequences of price changes. Investors and analysts use elasticity of demand to analyze a company’s potential as an investment.
As described in the preceding section, whether a firm will see its sales increase or fall as a result of a change in prices, and by how much, helps investors and analysts understand what drives a company’s profit, which, in turn, affects its stock valuation.
Income Elasticity of Demand
Income elasticity of demand is the percentage change in the quantity requested of a product divided by the corresponding percentage change in income. It quantifies the influence of changes in income on quantity required of a product when other parameters, like as the price of the product and the prices of similar products, remain the same.
Most products have positive income elasticities, meaning that when consumers’ income improves, they purchase a bigger quantity of the commodity.
Products having positive income elasticities are called normal products. In contrast, if people purchase less of a product as their income increases, the income elasticity is negative and the products are dubbed inferior goods. Consumers desire less inferior commodities when their income improves and they replace more expensive and desirable things, such as meat instead of potatoes or rice.
Income elasticity of demand also enables investors to discern between luxuries and requirements.
A luxury product usually has an income elasticity of larger than one.
A need product may have an income elasticity of almost zero; the quantity demanded will not change with a change in income.
Luxury purchases may include foreign vacation, spa treatments, and golf club memberships.
What is considered as a luxury item may alter over time since income elasticities will change as a society’s income improves.
Although a smartphone may be a luxury product at a specific income level, it may become a need at another.
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Investment - Market Equilibrium
The concept of economic equilibrium helps explain how prices are set in a world of supply and demand.
To discover how prices are set in a world of supply and demand, it is vital to comprehend the notion of economic equilibrium.
Market equilibrium happens at the price when amount demanded equals quantity supplied.
At the equilibrium price, quantity sought and quantity supplied are in balance, and neither buyers nor sellers have an incentive to try to modify the price, all other factors staying unchanged.
Interaction of Demand and Supply Curves
As seen in the illustration below , the interplay between the demand and supply curves determines the equilibrium price of a commodity.
The equilibrium price (EP) is the price at which the amount demanded (D) equals the quantity supplied (S).
In other terms, it is the point at which the demand and supply curves intersect.
The concept of economic equilibrium helps explain how prices are set in a world of supply and demand.
To discover how prices are set in a world of supply and demand, it is vital to comprehend the notion of economic equilibrium.
Market equilibrium happens at the price when amount demanded equals quantity supplied.
At the equilibrium price, quantity sought and quantity supplied are in balance, and neither buyers nor sellers have an incentive to try to modify the price, all other factors staying unchanged.
Interaction of Demand and Supply Curves
As seen in the illustration below , the interplay between the demand and supply curves determines the equilibrium price of a commodity.
The equilibrium price (EP) is the price at which the amount demanded (D) equals the quantity supplied (S).
In other terms, it is the point at which the demand and supply curves intersect.
At any price over the equilibrium price in the above exhibit, suppliers are willing to produce more of a product than customers are willing to buy. A price that is greater than the equilibrium price may result in increased stocks, which creates an incentive for suppliers to drop prices to reduce their stockpiles. Prices will thus gravitate back towards the equilibrium price.
Conversely, if the price is below the equilibrium price, customers will demand more of a product than providers find it profitable to create.
To fulfill consumers’ greater demand, suppliers’ inventory may be decreased. Once stockpiles are exhausted, suppliers have an incentive to raise prices and expand production. Prices will thus gravitate back towards the equilibrium price.
The only price at which suppliers and customers are both pleased, with no imbalance between the quantity produced and the quantity required, is at the equilibrium price.
Conversely, if the price is below the equilibrium price, customers will demand more of a product than providers find it profitable to create.
To fulfill consumers’ greater demand, suppliers’ inventory may be decreased. Once stockpiles are exhausted, suppliers have an incentive to raise prices and expand production. Prices will thus gravitate back towards the equilibrium price.
The only price at which suppliers and customers are both pleased, with no imbalance between the quantity produced and the quantity required, is at the equilibrium price.
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Investment - Demand and Supply
Properly functioning markets are vital to capitalism because the interaction of buyers and sellers determines the price and amount of a product or service exchanged. The structuring of markets is crucial in microeconomics.
Demand
Buyers desire a product, and sellers supply the product. Consumers buy things, such as vehicles, books, and furniture, from manufacturers and retailers who sell them in markets. These marketplaces can take the form of physical facilities, such as supermarkets or shops, or they might be virtual, internet-based markets, such as eBay or Amazon.
In certain markets, there is a single provider of a product or service, whereas in other markets, there are several companies providing the same or similar products or services. There may be only one regional power company producing electricity, for example, but multiple companies providing home insurance. How markets are arranged can affect how the enterprises engaged in these markets set pricing.
When economists refer to demand, they mean the desire for a product or service paired with the ability and willingness to pay a specific price for it. Consumers will want and pay for a product as long as the perceived advantage is greater than its cost or price.
The Law of Demand
It seems natural that if the price of a product goes higher, people will typically buy less of the product.
For instance, if the price of fuel rises, car owners will use their cars less and hence buy less fuel. The quantity desired of a product and its price are usually inversely connected, which is known as the law of demand.
The Demand Curve
The law of demand can be represented on a graph, with the amount demanded on the horizontal axis and the price of the product on the vertical axis. The curve that depicts the quantity demanded at different prices is the demand curve.
Shift in Demand Curve to the Right
Properly functioning markets are vital to capitalism because the interaction of buyers and sellers determines the price and amount of a product or service exchanged. The structuring of markets is crucial in microeconomics.
Demand
Buyers desire a product, and sellers supply the product. Consumers buy things, such as vehicles, books, and furniture, from manufacturers and retailers who sell them in markets. These marketplaces can take the form of physical facilities, such as supermarkets or shops, or they might be virtual, internet-based markets, such as eBay or Amazon.
In certain markets, there is a single provider of a product or service, whereas in other markets, there are several companies providing the same or similar products or services. There may be only one regional power company producing electricity, for example, but multiple companies providing home insurance. How markets are arranged can affect how the enterprises engaged in these markets set pricing.
When economists refer to demand, they mean the desire for a product or service paired with the ability and willingness to pay a specific price for it. Consumers will want and pay for a product as long as the perceived advantage is greater than its cost or price.
The Law of Demand
It seems natural that if the price of a product goes higher, people will typically buy less of the product.
For instance, if the price of fuel rises, car owners will use their cars less and hence buy less fuel. The quantity desired of a product and its price are usually inversely connected, which is known as the law of demand.
The Demand Curve
The law of demand can be represented on a graph, with the amount demanded on the horizontal axis and the price of the product on the vertical axis. The curve that depicts the quantity demanded at different prices is the demand curve.
Shift in Demand Curve to the Right
If people’s tastes change and they cease like pizza as much, demand will shift to the left, suggesting that consumers would demand less of the product at a given price. The range of pricing for the product has not changed, but the quantity requested at each price has reduced.
The figure depicts how a change in a factor that has made the product more attractive alters the demand curve to the right from D to D1.
Now, we will take a deeper look at the primary elements that affect the demand curve.
Effect of Income on Demand
A change in demand for a product coming from a change in purchasing power is called the income effect.
For most items, which are called typical goods, if income improves, demand increases too. Meat is an example of a normal good in most emerging nations.
For lesser commodities, the relationship works in the reverse direction. That is, demand for lesser things diminishes as income increases. Grain is frequently regarded an inferior good. So, when incomes are higher, individuals consume more meat relative to grain.
Demand for poor products often grows during recessions. When faced with a time of downturn in economic activity, people prefer to move to lower-cost brands and purchase more at discount stores than at department stores. During such a period, investors may focus on companies that sell inferior goods because they expect their stocks to perform better.
Effect of the Expected Future Price of a Product on Demand
There is a positive association between the predicted future price of a product and its current demand. In other words, the predicted future price and current demand move in the same direction.
If consumers predict that the price of rice will increase as a result of a shortage, the current quantity of rice requested may grow as consumers accumulate it to avoid paying a higher price in the future.
The amount demanded at all prices will rise in anticipation of the price increase, resulting to a change in the demand curve to the right.
In contrast, if the price of a product is predicted to reduce in the future, present demand may go down as people wait for the price to decrease before purchasing.
Effect of Changes in General Tastes and Preferences on Demand
Changes in consumers’ likes and preferences might impact a product’s demand curve.
If a report that linked eating chocolate to greater health is published, demand for chocolate bars may soar.
In that circumstance, the demand curve for chocolate will shift to the right. Investors and analysts typically examine demographic changes and shifts in consumers’ interests and preferences when appraising an investment.
Effect of Prices of Other Products on Demand
As we observed earlier, if the price of sandwiches increases, individuals may eat more pizza instead. The influence of a change in the prices of other items on a product’s demand curve relies on the sort of link between the products.
Substitute Products
A substitute product or substitute might normally take the place of another product. For many customers, Coke and Pepsi are regarded reasonably close replacements. Consumers exchange relatively cheaper products for relatively more expensive ones. If the price of a substitute product lowers, demand for the alternative may increase and demand for the original product may decline.
Example: The Effect of a Change in Coke’s Price on the Demand for Coke and Pepsi
If the price of Coke lowers, there is likely to be an increase in demand for Coke and a decrease in demand for Pepsi.
If a bottle of Coke and Pepsi each sell for USD1, individuals will have no preference based on price. But if the Coca-Cola Company seeks to boost its market share, it might decrease — possibly just momentarily — the price of a bottle of Coke to 90 cents.
Although there will still be many faithful Pepsi fans, there will probably be a number of people who will buy Coke instead of Pepsi because it is now cheaper.
Coca-Cola expects that some of these people then develop a preference for Coke over Pepsi and become loyal Coke drinkers, and Coca-Cola may subsequently return its price to USD1.
Complementary products or complements are products that are frequently consumed together. When the price of a product lowers, it leads to an increase in demand for both the product and for its complimentary products.
For example, printing paper and ink cartridges are complementary products. If the price of ink cartridges lowers, consumers may print more and purchase both more ink cartridges and printing paper.
Demand for a given product may be altered by the prices of other products that are not replacements or complements. A big increase in oil prices sometimes causes demand for other products, including pizzas, to decline. The reason is that many people use automobiles to travel to work, school, or shopping, and they will have to pay more to put petrol in their cars if the price of oil rises. As a result, they will have less money to buy other things.
Psychology is typically engaged in decision making, which makes the effects of price changes on demand challenging to analyze. Because individuals commonly buy oil-related products, they constantly watch how the price of these things fluctuates, and they may consume less overall if oil prices climb. And yet, an increase in the price of cars, which has a greater effect on the household budget, may not lead to a fall in demand.
The explanation is that consumers tend to pay less attention to the price adjustments of things that they purchase infrequently. Evaluating these types of psychological aspects helps investors determine if, for instance, a pizza company may notice a decline in sales when oil costs increase.
Supply
The supply curve illustrates the quantity supplied at different prices. The law of supply states that when the price of a commodity increases, the amount supplied increases too. Thus, the supply curve is upward sloping from left to right. The law of supply and the supply curve are represented in the following exhibit. S and S1 are supply curves.
Supply Curve
The figure depicts how a change in a factor that has made the product more attractive alters the demand curve to the right from D to D1.
Now, we will take a deeper look at the primary elements that affect the demand curve.
Effect of Income on Demand
A change in demand for a product coming from a change in purchasing power is called the income effect.
For most items, which are called typical goods, if income improves, demand increases too. Meat is an example of a normal good in most emerging nations.
For lesser commodities, the relationship works in the reverse direction. That is, demand for lesser things diminishes as income increases. Grain is frequently regarded an inferior good. So, when incomes are higher, individuals consume more meat relative to grain.
Demand for poor products often grows during recessions. When faced with a time of downturn in economic activity, people prefer to move to lower-cost brands and purchase more at discount stores than at department stores. During such a period, investors may focus on companies that sell inferior goods because they expect their stocks to perform better.
Effect of the Expected Future Price of a Product on Demand
There is a positive association between the predicted future price of a product and its current demand. In other words, the predicted future price and current demand move in the same direction.
If consumers predict that the price of rice will increase as a result of a shortage, the current quantity of rice requested may grow as consumers accumulate it to avoid paying a higher price in the future.
The amount demanded at all prices will rise in anticipation of the price increase, resulting to a change in the demand curve to the right.
In contrast, if the price of a product is predicted to reduce in the future, present demand may go down as people wait for the price to decrease before purchasing.
Effect of Changes in General Tastes and Preferences on Demand
Changes in consumers’ likes and preferences might impact a product’s demand curve.
If a report that linked eating chocolate to greater health is published, demand for chocolate bars may soar.
In that circumstance, the demand curve for chocolate will shift to the right. Investors and analysts typically examine demographic changes and shifts in consumers’ interests and preferences when appraising an investment.
Effect of Prices of Other Products on Demand
As we observed earlier, if the price of sandwiches increases, individuals may eat more pizza instead. The influence of a change in the prices of other items on a product’s demand curve relies on the sort of link between the products.
Substitute Products
A substitute product or substitute might normally take the place of another product. For many customers, Coke and Pepsi are regarded reasonably close replacements. Consumers exchange relatively cheaper products for relatively more expensive ones. If the price of a substitute product lowers, demand for the alternative may increase and demand for the original product may decline.
Example: The Effect of a Change in Coke’s Price on the Demand for Coke and Pepsi
If the price of Coke lowers, there is likely to be an increase in demand for Coke and a decrease in demand for Pepsi.
If a bottle of Coke and Pepsi each sell for USD1, individuals will have no preference based on price. But if the Coca-Cola Company seeks to boost its market share, it might decrease — possibly just momentarily — the price of a bottle of Coke to 90 cents.
Although there will still be many faithful Pepsi fans, there will probably be a number of people who will buy Coke instead of Pepsi because it is now cheaper.
Coca-Cola expects that some of these people then develop a preference for Coke over Pepsi and become loyal Coke drinkers, and Coca-Cola may subsequently return its price to USD1.
Complementary products or complements are products that are frequently consumed together. When the price of a product lowers, it leads to an increase in demand for both the product and for its complimentary products.
For example, printing paper and ink cartridges are complementary products. If the price of ink cartridges lowers, consumers may print more and purchase both more ink cartridges and printing paper.
Demand for a given product may be altered by the prices of other products that are not replacements or complements. A big increase in oil prices sometimes causes demand for other products, including pizzas, to decline. The reason is that many people use automobiles to travel to work, school, or shopping, and they will have to pay more to put petrol in their cars if the price of oil rises. As a result, they will have less money to buy other things.
Psychology is typically engaged in decision making, which makes the effects of price changes on demand challenging to analyze. Because individuals commonly buy oil-related products, they constantly watch how the price of these things fluctuates, and they may consume less overall if oil prices climb. And yet, an increase in the price of cars, which has a greater effect on the household budget, may not lead to a fall in demand.
The explanation is that consumers tend to pay less attention to the price adjustments of things that they purchase infrequently. Evaluating these types of psychological aspects helps investors determine if, for instance, a pizza company may notice a decline in sales when oil costs increase.
Supply
The supply curve illustrates the quantity supplied at different prices. The law of supply states that when the price of a commodity increases, the amount supplied increases too. Thus, the supply curve is upward sloping from left to right. The law of supply and the supply curve are represented in the following exhibit. S and S1 are supply curves.
Supply Curve
Lower manufacturing costs, which may be the result of improvements in technology, cheaper raw materials or labour, or lower taxes, will result in higher supply for a given price. The supply curve will move to the right. Changes in the supply curve are of major interest to investors and analysts. A shift in the supply curve induced by greater or lower costs might alter the profits generated by a corporation. A car manufacturer facing increased steel prices may be willing to build fewer automobiles at a given price level, which affects the supply curve. Whether a corporation can pass on any cost increases to customers helps investors assess the company’s potential profits.
A corporation that cannot cover its costs and earn a profit at prices along particular regions of the supply curve would not supply products at those prices. Companies may perceive factors affecting the supply curve as transient and be ready to continue operating despite short-term losses. But if the discrepancy between sales and costs remains for extended periods, it can trigger corporate shutdowns and bankruptcy.
Many airlines have confronted this dilemma as their manufacturing expenses, such as the cost of fuel, increased.
Their capacity to hike fares was constrained since passengers may have selected an alternate airline or mode of travel.
Equally, they could not readily raise or reduce the number of seats on their planes. Some airlines have accrued enormous losses and been forced to declare bankruptcy.
A corporation that cannot cover its costs and earn a profit at prices along particular regions of the supply curve would not supply products at those prices. Companies may perceive factors affecting the supply curve as transient and be ready to continue operating despite short-term losses. But if the discrepancy between sales and costs remains for extended periods, it can trigger corporate shutdowns and bankruptcy.
Many airlines have confronted this dilemma as their manufacturing expenses, such as the cost of fuel, increased.
Their capacity to hike fares was constrained since passengers may have selected an alternate airline or mode of travel.
Equally, they could not readily raise or reduce the number of seats on their planes. Some airlines have accrued enormous losses and been forced to declare bankruptcy.
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Investment -Monetary and Fiscal Policies
Governments and central banks are inclined to act in reaction to economic conditions when economic conditions are exceptionally challenging. Monetary and fiscal policy affect the economy via distinct ways.
Monetary and Fiscal Policies
Economic growth, inflation, and unemployment are key issues for central banks and governments. They each utilize distinct financial tools to effect economic activity. Central banks, which are frequently independent of governments, use monetary policy. Governments utilize fiscal policy.
Monetary Policy
Monetary policy refers to central bank activities that are focused towards affecting the money supply — the amount of money in circulation — and credit — the amount of money available for borrowing and at the cost or interest rate. The purpose is to influence major macroeconomic targets:
Output or GDP Price stability Employment
Most central banks have a mission of maintaining price stability by regulating inflation while preventing deflation, which has indirect implications on other macroeconomic aims, such as employment and output. Many central banks strive to sustain employment levels and to encourage economic growth or slow it down. But by focused primarily on job levels and growth, it may leave opportunity for price volatility; increased employment and rapid economic growth is typically accompanied by inflation.
Consumers and firms should, in theory, be motivated by reduced interest rates to borrow and spend more and therefore stimulate the economy. As interest rates fall, the stock market may seem a more appealing place to invest, leading to gains in share prices and a broad impression of enhanced prosperity. This sensation of enhanced prosperity should motivate people to spend more and conserve less, and therefore further stimulate the economy.
Reducing interest rates may raise output and employment, so meeting two of the primary macroeconomic aims of policymakers. Similarly, increasing interest rates may slow the economy.
The tools used for monetary policy include open market operations, changes in the central bank lending rate, and changes in reserve requirements for commercial banks
Open Market Operations
The central bank can either purchase or sell securities issued by the government to effect the money supply. Open market activities involve the purchase and sale of government notes and bonds. If a central bank wants to expand the availability of money and credit to stimulate the economy, it can do so by purchasing financial assets, mainly short-term government instruments held by commercial banks.
The banks give up short-term government securities for cash from the central bank, which puts more money in circulation. The injection of money allows banks to decrease interest rates and offer more loans because they now have bigger cash reserves at the central bank.
By performing open market operations, the central bank produces a shortfall or surplus of money. Effectively, the central bank is pressuring commercial banks to modify their lending rates.
Central Bank Lending Rates
A central bank can impact interest rates by adjusting the discount rate. The discount rate is the rate at which banks borrow directly from the central bank of the country. It is used to effect short-term interest rates as well as to indirectly influence longer-term interest rates and other commercial rates.
The belief is that changes in interest rates can influence economic activity and affect inflation and economic growth. When a central bank wishes to stimulate the economy, it may cut its lending rate. When a central bank intends to slow the economy, it may increase its lending rate.
Reserve Requirements
Central banks can change the quantity of money available for borrowing in an economy by modifying bank reserve requirements. The reserve requirement is the proportion of deposits that must be retained by a bank rather than be lent to borrowers.
By increasing the reserve requirement, central banks decrease access to credit in the economy since bank lending is reduced. When they cut the reserve requirement, central banks boost access to credit because commercial banks are able to issue more loans. In practice, this instrument is not typically employed by central banks.
Quantitative Easing
The policy of quantitative easing (QE), employed in a number of nations during the financial crisis of 2008, is similar to open market operations, but on a considerably bigger scale and it entails the purchase of items other than short-term government instruments. In the United States, QE diverged from open market operations in that it entailed the purchase of mortgage bonds as well as large-scale purchases of longer-term US Treasury securities.
The objective was to cut longer-term interest rates on bonds and across a variety of credit products, promote bank lending, and thereby increase actual economic activity. It has proven difficult to measure the effectiveness of QE because other stimulus initiatives appeared at the same time in the wake of the financial crisis.
Limitations of Monetary Policy
The efficiency of monetary policy is subject to debate. Economists who challenge its effectiveness cite evidence of poor growth in some nations where interest rates are very low. This situation may occur because individuals and firms do not respond to reduced borrowing rates by spending more. Instead, they may opt to add to their cash holdings because they believe either that the economy will slow further and they need protection reserves or that prices may drop and offer better purchasing chances later. Alternatively, households and organizations respond to reduced interest rates by paying off debt, a process that is called deleveraging.
The psychology and expected responses of consumers and companies must be addressed while deciding on an effective monetary policy. Consider a scenario in which the central bank boosts interest rates to lower consumer spending and demand because it is concerned about inflationary pressures. If an economy is functioning well, overall optimism regarding income, employment, and business profits may be strong. In that instance, rises in borrowing costs are less efficient in restraining expenditure. At other times, an increase in interest rates may be useful since optimism is less established. The levels of consumer and business confidence determine the effectiveness of monetary policy.
Fiscal Policy
Governments utilize fiscal policy to effect economic activity. Fiscal policy involves the utilization of government spending and taxes. Fiscal policy may strive to stimulate a sluggish economy by greater spending or decreased taxes, or it may seek to moderate an overheating economy through decreased expenditure or increased taxes.
The Role and Tools of Fiscal Policy
One way that fiscal policy operates is by decreasing or increasing taxes. Governments can also affect GDP directly by spending more or less.
An expansionary strategy, which tries to boost a weak economy, will decrease taxes on consumers or corporations to increase consumer and company spending and the level of demand. Alternatively, it may raise public spending on social goods and infrastructure, such as hospitals and schools, which stimulates spending and demand directly.
An expansionary strategy can also stimulate spending and demand indirectly by increasing personal earnings and company revenues when it hires individuals and corporations to develop those public projects.
The success of these initiatives will vary over time and among countries. In a recession with rising unemployment, decreasing income taxes would not always promote consumer spending since people may desire to increase their savings in expectation of greater worsening in the economy.
Limitations of Fiscal Policy
The effectiveness of fiscal policy is constrained by the following:
Time lags
Unexpected responses by consumers and companies
Unintended consequences
Time Lags
There might be a large time lag between the understanding that intervention is required and observable fiscal policy impact. First, a recognition that the economy requires aid must arise, then a choice must be taken on what the adjustment in fiscal policy will be, then that decision has to be implemented, and then the economy has to have time to respond.
Unexpected Responses
As with monetary policy, consumers and corporations may not respond as expected to changes in fiscal policy. When a tax decrease is announced, private sector spending is likely to grow. But spending may remain unchanged or even fall if the private sector chooses to keep the income or pay down debt rather than spend.
Alternatively, spending may climb by more than planned. Similarly, if government spending increases, consumer and corporate responses may negate the effects of the change in government expenditure on GDP by reducing their own spending.
In other words, it takes time for policymakers to acknowledge that a problem exists, for decisions to be made and implemented, and for those efforts to have an influence on the economy. By the time the acts effect the economy, economic conditions may have already altered.
Unintended Consequences
Changes in fiscal policy may also have unforeseen repercussions. If the government raises expenditure with the purpose of increasing demand and GDP, the higher demand may increase employment and lead to a tightening labor market and rising wages and prices. This will allow the economy (GDP) to develop as anticipated, but inflation will also increase. Policymakers may be reluctant to adopt fiscal policy to stimulate an economy given the danger of causing inflation.
Crowding out, another example of unintended effects, is when the government borrows from a finite pool of savings and competes with the private sector for funding, crowding out private firms. As a result, the cost of borrowing may rise, and economic growth and investment created by the private sector may drop.
Fiscal or Monetary Policy?
Both governments and central banks are concerned with economic growth, inflation, and unemployment. Each has varied means at its disposal to effect economic activity. Government instruments include taxes and government spending. Central bank tools include open market operations, central bank lending rates, and reserve requirements.
Each entity is subject to much the same limitations: time lags between when a change in economic conditions occurs and when policy actions take effect; unexpected responses by consumers and companies; and unintended consequences, such as successfully stimulating the economy but at the same time increasing inflation. However, the time lag for monetary policy may be lower because central banks may be able to respond more swiftly than governments.
In actuality, both governments and central banks are likely to move in reaction to economic conditions. This is particularly true when economic conditions are exceptionally alarming, such as when a recession is diagnosed or when inflation or unemployment are high. The contemporary economy is a complex system of human conduct and connections.
To support growth in real GDP requires extensive insight into the effects of interest rate or tax changes on the decisions that will be thereafter taken by consumers and enterprises. After all, the economy represents the combined behavior of many millions of customers, firms, and governments around the globe.
Governments and central banks are inclined to act in reaction to economic conditions when economic conditions are exceptionally challenging. Monetary and fiscal policy affect the economy via distinct ways.
Monetary and Fiscal Policies
Economic growth, inflation, and unemployment are key issues for central banks and governments. They each utilize distinct financial tools to effect economic activity. Central banks, which are frequently independent of governments, use monetary policy. Governments utilize fiscal policy.
Monetary Policy
Monetary policy refers to central bank activities that are focused towards affecting the money supply — the amount of money in circulation — and credit — the amount of money available for borrowing and at the cost or interest rate. The purpose is to influence major macroeconomic targets:
Output or GDP Price stability Employment
Most central banks have a mission of maintaining price stability by regulating inflation while preventing deflation, which has indirect implications on other macroeconomic aims, such as employment and output. Many central banks strive to sustain employment levels and to encourage economic growth or slow it down. But by focused primarily on job levels and growth, it may leave opportunity for price volatility; increased employment and rapid economic growth is typically accompanied by inflation.
Consumers and firms should, in theory, be motivated by reduced interest rates to borrow and spend more and therefore stimulate the economy. As interest rates fall, the stock market may seem a more appealing place to invest, leading to gains in share prices and a broad impression of enhanced prosperity. This sensation of enhanced prosperity should motivate people to spend more and conserve less, and therefore further stimulate the economy.
Reducing interest rates may raise output and employment, so meeting two of the primary macroeconomic aims of policymakers. Similarly, increasing interest rates may slow the economy.
The tools used for monetary policy include open market operations, changes in the central bank lending rate, and changes in reserve requirements for commercial banks
Open Market Operations
The central bank can either purchase or sell securities issued by the government to effect the money supply. Open market activities involve the purchase and sale of government notes and bonds. If a central bank wants to expand the availability of money and credit to stimulate the economy, it can do so by purchasing financial assets, mainly short-term government instruments held by commercial banks.
The banks give up short-term government securities for cash from the central bank, which puts more money in circulation. The injection of money allows banks to decrease interest rates and offer more loans because they now have bigger cash reserves at the central bank.
By performing open market operations, the central bank produces a shortfall or surplus of money. Effectively, the central bank is pressuring commercial banks to modify their lending rates.
Central Bank Lending Rates
A central bank can impact interest rates by adjusting the discount rate. The discount rate is the rate at which banks borrow directly from the central bank of the country. It is used to effect short-term interest rates as well as to indirectly influence longer-term interest rates and other commercial rates.
The belief is that changes in interest rates can influence economic activity and affect inflation and economic growth. When a central bank wishes to stimulate the economy, it may cut its lending rate. When a central bank intends to slow the economy, it may increase its lending rate.
Reserve Requirements
Central banks can change the quantity of money available for borrowing in an economy by modifying bank reserve requirements. The reserve requirement is the proportion of deposits that must be retained by a bank rather than be lent to borrowers.
By increasing the reserve requirement, central banks decrease access to credit in the economy since bank lending is reduced. When they cut the reserve requirement, central banks boost access to credit because commercial banks are able to issue more loans. In practice, this instrument is not typically employed by central banks.
Quantitative Easing
The policy of quantitative easing (QE), employed in a number of nations during the financial crisis of 2008, is similar to open market operations, but on a considerably bigger scale and it entails the purchase of items other than short-term government instruments. In the United States, QE diverged from open market operations in that it entailed the purchase of mortgage bonds as well as large-scale purchases of longer-term US Treasury securities.
The objective was to cut longer-term interest rates on bonds and across a variety of credit products, promote bank lending, and thereby increase actual economic activity. It has proven difficult to measure the effectiveness of QE because other stimulus initiatives appeared at the same time in the wake of the financial crisis.
Limitations of Monetary Policy
The efficiency of monetary policy is subject to debate. Economists who challenge its effectiveness cite evidence of poor growth in some nations where interest rates are very low. This situation may occur because individuals and firms do not respond to reduced borrowing rates by spending more. Instead, they may opt to add to their cash holdings because they believe either that the economy will slow further and they need protection reserves or that prices may drop and offer better purchasing chances later. Alternatively, households and organizations respond to reduced interest rates by paying off debt, a process that is called deleveraging.
The psychology and expected responses of consumers and companies must be addressed while deciding on an effective monetary policy. Consider a scenario in which the central bank boosts interest rates to lower consumer spending and demand because it is concerned about inflationary pressures. If an economy is functioning well, overall optimism regarding income, employment, and business profits may be strong. In that instance, rises in borrowing costs are less efficient in restraining expenditure. At other times, an increase in interest rates may be useful since optimism is less established. The levels of consumer and business confidence determine the effectiveness of monetary policy.
Fiscal Policy
Governments utilize fiscal policy to effect economic activity. Fiscal policy involves the utilization of government spending and taxes. Fiscal policy may strive to stimulate a sluggish economy by greater spending or decreased taxes, or it may seek to moderate an overheating economy through decreased expenditure or increased taxes.
The Role and Tools of Fiscal Policy
One way that fiscal policy operates is by decreasing or increasing taxes. Governments can also affect GDP directly by spending more or less.
An expansionary strategy, which tries to boost a weak economy, will decrease taxes on consumers or corporations to increase consumer and company spending and the level of demand. Alternatively, it may raise public spending on social goods and infrastructure, such as hospitals and schools, which stimulates spending and demand directly.
An expansionary strategy can also stimulate spending and demand indirectly by increasing personal earnings and company revenues when it hires individuals and corporations to develop those public projects.
The success of these initiatives will vary over time and among countries. In a recession with rising unemployment, decreasing income taxes would not always promote consumer spending since people may desire to increase their savings in expectation of greater worsening in the economy.
Limitations of Fiscal Policy
The effectiveness of fiscal policy is constrained by the following:
Time lags
Unexpected responses by consumers and companies
Unintended consequences
Time Lags
There might be a large time lag between the understanding that intervention is required and observable fiscal policy impact. First, a recognition that the economy requires aid must arise, then a choice must be taken on what the adjustment in fiscal policy will be, then that decision has to be implemented, and then the economy has to have time to respond.
Unexpected Responses
As with monetary policy, consumers and corporations may not respond as expected to changes in fiscal policy. When a tax decrease is announced, private sector spending is likely to grow. But spending may remain unchanged or even fall if the private sector chooses to keep the income or pay down debt rather than spend.
Alternatively, spending may climb by more than planned. Similarly, if government spending increases, consumer and corporate responses may negate the effects of the change in government expenditure on GDP by reducing their own spending.
In other words, it takes time for policymakers to acknowledge that a problem exists, for decisions to be made and implemented, and for those efforts to have an influence on the economy. By the time the acts effect the economy, economic conditions may have already altered.
Unintended Consequences
Changes in fiscal policy may also have unforeseen repercussions. If the government raises expenditure with the purpose of increasing demand and GDP, the higher demand may increase employment and lead to a tightening labor market and rising wages and prices. This will allow the economy (GDP) to develop as anticipated, but inflation will also increase. Policymakers may be reluctant to adopt fiscal policy to stimulate an economy given the danger of causing inflation.
Crowding out, another example of unintended effects, is when the government borrows from a finite pool of savings and competes with the private sector for funding, crowding out private firms. As a result, the cost of borrowing may rise, and economic growth and investment created by the private sector may drop.
Fiscal or Monetary Policy?
Both governments and central banks are concerned with economic growth, inflation, and unemployment. Each has varied means at its disposal to effect economic activity. Government instruments include taxes and government spending. Central bank tools include open market operations, central bank lending rates, and reserve requirements.
Each entity is subject to much the same limitations: time lags between when a change in economic conditions occurs and when policy actions take effect; unexpected responses by consumers and companies; and unintended consequences, such as successfully stimulating the economy but at the same time increasing inflation. However, the time lag for monetary policy may be lower because central banks may be able to respond more swiftly than governments.
In actuality, both governments and central banks are likely to move in reaction to economic conditions. This is particularly true when economic conditions are exceptionally alarming, such as when a recession is diagnosed or when inflation or unemployment are high. The contemporary economy is a complex system of human conduct and connections.
To support growth in real GDP requires extensive insight into the effects of interest rate or tax changes on the decisions that will be thereafter taken by consumers and enterprises. After all, the economy represents the combined behavior of many millions of customers, firms, and governments around the globe.
- Published on
Investment - Imports and Exports
A demand is created by customer requirement. Imports and exports are ways utilized to address this need.
When you walk into a supermarket where you can buy Scottish salmon, Kenyan veggies, Thai rice, South African wine, and Colombian coffee, you are enjoying the benefits of international trade. Without international trade, consumers’ wants may not be fulfiled since people would only have access to products and services produced domestically. Some items and services have no domestic source, such as specific food, vaccines, and automobiles, for example.
International trade is the exchange of products, services, and capital between countries. The expansion in international trade, from USD296 billion in 1950 to USD22 trillion in 2020,1 can be considered as both a cause and result of globalization.
Consider the effect of international trade on a multinational firm such as Nestlé. At the end of 2013, the Switzerland-based corporation has plants in 79 countries and marketed its products in 186 nations.2 International trade has contributed greatly to Nestlé’s development in sales and profit, but it comes with problems.
One concern is the risk associated with foreign exchange rate variations or changes in the relative value of different countries’ currencies. Multinational corporations, such as Nestlé, do business in numerous currencies, therefore they are influenced by changes in currency exchange rates. Thus, investment professionals must include foreign exchange rate swings when they anticipate the future sales and earnings of international organizations.
Imports and Exports
The flow of commodities and services in international trade between countries is primarily measured by imports and exports.
Imports Products and services that are produced outside a country’s borders and are then brought into the country, or imported.
Exports Products and services that are produced within a country’s borders and then moved to another country, or exported. For example, Japan exports consumer electronics to the rest of the world.
International commerce gives countries access to resources for which there is no or insufficient supply domestically.
For example, since 2018, no automobiles have been built in Australia; they are entirely imported. Furthermore, international trade creates additional demand for products and services. If Japanese manufacturers could not sell consumer electronics abroad, they would have to limit their production to the number that is consumed in Japan, which is a rather limited market.
International trade also gives consumers with more choices and reduced pricing for goods and services. Again, picture the difficulty someone in Australia would have trying to buy a car if there were no automobile imports. The larger range of goods and services encourages competition amongst suppliers and leads to improved quality and reduced prices.
Two important trends have increased international trade:
Fewer trade barriers
Better transportation and communications
Trade barriers are constraints, generally imposed by governments, on the free trade of products and services. The table below gives descriptions of common sorts of trade barriers.
Common Forms of Trade Barriers Tariffs
Taxes (duties) levied on imported products and services. They allow governments not just to impose trade obstacles, frequently to protect domestic suppliers, but also to earn income.
Quotas Limits set on the quantity of products that can be imported.
Non-Tariff Barriers Measures, such as certification, licensing, sanctions, or embargoes, that make it more difficult and expensive for foreign producers to compete with domestic producers.
Embargoes Measures that prevent trade with a country.
A country, or group of countries, may apply economic penalties against a country or group of countries.
Economic sanctions are commercial and financial penalties that are aimed to restrict or reduce international trade with another country.
Sanctions may include entire trade embargoes, embargoes on certain commodities and services, prohibition on foreign investment in the sanctioned country, and asset freezes. They are aimed to impair the economic activity of the sanctioned country by decreasing its imports and exports.
In 2022, the European Union and the United States enacted severe economic sanctions against Russia in response to its military attacks on Ukraine. Sanctions can have substantial economic consequences: At the time they were imposed, many believed the economic sanctions against Russia would lead to soaring inflation and potentially wipe out Russia’s previous 15 years of economic success.
But in general, international trade barriers have steadily fallen since the signing of the General Agreement on Tariffs and Trade (GATT) in 1947 and the foundation of the World Trade Organisation (WTO) in 1995.
The WTO, with more than 150 member nations, is established to ensure adherence to trade agreements and to help countries negotiate new trade deals. The WTO also provides a dispute resolution process between countries. International trade has been further promoted by the creation of regional trade agreements, such as the Association of Southeast Asian Nations’ (ASEAN) Free Trade Area (AFTA), the United States-Mexico-Canada Agreement (USMCA), the Southern Common Market (Mercosur), and the African Continental Free Trade Area (AfCFTA).
Improvements in transportation and communications have helped international trade develop. Large shipping containers allow producers to move non-perishable products more easily on ships, trains, and trucks, while jumbo aircraft transport perishable products fast around the globe. The ability to communicate digitally has also contributed to the development in the worldwide trade of products and services.
A demand is created by customer requirement. Imports and exports are ways utilized to address this need.
When you walk into a supermarket where you can buy Scottish salmon, Kenyan veggies, Thai rice, South African wine, and Colombian coffee, you are enjoying the benefits of international trade. Without international trade, consumers’ wants may not be fulfiled since people would only have access to products and services produced domestically. Some items and services have no domestic source, such as specific food, vaccines, and automobiles, for example.
International trade is the exchange of products, services, and capital between countries. The expansion in international trade, from USD296 billion in 1950 to USD22 trillion in 2020,1 can be considered as both a cause and result of globalization.
Consider the effect of international trade on a multinational firm such as Nestlé. At the end of 2013, the Switzerland-based corporation has plants in 79 countries and marketed its products in 186 nations.2 International trade has contributed greatly to Nestlé’s development in sales and profit, but it comes with problems.
One concern is the risk associated with foreign exchange rate variations or changes in the relative value of different countries’ currencies. Multinational corporations, such as Nestlé, do business in numerous currencies, therefore they are influenced by changes in currency exchange rates. Thus, investment professionals must include foreign exchange rate swings when they anticipate the future sales and earnings of international organizations.
Imports and Exports
The flow of commodities and services in international trade between countries is primarily measured by imports and exports.
Imports Products and services that are produced outside a country’s borders and are then brought into the country, or imported.
Exports Products and services that are produced within a country’s borders and then moved to another country, or exported. For example, Japan exports consumer electronics to the rest of the world.
International commerce gives countries access to resources for which there is no or insufficient supply domestically.
For example, since 2018, no automobiles have been built in Australia; they are entirely imported. Furthermore, international trade creates additional demand for products and services. If Japanese manufacturers could not sell consumer electronics abroad, they would have to limit their production to the number that is consumed in Japan, which is a rather limited market.
International trade also gives consumers with more choices and reduced pricing for goods and services. Again, picture the difficulty someone in Australia would have trying to buy a car if there were no automobile imports. The larger range of goods and services encourages competition amongst suppliers and leads to improved quality and reduced prices.
Two important trends have increased international trade:
Fewer trade barriers
Better transportation and communications
Trade barriers are constraints, generally imposed by governments, on the free trade of products and services. The table below gives descriptions of common sorts of trade barriers.
Common Forms of Trade Barriers Tariffs
Taxes (duties) levied on imported products and services. They allow governments not just to impose trade obstacles, frequently to protect domestic suppliers, but also to earn income.
Quotas Limits set on the quantity of products that can be imported.
Non-Tariff Barriers Measures, such as certification, licensing, sanctions, or embargoes, that make it more difficult and expensive for foreign producers to compete with domestic producers.
Embargoes Measures that prevent trade with a country.
A country, or group of countries, may apply economic penalties against a country or group of countries.
Economic sanctions are commercial and financial penalties that are aimed to restrict or reduce international trade with another country.
Sanctions may include entire trade embargoes, embargoes on certain commodities and services, prohibition on foreign investment in the sanctioned country, and asset freezes. They are aimed to impair the economic activity of the sanctioned country by decreasing its imports and exports.
In 2022, the European Union and the United States enacted severe economic sanctions against Russia in response to its military attacks on Ukraine. Sanctions can have substantial economic consequences: At the time they were imposed, many believed the economic sanctions against Russia would lead to soaring inflation and potentially wipe out Russia’s previous 15 years of economic success.
But in general, international trade barriers have steadily fallen since the signing of the General Agreement on Tariffs and Trade (GATT) in 1947 and the foundation of the World Trade Organisation (WTO) in 1995.
The WTO, with more than 150 member nations, is established to ensure adherence to trade agreements and to help countries negotiate new trade deals. The WTO also provides a dispute resolution process between countries. International trade has been further promoted by the creation of regional trade agreements, such as the Association of Southeast Asian Nations’ (ASEAN) Free Trade Area (AFTA), the United States-Mexico-Canada Agreement (USMCA), the Southern Common Market (Mercosur), and the African Continental Free Trade Area (AfCFTA).
Improvements in transportation and communications have helped international trade develop. Large shipping containers allow producers to move non-perishable products more easily on ships, trains, and trucks, while jumbo aircraft transport perishable products fast around the globe. The ability to communicate digitally has also contributed to the development in the worldwide trade of products and services.
- Published on
Investment -Inflation
Understanding inflation is key to investing since inflation can diminish the value of investment returns. Inflation affects all parts of the economy.
Inflation
Inflation is a general rise in prices for items and services. Changing inflation has ramifications for economic activity and national competitiveness. Companies must monitor increases in expenses and pricing, and they examine their competitive environment to decide how to respond to these changes. Consumers use changes in prices to make their purchase decisions. Accurate measuring of inflation is vital.
Measuring Inflation
There are numerous different measures of inflation based on different price indexes. A price index measures the price of a commodity or service, or a basket of items and services (usually referred to as a basket of goods), over time. The simplest metric of inflation is the percentage change in an index from one period to another.
Consumer Price Index
A consumer price index (CPI) assumes a basket of items matches a typical household’s spending, and it tracks the price of that basket over time.
Weights of the components of this index can be adjusted when long-term consumer trends shift. Computers and technology may not have been found in normal households in the past, therefore they were not included in the basket of commodities. Today their weighting may be relatively high. Inflation recorded by a CPI may overestimate or understate inflation for a given consumer or household, depending on how their spending patterns compare with the basket of items.
The basket of commodities is likely to vary in different countries. In the United Kingdom, at least two CPIs are reported: a retail price index (RPI) based on a basket of goods that includes housing expenses, and a CPI with a narrower basket of items that does not include housing. Inflation rates as measured by the UK RPI and CPI are often not the same.
Price volatility can involve sudden jumps up or down; food and energy costs can change in this fashion. There are indices based on core inflation, such as the US Core CPI, that eliminate the effects of momentary volatility in prices, even if the consequences are felt by households and companies. Policymakers, such as governments and central banks, find these indicators useful.
Producer Price Index
Another indicator of inflation is a producer price index (PPI). PPIs measure the average selling price of products. They are larger than CPIs in that they include the price of investment items, but they are also narrower in that they do not cover services. PPI numbers can be informed by reports from specific industries, from changing commodity prices, or from reporting on certain stages of processing, such as raw materials or completed goods.
Inflation Rates and Price Indices
Different indices can give different inflation measures, even in the same country during the same period. As you can see in the example below, which illustrates inflation rates based on the CPI and PPI indices for the United States, inflation rates over the same period can differ considerably depending on the price index utilized.
The link between CPIs and PPIs is frequently used to determine the degree to which producers’ costs are passed on to consumers. If consumer prices (or costs to consumers) remain steady while producer prices (or costs to producers) are growing, then producers seem unable to pass on the costs to consumers. Examining increases in manufacturing costs relative to consumer price increases can show if profit margins are rising or narrowing.
Effects of Inflation on Consumers, Businesses, and Investments
Changes in price levels can affect economic growth because people and businesses may modify the timing of their purchases, the quantity of their spending, and their saving and borrowing decisions based on the changes in prices they anticipate. The value of investments may also be altered by changes in price levels.
CONSUMERS
If customers expect prices to increase, they may buy now rather than save. Or they may choose to borrow to expand spending. Borrowers benefit from inflation because they repay loans with money that is worth less; in other words, the money has decreased purchasing power.
Inflation can encourage economic growth if customers respond to predictions of price increases by making purchases now rather than deferring them. But the increased spending may only assist economic development in the near run because some of those purchases would have been made otherwise. Accordingly, inflation may simply transfer demand from the future to the present. This extra short-term demand can further boost inflationary pressure.
During periods of inflation, wages may not increase at the same rate as the prices of items and services. If salaries increase by a lesser amount, consumers may have less money to spend as their budgets are strained. Additionally, if unemployment is high, consumers’ bargaining power falls, and real consumer expenditure (consumer spending adjusted for inflation) may weaken. This scenario may help interrupt the inflationary cycle.
BUSINESS
Generally, inflation will have a negative influence on corporate planning and investment. Budgeting becomes more challenging because of the uncertainty produced by growing prices and costs. Consumers consume rather than invest, therefore access to finance is decreased for enterprises, which leads in less corporate spending on physical capital.
they’ earnings may drop as costs grow, particularly if they are unable to pass on the greater costs to consumers in the form of higher pricing. If inflation becomes entrenched, overall economic performance may decline as enterprises raise prices and are perhaps unable to invest in capital or pursue efficiency improvements.
assets Inflation impacts the value of financial assets. Any investment paying a set cash amount will drop in value if interest rates rise. As inflation grows, interest rates normally rise, hence rising inflation will lead to lower values for fixed-income investments, such as bonds. Inflation tends to help borrowers, as explained above, and penalize lenders.
But shares may be an excellent long-term hedge, or form of protection, against inflation; if corporations are able to increase the selling prices of their products when their input prices increase, a move which may enhance their stock price, if successful.
Other Changes in the Level of Prices
Inflation is an important economic issue for investors and is more usual than deflation, stagflation, and hyperinflation, which we cover here. These can be equally or even more harmful for consumers, firms, policymakers in central banks and governments, and economies.
A consistent and substantial fall in prices across most items and services in an economy is called deflation. Deflation was experienced in the 1930s during the Great Depression in the United States and more recently in Japan. If customers expect prices to decline, they may choose to save, even if they receive zero interest, and defer purchases until prices decrease more. As a result, demand diminishes, enterprises reduce production and labour, and unemployment grows.
Encouraging consumption and ending this vicious loop is quite tough. Japan, for instance, has endured deflation for much of the past 20 years.
STAGFLATION
Inflation frequently occurs in periods of rapid economic growth. However, excessive inflation can occur in periods of little or no economic development, and this scenario is stagflation. Stagflation is often associated with inflation that originates outside the domestic economy.
Many developed economies suffered stagflation in the 1970s and early 1980s because oil prices abruptly and significantly surged, generating inflation as costs of production rose. Investment spending by enterprises fell. Consumer spending declined as they acclimated to increasing oil prices. As a result, unemployment rates soared, and customers had even less money to spend.
HYPERINFLATION
Hyperinflation entails price increases so huge and rapid that customers find it impossible to afford numerous products and services. Consumers want to spend money as quickly as they acquire it, anticipating rises in pricing of items and services and preferring to possess real assets rather than money. Products and services are often not available because producers hold back, anticipating additional price increases.
Although most typically associated with emerging countries, Germany experienced hyperinflation following World War I. Hyperinflation causes tremendous damage to an economy and cannot be readily counteracted by governments or central banks. Fortunately, incidents of hyperinflation are rather rare.
Understanding inflation is key to investing since inflation can diminish the value of investment returns. Inflation affects all parts of the economy.
Inflation
Inflation is a general rise in prices for items and services. Changing inflation has ramifications for economic activity and national competitiveness. Companies must monitor increases in expenses and pricing, and they examine their competitive environment to decide how to respond to these changes. Consumers use changes in prices to make their purchase decisions. Accurate measuring of inflation is vital.
Measuring Inflation
There are numerous different measures of inflation based on different price indexes. A price index measures the price of a commodity or service, or a basket of items and services (usually referred to as a basket of goods), over time. The simplest metric of inflation is the percentage change in an index from one period to another.
Consumer Price Index
A consumer price index (CPI) assumes a basket of items matches a typical household’s spending, and it tracks the price of that basket over time.
Weights of the components of this index can be adjusted when long-term consumer trends shift. Computers and technology may not have been found in normal households in the past, therefore they were not included in the basket of commodities. Today their weighting may be relatively high. Inflation recorded by a CPI may overestimate or understate inflation for a given consumer or household, depending on how their spending patterns compare with the basket of items.
The basket of commodities is likely to vary in different countries. In the United Kingdom, at least two CPIs are reported: a retail price index (RPI) based on a basket of goods that includes housing expenses, and a CPI with a narrower basket of items that does not include housing. Inflation rates as measured by the UK RPI and CPI are often not the same.
Price volatility can involve sudden jumps up or down; food and energy costs can change in this fashion. There are indices based on core inflation, such as the US Core CPI, that eliminate the effects of momentary volatility in prices, even if the consequences are felt by households and companies. Policymakers, such as governments and central banks, find these indicators useful.
Producer Price Index
Another indicator of inflation is a producer price index (PPI). PPIs measure the average selling price of products. They are larger than CPIs in that they include the price of investment items, but they are also narrower in that they do not cover services. PPI numbers can be informed by reports from specific industries, from changing commodity prices, or from reporting on certain stages of processing, such as raw materials or completed goods.
Inflation Rates and Price Indices
Different indices can give different inflation measures, even in the same country during the same period. As you can see in the example below, which illustrates inflation rates based on the CPI and PPI indices for the United States, inflation rates over the same period can differ considerably depending on the price index utilized.
The link between CPIs and PPIs is frequently used to determine the degree to which producers’ costs are passed on to consumers. If consumer prices (or costs to consumers) remain steady while producer prices (or costs to producers) are growing, then producers seem unable to pass on the costs to consumers. Examining increases in manufacturing costs relative to consumer price increases can show if profit margins are rising or narrowing.
Effects of Inflation on Consumers, Businesses, and Investments
Changes in price levels can affect economic growth because people and businesses may modify the timing of their purchases, the quantity of their spending, and their saving and borrowing decisions based on the changes in prices they anticipate. The value of investments may also be altered by changes in price levels.
CONSUMERS
If customers expect prices to increase, they may buy now rather than save. Or they may choose to borrow to expand spending. Borrowers benefit from inflation because they repay loans with money that is worth less; in other words, the money has decreased purchasing power.
Inflation can encourage economic growth if customers respond to predictions of price increases by making purchases now rather than deferring them. But the increased spending may only assist economic development in the near run because some of those purchases would have been made otherwise. Accordingly, inflation may simply transfer demand from the future to the present. This extra short-term demand can further boost inflationary pressure.
During periods of inflation, wages may not increase at the same rate as the prices of items and services. If salaries increase by a lesser amount, consumers may have less money to spend as their budgets are strained. Additionally, if unemployment is high, consumers’ bargaining power falls, and real consumer expenditure (consumer spending adjusted for inflation) may weaken. This scenario may help interrupt the inflationary cycle.
BUSINESS
Generally, inflation will have a negative influence on corporate planning and investment. Budgeting becomes more challenging because of the uncertainty produced by growing prices and costs. Consumers consume rather than invest, therefore access to finance is decreased for enterprises, which leads in less corporate spending on physical capital.
they’ earnings may drop as costs grow, particularly if they are unable to pass on the greater costs to consumers in the form of higher pricing. If inflation becomes entrenched, overall economic performance may decline as enterprises raise prices and are perhaps unable to invest in capital or pursue efficiency improvements.
assets Inflation impacts the value of financial assets. Any investment paying a set cash amount will drop in value if interest rates rise. As inflation grows, interest rates normally rise, hence rising inflation will lead to lower values for fixed-income investments, such as bonds. Inflation tends to help borrowers, as explained above, and penalize lenders.
But shares may be an excellent long-term hedge, or form of protection, against inflation; if corporations are able to increase the selling prices of their products when their input prices increase, a move which may enhance their stock price, if successful.
Other Changes in the Level of Prices
Inflation is an important economic issue for investors and is more usual than deflation, stagflation, and hyperinflation, which we cover here. These can be equally or even more harmful for consumers, firms, policymakers in central banks and governments, and economies.
A consistent and substantial fall in prices across most items and services in an economy is called deflation. Deflation was experienced in the 1930s during the Great Depression in the United States and more recently in Japan. If customers expect prices to decline, they may choose to save, even if they receive zero interest, and defer purchases until prices decrease more. As a result, demand diminishes, enterprises reduce production and labour, and unemployment grows.
Encouraging consumption and ending this vicious loop is quite tough. Japan, for instance, has endured deflation for much of the past 20 years.
STAGFLATION
Inflation frequently occurs in periods of rapid economic growth. However, excessive inflation can occur in periods of little or no economic development, and this scenario is stagflation. Stagflation is often associated with inflation that originates outside the domestic economy.
Many developed economies suffered stagflation in the 1970s and early 1980s because oil prices abruptly and significantly surged, generating inflation as costs of production rose. Investment spending by enterprises fell. Consumer spending declined as they acclimated to increasing oil prices. As a result, unemployment rates soared, and customers had even less money to spend.
HYPERINFLATION
Hyperinflation entails price increases so huge and rapid that customers find it impossible to afford numerous products and services. Consumers want to spend money as quickly as they acquire it, anticipating rises in pricing of items and services and preferring to possess real assets rather than money. Products and services are often not available because producers hold back, anticipating additional price increases.
Although most typically associated with emerging countries, Germany experienced hyperinflation following World War I. Hyperinflation causes tremendous damage to an economy and cannot be readily counteracted by governments or central banks. Fortunately, incidents of hyperinflation are rather rare.
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Investment - Comparative Advantages Among Countries
Rather of manufacturing everything within the bounds of their own borders, countries frequently specialise in items and services for which they have a comparative advantage – that is, the products and services that they can manufacture substantially more effectively than other countries.
According to the principle of comparative advantage, countries should export items and services in which they have a comparative advantage and import things and services in which they do not have a comparative advantage.
The source of a competitive advantage might be tied to natural, human, or capital resources. Some countries have access to natural resources, such as fossil fuels, metals, or minerals, that are not available or are in restricted supply in other countries. Some countries can create products and services less expensively than others or make products that demand more expertise. The United States imports apparel and toys, for example, but exports complex technology, such as aeroplanes and turbines.
The combination of comparative advantage and international commerce ultimately helps all countries, leading to a better allocation of resources and increased prosperity.
Rather of manufacturing everything within the bounds of their own borders, countries frequently specialise in items and services for which they have a comparative advantage – that is, the products and services that they can manufacture substantially more effectively than other countries.
According to the principle of comparative advantage, countries should export items and services in which they have a comparative advantage and import things and services in which they do not have a comparative advantage.
The source of a competitive advantage might be tied to natural, human, or capital resources. Some countries have access to natural resources, such as fossil fuels, metals, or minerals, that are not available or are in restricted supply in other countries. Some countries can create products and services less expensively than others or make products that demand more expertise. The United States imports apparel and toys, for example, but exports complex technology, such as aeroplanes and turbines.
The combination of comparative advantage and international commerce ultimately helps all countries, leading to a better allocation of resources and increased prosperity.
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Investment - Introduction to Derivatives Contracts
When you plan a vacation, you do not normally wait until you reach to your chosen destination to book a lodging. Booking a hotel room in advance provides certainty that a room will be available and locks in the price. Your action minimizes uncertainty (risk) for you. It also lowers uncertainty for the hotel.
Now, pretend that you are a wheat farmer and wish to reduce some of the risk of farming. You might presell some of your crop at a fixed price. In fact, contracts to lessen the unpredictability of agricultural products have been dated back to the 16th century. These contracts on agricultural products may be the oldest form of what are known as derivatives contracts or, simply, derivatives.
Derivatives are contracts that draw their value from the performance of an underlying asset, event, or outcome – hence their name. Since the invention of derivatives contracts to assist minimize risk for farmers, the purposes and varieties of derivatives contracts, and the size of the derivatives market, have risen dramatically. Derivatives are no longer just about lowering risk, but constitute part of the investment plans of many fund managers.
When you plan a vacation, you do not normally wait until you reach to your chosen destination to book a lodging. Booking a hotel room in advance provides certainty that a room will be available and locks in the price. Your action minimizes uncertainty (risk) for you. It also lowers uncertainty for the hotel.
Now, pretend that you are a wheat farmer and wish to reduce some of the risk of farming. You might presell some of your crop at a fixed price. In fact, contracts to lessen the unpredictability of agricultural products have been dated back to the 16th century. These contracts on agricultural products may be the oldest form of what are known as derivatives contracts or, simply, derivatives.
Derivatives are contracts that draw their value from the performance of an underlying asset, event, or outcome – hence their name. Since the invention of derivatives contracts to assist minimize risk for farmers, the purposes and varieties of derivatives contracts, and the size of the derivatives market, have risen dramatically. Derivatives are no longer just about lowering risk, but constitute part of the investment plans of many fund managers.
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Investment - Comparing Equity and Debt Securities
There are considerable risk and return disparities between debt and equity instruments due of differences in cash flows, voting rights, and priority of claims.
Risk
Debt securities are the least dangerous because debt capital is borrowed money and represents a contractual liability of the corporation. Thus, debt investors have a larger claim on the company’s assets than stock investors. Investing in debt securities is also less risky than investing in equity securities since the predicted cash flows of fixed-rate and zero-coupon bonds are known in advance and are fairly reasonable to forecast in the case of floating-rate bonds.
Priority of Claims
After the claims of debt investors have been satisfied, preferred stock holders are next in line to get what they are due. Preferred stock is less riskier than common stock since it ranks higher than common stock when it comes to the payment of dividends. The risk of preferred shares is also lessened to some degree by the prospect of a dividend each year. Although the dividend is not a contractual obligation, firms are often reluctant to miss dividends on preferred shares.
Common shareholders are last in line and are known as the residual claimants of a firm. Common shareholders divide the leftover assets proportionately once all other claims have been fulfilled. If finances are insufficient to pay out all claims, equity owners will likely receive only a part of their investment back, or may potentially lose their entire investment. Accordingly, investment in equity securities is riskier than investing in corporate debt instruments. Common stock is regarded the riskiest of the three since it ranks last in the seniority hierarchy when it comes to the payment of dividends and distribution of net assets if the firm is liquidated.
Equity investors are, however, protected by limited liability, which means that higher claimants, particularly debt investors, cannot recover money from other assets belonging to the shareholders if the company’s assets are insufficient to fully cover their claims (except in cases of fraud and wilful negligence). Because a corporation is a legal entity apart from its owners, it is accountable, at the corporate level, for all company liabilities. By legally isolating the shareholders from the corporation, an individual shareholder’s responsibility is restricted to the amount he or she invested. So, stockholders cannot lose more money than they have invested in the company.
Return Potential
The return potential for both debt securities and preferred stock is limited because the cash flows (interest, dividends, and repayment of par value) do not increase if the company does well. The return potential to common shareholders is bigger since the share price rises if the company performs successfully. Relative to holders of debt securities and preferred stock, common stockholders expect a better return, but must tolerate greater risk. The voting rights of common shareholders may offer them some influence over the company’s business decisions and so somewhat lessen risk.
Given the fact that equity securities are riskier than debt securities, shareholders anticipate to receive higher returns on equity securities over the long term. Because equity is riskier than debt, risk-averse investors may choose debt assets to equity instruments. However, although debt securities are safer than equity securities for a particular organization, debt securities are not risk-free; they are vulnerable to several risk factors, as stated above.
Equity returns over the period are higher than government bond returns within every country. The real equity return was positive in every site, often at a level of 3% to 6% per year. The statistics are broadly consistent with the idea that riskier equities instruments should provide higher returns over the long run than lower risk debt securities.
There are considerable risk and return disparities between debt and equity instruments due of differences in cash flows, voting rights, and priority of claims.
Risk
Debt securities are the least dangerous because debt capital is borrowed money and represents a contractual liability of the corporation. Thus, debt investors have a larger claim on the company’s assets than stock investors. Investing in debt securities is also less risky than investing in equity securities since the predicted cash flows of fixed-rate and zero-coupon bonds are known in advance and are fairly reasonable to forecast in the case of floating-rate bonds.
Priority of Claims
After the claims of debt investors have been satisfied, preferred stock holders are next in line to get what they are due. Preferred stock is less riskier than common stock since it ranks higher than common stock when it comes to the payment of dividends. The risk of preferred shares is also lessened to some degree by the prospect of a dividend each year. Although the dividend is not a contractual obligation, firms are often reluctant to miss dividends on preferred shares.
Common shareholders are last in line and are known as the residual claimants of a firm. Common shareholders divide the leftover assets proportionately once all other claims have been fulfilled. If finances are insufficient to pay out all claims, equity owners will likely receive only a part of their investment back, or may potentially lose their entire investment. Accordingly, investment in equity securities is riskier than investing in corporate debt instruments. Common stock is regarded the riskiest of the three since it ranks last in the seniority hierarchy when it comes to the payment of dividends and distribution of net assets if the firm is liquidated.
Equity investors are, however, protected by limited liability, which means that higher claimants, particularly debt investors, cannot recover money from other assets belonging to the shareholders if the company’s assets are insufficient to fully cover their claims (except in cases of fraud and wilful negligence). Because a corporation is a legal entity apart from its owners, it is accountable, at the corporate level, for all company liabilities. By legally isolating the shareholders from the corporation, an individual shareholder’s responsibility is restricted to the amount he or she invested. So, stockholders cannot lose more money than they have invested in the company.
Return Potential
The return potential for both debt securities and preferred stock is limited because the cash flows (interest, dividends, and repayment of par value) do not increase if the company does well. The return potential to common shareholders is bigger since the share price rises if the company performs successfully. Relative to holders of debt securities and preferred stock, common stockholders expect a better return, but must tolerate greater risk. The voting rights of common shareholders may offer them some influence over the company’s business decisions and so somewhat lessen risk.
Given the fact that equity securities are riskier than debt securities, shareholders anticipate to receive higher returns on equity securities over the long term. Because equity is riskier than debt, risk-averse investors may choose debt assets to equity instruments. However, although debt securities are safer than equity securities for a particular organization, debt securities are not risk-free; they are vulnerable to several risk factors, as stated above.
Equity returns over the period are higher than government bond returns within every country. The real equity return was positive in every site, often at a level of 3% to 6% per year. The statistics are broadly consistent with the idea that riskier equities instruments should provide higher returns over the long run than lower risk debt securities.
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Investment - Yield Curve
When investors try to estimate the right discount rate (yield to maturity or necessary rate of return) to value a particular corporate bond, they generally begin by looking at the yields to maturity offered by government bonds.
The term structure of interest rates, frequently referred to simply as the term structure, depicts how interest rates on government bonds fluctuate with maturity. The term structure is commonly displayed in graphical form, referred to as the yield curve.
The yield curve compares the yield to maturity of government bonds (y-axis) versus the maturity of these bonds (x-axis). It is vital when building a yield curve to ensure that bonds have similar features other than their maturity. In other words, the bonds assessed should simply differ in maturity.
A yield curve applied to US debt instruments is the US Treasury yield curve, which graphs yields on US government bonds by maturity.
Shown below is the US Treasury yield curve as of 19 July 2022. In this scenario, the yield curve is upward sloping in the short-term maturities before flattening off in the longer maturities.
When investors try to estimate the right discount rate (yield to maturity or necessary rate of return) to value a particular corporate bond, they generally begin by looking at the yields to maturity offered by government bonds.
The term structure of interest rates, frequently referred to simply as the term structure, depicts how interest rates on government bonds fluctuate with maturity. The term structure is commonly displayed in graphical form, referred to as the yield curve.
The yield curve compares the yield to maturity of government bonds (y-axis) versus the maturity of these bonds (x-axis). It is vital when building a yield curve to ensure that bonds have similar features other than their maturity. In other words, the bonds assessed should simply differ in maturity.
A yield curve applied to US debt instruments is the US Treasury yield curve, which graphs yields on US government bonds by maturity.
Shown below is the US Treasury yield curve as of 19 July 2022. In this scenario, the yield curve is upward sloping in the short-term maturities before flattening off in the longer maturities.
The term structure for government bonds, such as Treasury bonds, offers investors with a base yield to maturity, which serves as a basis to compare yields to maturity offered by riskier bonds. Relative to Treasury bonds, riskier bonds should pay higher yields to maturity to compensate investors for the increased credit or default risk.