Finance vs. Economics: An Overview
Although they are often taught and presented as separate disciplines, economics and finance are interrelated and inform and influence each other. Investors care about these studies because they also influence the markets to a great degree. It’s important for investors to avoid “either/or” arguments regarding economics and finance; both are important and have valid applications.
As a general social science, the focus of economics is more on the big picture, or general questions about human behavior around the allocation of real resources. The focus of finance is more on the techniques and tools of managing money. Both economic and finance also focus on how companies and investors evaluate risk and return. Historically, economics has been more theoretical and finance more practical, but in the last 20 years, the distinction has become much less pronounced.
In fact, the two disciplines seem to be converging in some respects. Both economists and finance professionals are being employed in governments, corporations, and financial markets. At some fundamental level, there will always be a separation, but both are likely to remain very important to the economy, investors, and the markets for years to come.
Finance
Finance in many respects is an offshoot of economics. Finance describes the management, creation, and study of money, banking, credit, investments, assets, and liabilities that make up financial systems, as well as the study of those financial instruments. Finance can be divided into three categories: public finance, corporate finance, and personal finance.
Finance typically focuses on the study of prices, interest rates, money flows, and the financial markets. Thinking more broadly, finance tends to center around topics that include the time value of money, rates of return, cost of capital, optimal financial structures, and the quantification of risk.
Finance, as in the case of corporate finance, involves managing assets, liabilities, revenues, and debt for a business. Businesses obtain financing through a variety of means, ranging from equity investments to credit arrangements. A firm might take out a loan from a bank or arrange for a line of credit—acquiring and managing debt properly can help a company expand and ultimately become more profitable.
Personal finance defines all financial decisions and activities of an individual or household, including budgeting, insurance, mortgage planning, savings, and retirement planning.
Public finance includes tax systems, government expenditures, budget procedures, stabilization policy and instruments, debt issues, and other government concerns.
Special Considerations
A degree in finance is a common denominator among many of those who work on Wall Street as analysts, bankers, or fund managers. Likewise, many of those employed by commercial banks, insurance companies, and other financial service providers have college backgrounds in finance. Apart from the finance industry itself, a degree in finance can be a pathway to senior management of companies and corporations.
Finance involves assessing the value of financial instruments, such as the determination of fair value for a wide range of investment products. Finance includes the use of stock-pricing models like the capital asset pricing model (CAPM) and option models like Black-Scholes. Finance also includes determining the optimal dividend or debt policy for a corporation or the proper asset allocation strategy for an investor.
It can also be argued that finance affects the markets with a seemingly constant stream of new products. Although many derivatives and advanced financial products have been maligned in the wake of the Great Recession, many of these instruments were designed to address and solve market demands and needs. For example, derivatives can be used to hedge risk for investors, hedge funds, or large banks, thus protecting the financial system from harm in the event of a recession.
Economics takes a more theoretical look, while finance is more applied, however, both are connected disciplines, with some overlap.
Economics
Economics is a social science that studies the production, consumption, and distribution of goods and services, with the aim of explaining how economies work and how people interact. Although labeled a “social science” and often treated as one of the liberal arts, modern economics is in fact often very quantitative and heavily math-oriented in practice. There are two main branches of economics: macroeconomics and microeconomics.
Macroeconomics is a branch of economics that studies how the aggregate economy behaves. In macroeconomics, a variety of economy-wide phenomena are thoroughly examined, such as inflation, national income, gross domestic product (GDP), and changes in unemployment.
Microeconomics is the study of economic tendencies, or what’s likely to happen when individuals make certain choices or when the factors of production change. Just as macroeconomics focuses on how the aggregate economy behaves, microeconomics focuses on the smaller factors that affect choices made by individuals and companies.
Microeconomics also explains what to expect if certain conditions change. If a manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer than before. If a major copper mine collapses in South America, the price of copper will tend to increase, because supply is restricted.
Macroeconomics can be applied in tracking GDP, inflation, and deficits to help investors make more informed decisions. Microeconomics could help an investor see why Apple Inc. stock prices might fall if consumers buy fewer iPhones. Microeconomics could also explain why a higher minimum wage might force a company to hire fewer workers.