Finance

How Do Politics And Political Instability Affect The Financial Market?

How Do Politics And Political Instability Affect The Financial Market

Political instability is defined as the propensity of a government to collapse due to conflicts or rampant competition between various political parties. Also, whenever a government changes, there is a likelihood of more changes that might bring about instability, and this threat is always lurking. That said, economic growth and political stability are deeply interconnected as the uncertainty associated with an unstable political environment can reduce investment and the pace of economic development. Also, poor economic performance may lead to government collapse and political unrest.

Even though political stability can be achieved through oppression or having no democracy where a given political party doesn’t have to compete to be re-elected, political stability is a double-edged sword in such cases. On the one hand, the peaceful environment created by political stability can be desirable; however, it can easily become a breeding ground for cronyism with impunity. This eventually can lead to the collapse of the economy. To understand the implications of an unstable government on markets, you need to understand the political economy.

How Do Politics And Political Instability Affect The Stock Market?

Economists have found a direct link between poor economic performance and dismal stock market performance. It goes without saying if the conditions are not right for the economy to thrive, then even the nation’s stock market will be affected. Investors take bets on economies with signs of growth, and the political environment has to be conducive to allow this growth to happen. Otherwise, they are likely to avoid stocks or take out money from companies based in a country with an unstable political system.

What Is Political Economy?

In the past, political economy was a term commonly used to describe the field of economics. Today it is defined as an interdisciplinary branch of the social sciences that focus on the interrelationships among individuals, governments, and public policy. As a political economist, you will study how economic theories such as capitalism, socialism, and communism work in the real world. The goal is to understand how to distribute a finite amount of resources in a way that benefits the greatest number of individuals. Overall, the term is used to describe any government policy that has an economic impact.

Why Do Governments Need To Impose Certain Regulations?

While there are multiple ways to quantify the health of modern economies, one of the most visible is the stock market and its representative indices. Therefore, examining the reactions of stock market indices is a natural experiment to measure the effects of government action undertaken, for instance, to revitalize an economy.

Therefore analyzing the returns offered by stock markets, it’s possible to measure the effects of government actions on investor actions and subsequent economic effects. During economic hardships, researchers have discovered that pessimism causes lower valuations for hard-to-value stocks, and optimism leads to higher valuations than would exist in the absence of sentiment. Even if stock market returns will have greater variance than investor sentiment, they still reflect investor sentiment changes and can magnify these changes. This is truer when considering highly volatile stocks that can be hard to value but are majorly influenced by investor sentiment.

What Is The Role Of The Governments In The Financial World?

One way the government incentivizes economic growth is through interest rate changes. Reduced interest rates tend to encourage economic growth as the effective costs for capital investments and consumer goods fall. John Maynard Keynes’s IS-LM model helps explain this relationship better. National output is the sum of consumption, investment, and government spending.

The equilibrium interest rate is determined by the intersection of two curves graphed against national output: the downward-sloping investment and savings curve (the “IS” curve) and the upward-sloping liquidity and money curve (the “LM” curve). The former represents the market for goods and services and is affected by fiscal policies such as changes in government expenditures and tax rates. It slopes down because decreasing interest rates increase investment, which increases national output.”

The latter represents the money market and is affected by monetary policy, especially the supply of money in the economy as determined by central bank policies.

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