The Interrelations of Finance and Economics: Theoretical Perspectives
Abstract
It is traditional in a discussion piece to organize the material in one of two ways. The writer can either take a historical perspective and attempt to explain how it is we got where we are today and where we are likely to go from here, or the writer can describe the current state of the art, dwelling on particular points of interest or promise in the prevailing research. Having quite recently done both, I thought I would take a somewhat different approach. I would like to try to briefly describe the main characteristics of a neoclassical theory of finance that captures the essential themes of modern finance and relate these characteristics to the general themes of economics. Finance uses the modeling framework constructed in economics but, within this scaffolding, finance has taken a different methodological perspective. It is wrong to characterize finance, or financial economics to be formal, as simply another of the specialty areas of economics-not unlike, for example, labor economics or development economics or public finance. While finance is specialized in its focus on the financial markets, the differences between economics and finance only begin there. The principal distinction is one of methodology rather than of focus. If labor markets behaved like financial markets, the theories of finance would be used to study them. Indeed, the line where financial theoretic analysis leaves off and more conventional patterns of economic reasoning begin is an active research issue.
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