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Overview of Economics

• Economic news and events are announced regularly.

• Investors and advisors should consider the impact of these events on markets and individual investments.

• Understanding economics involves understanding the choices people make and how these choices affect the economy.

• Consumer choices and economic participants interact in an organized market.

• Prices are determined by demand and supply.

• An example of an organized market is the Toronto Stock Exchange.

• Buyers and sellers have different views about a security's future value.

• Economic analysis informs buy and sell decisions.

• The goal is to provide a basic understanding of key economic variables.

• Participants in the securities industry should pay attention to economic events and their impact on investments.

Defining Economics

• Economics is the process of understanding financial choices and their impact on the economy.

• A market economy encompasses activities related to producing and consuming goods and services.

• Decisions by individuals, businesses, and governments determine resource allocation.

• The interaction between market participants determines the price of goods, services, stocks, bonds, and mutual funds, which in turn influences consumer behavior and investment strategies.

Microeconomics and Macroeconomics

• Economics comprises two areas of study: microeconomics and macroeconomics:

  • Microeconomics applies to individual markets of goods and services, focusing on production decisions of businesses and consumption decisions of individuals.

  • Macroeconomics focuses on broader issues such as employment, interest rates, inflation, recessions, government spending, and economic interactions between countries.

Table 4.1 | Microeconomics and Macroeconomics

The Decision Makers

• The three broad groups that interact in the economy include consumers, businesses, and governments:

  • Consumers: maximize satisfaction and well-being within available resources.

  • Businesses: maximize profits by selling goods or services.

  • Governments: spend money on education, health care, employment training, military, and public works projects.

• The decisions these groups make and their interactions affect the state of the economy.

The Market

• Activity between consumers, businesses, and governments takes place in various markets.

• A market is any arrangement that allows buyers and sellers to conduct business.

• Most markets in the financial services industry are not physical and interactions are facilitated electronically.

Demand, Supply, and Market Equilibrium

• The price of a product is a key factor in determining how much people will buy or sell.

• Everything has a price, including financial products and services.

• Prices for products are largely determined by demand and supply.

• Two general economic principles explain the interaction between demand and supply:

  1. Quantity demanded: The higher the price, the lower the demand; the lower the price, the higher the demand.

  2. Quantity supplied: The higher the price, the greater the quantity supplied.

• The interaction between buyers and sellers determines an equilibrium price.

• At the equilibrium price, the number of buyers and sellers are in balance.

• In a state of market equilibrium, anyone who wants to buy or sell can do so.

• Equilibrium Price: The price at which the quantity demanded equals the quantity supplied.

Figure 4.1 | Equilibrium in the Market for a Product

• The equilibrium price of a particular product is 2,000, and the quantity supplied is 200 units.

• If the producer tries to sell the product at a higher price, it will have unsold inventory.

• If the price is set too low, demand for the product will not be satisfied, and the supplier would be able to increase the price.

Table 4.2 | Equilibrium in the Market for a Product

• The price that ensures a balance between the quantity demanded and the quantity supplied is 2,000.

• This intersection yields an equilibrium price of 2,000 and an equilibrium supply of 200 units.

Measuring Economic Growth

• Economic growth occurs when an economy produces more output over time.

• Measuring growth helps understand the overall health of the economy.

Gross Domestic Product

• Gross domestic product (GDP) is the total market value of all final goods and services produced in a country over a given period.

• Economic growth is measured by the increase in GDP from one period to the next.

Two Methods to Measure GDP

• There are two generally accepted ways of measuring GDP: the expenditure approach and the income approach.

• Both methods set out to give an approximation of the monetary value of all the final goods and services produced in the economy.

• The two approaches generally produce the same number.

  • Income approach: GDP using the income approach adds up all of the income generated by this economic activity.

  • Expenditure approach: add up everything that consumers, businesses, and governments spend money on during a certain period.

Figure 4.2 | Expenditure Approach to Calculating Gross Domestic Product

• The expenditure approach is the more common way of calculating GDP is to add up everything that consumers, businesses, and governments spend money on during a certain period.

• Included in the calculation are business investments and all of the exports and imports that flow through the economy.

GDP = C + I + G + (X – M)

• Where:

  • C = consumers.

  • I = business spending and investment.

  • G = government spending.

  • X – M = the amount of exports (X) and imports (M) that consumers and businesses buy during the period

Real and Nominal Gross Domestic Product

• In general, when a nation produces more goods and services, its standard of living improves.

• Economists’ term for the condition of rising prices is inflation.

• Nominal gross domestic product (nominal GDP) is the dollar value of all goods and services produced in a given year at prices that prevailed in that same year.

• However, changes in nominal GDP from year to year can be misleading because they reflect not only changes in output but also changes in the prices of goods and services.

• To measure a nation’s true productivity in a year, we need to look at real gross domestic product (real GDP).

• This measure removes the changes in output that are attributable to inflation and allows us to see how much GDP has grown, based solely on productivity.

Productivity and Determinants of Economic Growth

• Economists use the term productivity to describe output (e.g., GDP) per unit of input (e.g., the labour and capital used to produce the goods and services).

• When productivity increases, more of something is produced with less expenditure, creating a net benefit for the economy.

• Growth in GDP results from a variety of factors, but a few key factors contribute to gains in productivity:

  • Technological advances

  • Population growth

  • Improvements in training, education, and skills

• These factors contribute to growth in GDP and make nations wealthier.

The Business Cycle

• The economy tends to move in cycles that include periods of economic expansion followed by periods of economic contraction.

• These fluctuations, which directly affect the value of investments over time, are called business cycles.

• Real GDP has grown on average by about 3.4% since the 1960s.

• During years where growth was negative, our GDP declined.

Phases of the Business Cycle

• Expansion or growth in the economy is measured by the increase in real GDP, while contraction is measured by a decrease in real GDP.

• Nonetheless, a relatively typical sequence of events occurs over the course of a business cycle. This sequence of expansion, peak, contraction, trough, and recovery is illustrated in Figure 4.4.

Expansion

• An expansion is a period of significant economic growth and business activity during which GDP expands until it reaches a peak.

• An economic expansion is characterized by the following activities:

  • Inflation, and therefore the rise in prices of goods and services, is stable.

  • Businesses adjust inventories and invest in new capacity to meet increased demand and avoid shortages.

  • Corporate profits rise.

  • New business start-ups outnumber bankruptcies.

  • Stock market activity is strong, and the markets typically rise.

  • Job creation is steady, and the unemployment rate is steady or falling.

Peak

• The peak of the business cycle is the top of the cycle between the end of an expansion and start of a contraction.

• A peak is characterized by the following activities:

  • Demand begins to outstrip the capacity of the economy to supply it.

  • Labour and product shortages cause wage and price increases, and inflation rises accordingly.

  • Interest rates rise, and bond prices fall, which dampens business investment and reduces sales of houses and other big-ticket consumer goods.

  • Business sales decline, resulting in accumulation of unwanted inventory and reduced profits.

  • Stock prices generally begin to fall along with falling profits, and stock market activity declines.

Contraction

• A contraction is a decline in economic activity.

• If the contraction lasts at least two consecutive quarters, the economy is considered to be in recession.

• A contraction is characterized by the following activities:

  • Economic activity begins to decline, and real GDP decreases.

  • Faced with unwanted inventories and declining profits, firms reduce production, postpone investment, curtail hiring, and may lay off employees.

  • Business failures outnumber start-ups.

  • Falling employment erodes household income and consumer confidence.

  • Consumers react by spending less and saving more, which further cuts into sales and further fuels the contraction.

  • Stock market activity is low.

Trough

• As contraction continues, falling demand and excess capacity curtail the ability of firms to raise prices and of workers to demand higher salaries.

• The growth cycle reaches a trough, its lowest point.

• A trough is characterized by the following activities:

  • Interest rates fall, triggering a bond rally.

  • Inflation falls.

  • Consumers who postponed purchases during the contraction are spurred by lower interest rates and begin to spend.

  • Stock prices rally.

Recovery

• During recovery, GDP returns to its previous peak.

• The recovery typically begins with renewed buying of items such as houses and cars, which are sensitive to interest rates.

• A recovery is characterized by the following activities:

  • Firms that reduced inventories during the contraction must increase production to meet new demand.

  • They are typically still too cautious to hire back significant numbers of workers, but the period of widespread layoffs is over.

  • Firms are not yet ready to make significant new investment.

  • Unemployment remains high, wage pressures are restrained, and inflation may decline further.

When the economy rises above its previous peak, another expansion has begun.

Economic Indicators

• Economic indicators provide information on business conditions and current economic activity.

• They can help to show whether the economy is expanding or contracting.

• Economic indicators are classified as leading, coincident, or lagging:

  • Leading indicators tend to peak and trough before the overall economy.

  • Coincident indicators change at approximately the same time as the whole economy.

  • Lagging indicators change after the economy as a whole changes.

Table 4.3 | Using Economic Indicators

The Labour Market

• Statistics Canada defines the working age population as people 15 years of age and older.

• It further divides this population into three groups:

  • Those who are unable to work

  • Those who are not working by choice

  • The labour force

Table 4.4 | The Working Age Population

The unemployment rate is defined as the share of the labour force that is unemployed and actively looking for work.: The unemployment rate equals 5% (1M / 20M).

Types of Unemployment

• There are four general types of unemployment: cyclical, seasonal, frictional, and structural.

  • Cyclical unemployment: Tied directly to fluctuations in the business cycle.

  • Seasonal unemployment: Some industries operate only during part of the year.

  • Frictional unemployment: Normal labor turnover that occurs when people enter and leave the work force, and during ongoing creation and destruction of jobs.

  • Structural unemployment: Reflects a mismatch between jobs and potential workers.

Frictional and structural factors in the economy will always exist. Therefore, the unemployment rate can never fall to zero, not even in times of healthy economic growth. The minimal level, below which unemployment does not drop, is called the natural unemployment rate.

The Role of Interest Rates

• Interest rates are an important link between current and future economic activity.

• For consumers who save rather than borrow for a major purchase, interest rates represent the gain made from deferring consumption.

• For businesses, interest rates represent one component of the cost of capital—that is, the cost of borrowing money.

• Interest rates are essentially the price of credit.

• Changes in interest rates reflect, and affect, the demand and supply for credit and debt, which has direct implications for the bond and money markets.

• Changes in interest rates through monetary policy decisions made by the Bank of Canada also have broad implications for the entire economy.

Determinants of Interest Rates

• A broad range of factors influences interest rates.

  • Demand and supply of capital: A large government deficit or a boom in business investment raises the demand for capital and forces interest rates to rise.

  • Default risk: The greater the risk of default, the higher the interest rate demanded by lenders.

  • Foreign interest rates and the exchange rate: Foreign interest rates and financial conditions can also influence Canadian interest rates.

  • Central bank credibility: Central banks of different countries exercise their influence on the economy by raising and lowering short-term interest rates.

  • Inflation: When the inflation rate is expected to rise, lenders charge higher interest rates to compensate for the erosion of the money’s purchasing power over the duration of the loan.

How Interest Rates Affect the Economy

• Higher interest rates have a negative effect on growth prospects.

• Conversely, lower interest rates can provide a positive environment for economic growth.

• Higher interest rates tend to affect the economy in the following ways:

  • They reduce business investment

  • They encourage saving

  • They reduce consumption

Expectations and Interest Rates

• Investment decisions are forward-looking because any decision to purchase a security is based on an expectation about its future return.

• Nominal interest rates will be higher when the rate of inflation is higher.

• Real interest rate = nominal interest rate - expected inflation rate.

The Impact of Inflation

• Inflation is a sustained trend of rising prices on goods and services across the economy over a period.

• (In contrast, deflation is a general decrease in prices across the economy.)

• As prices rise, money begins to lose its value, and a larger amount of money is needed to buy the same amount of goods and services.

Measuring Inflation

• The inflation rate is the percentage of change in the average level of prices over a given period.

• The Consumer Price Index (CPI) is a widely used measure of inflation.

• The CPI monitors how the average price of a basket of goods and services, purchased by a typical Canadian household, changes from month to month or year to year.

Inflation Rate = \frac{CPI{Current Period} - CPI{Previous Period}}{CPI_{Previous Period}} * 100

The Costs of Inflation

• Inflation imposes many costs on the economy for the following reasons:

  • It can erode the standard of living of Canadians, particularly of people on a fixed income

  • It reduces the real value of investments, such as fixed-rate loans, because the loans must be paid back in dollars that buy less.

  • It distorts the price signals sent to market participants.

  • Accelerating inflation usually brings about rising interest rates and a recession.

The Causes of Inflation

• An important determinant of inflation is the balance between supply and demand conditions in the economy.

• If demand for all goods and services is higher than what the economy can produce, prices will increase as consumers compete for too few goods.

• This state of affairs is called demand-pull inflation.

• Inflation can also rise or fall due to shocks from the supply side of the economy—that is, when the costs of production change.

• The higher costs push inflation higher. This state of affairs is called cost-push inflation.

Deflation and Disinflation

• Disinflation is a decline in the rate at which prices rise (i.e., a decrease in the rate of inflation).

• Deflation is a sustained fall in prices, where the annual change in the CPI is negative year after year.

• Deflation is simply the opposite of inflation.

Costs of Deflation and Disinflation

• In general, there is an inverse relationship between inflation and unemployment.

• When unemployment is low, inflation tends to be high; when unemployment is high, inflation tends to be low. This relationship is described by the Phillips curve.

International Finance and Trade

• International finance refers to Canada’s interaction with the rest of the world, including trade, investment, capital flows, and exchange rates.

• Canada is dependent on trade; exports of goods and services account for about one third of our GDP. Consequently, the economic performance of our trading partners directly affects Canada’s economy.

The Balance of Payments

• The balance of payments is a detailed statement of a country’s economic transactions with the rest of the world over a given period (typically a quarter or a year).

• The balance of payments has two main components: the current account, and the capital and financial account.

Current Account

• This account records the import and export of goods and services between Canadians and foreigners, as well as net transfers such as for foreign aid.

Capital and Financial Account

• This account records financial flows between Canadians and foreigners, related to investments by foreigners in Canada and investments by Canadians abroad.

The Exchange Rate

• Buying foreign goods or investing in a foreign country requires the use of another currency to complete the transactions.

• The foreign exchange market includes all the places in which one nation’s currency is exchanged for another, at a specific exchange rate.

• The exchange rate is the current price of one currency in terms of another.

Determinants of Exchange Rates

• The following factors are widely accepted as influencing the exchange rate:

  • Commodities: One of the strongest influences on the Canadian exchange rate is the price level of commodities.

  • Inflation: Over time, the currencies of countries with consistently lower inflation rates rise, reflecting their increased purchasing power relative to other currencies.

  • Interest rates: Central banks can influence the value of their exchange rate by raising and lowering short-term nominal interest rates.

  • Trade: When we export goods and services, other countries must buy Canadian dollars to pay for the goods, which increases the demand for, and value of, Canadian dollars.

  • Economic performance: A country with a strongly growing economy may be more attractive to foreign investors because it improves investment returns and attracts investment capital.

  • Public debts and deficits: Countries with large public-sector debts and deficits are less attractive to foreign investors.

  • Political stability: Investors seldom like to invest in countries with unstable or disreputable governments, or those at risk of disintegrating politically.

Introduction

• Each year, the federal minister of finance announces the government’s budgetary requirements.

• The Bank of Canada uses monetary policy to maintain balance in the economy.

• The government operates largely independently from the Bank of Canada.

Fiscal and Monetary Policy

• Economic policy and the policy decisions made by the federal government and the Bank of Canada are key factors in making investment decisions.

Fiscal Policy

• Fiscal policy informs government decisions around the use of its spending and taxation powers.

• The federal government is responsible for services including national defence, employment insurance, pension income for seniors and the disabled, veterans’ affairs, foreign affairs, and indigenous and northern affairs.

• Provincial governments are responsible for other services including health care, education, securities regulation, and various social services.

• A large segment of federal spending consists of transfer payments to the provincial governments to help pay for such shared responsibilities.

The Federal Budget

• The government’s revenue comes primarily from different forms of taxation.

• The government’s budget balance is equal to that revenue less total spending.

• The government’s proposed annual budget has one of the following three possible positions:

  • Budget surplus: Revenue > Spending

  • Budget deficit: Revenue < Spending

  • Balanced budget: Revenue = Spending

National Debt

• The national debt consists of accumulated past deficits minus accumulated past surpluses in the federal budget.

• Government borrowings comprise these two amounts: refinanced debt and new debt.

The supply of capital may not be sufficient to meet the needs of the business community, and like any other market, when supply is less than demand, prices go up. In other words, interest rates rise, and it costs more to borrow money.

How Fiscal Policy Affects the Economy

• As we discussed in the previous chapter, gross domestic product (GDP) largely comprises three major components: government spending, consumer spending, and business spending and investment.

• Fiscal policy generally targets all three components.

• The government’s key fiscal policy tools are spending and taxation.

Information Only

• Keynesian economics advocates direct government intervention as a means of achieving economic growth and stability.

Spending

• Just as companies spend money to run their business, the federal government spends money to run the country.

• When the government provides funding for new infrastructure, the government spending component of the GDP obviously increases, but that is not all.

Taxation

• Several types of taxes provide the revenue for government spending. Some taxes are imposed on businesses; others are imposed on consumers.

Persistent Deficits

• Persistent deficits emerged in Canada during the 1980s, after which the annual deficit grew considerably and a vicious cycle emerged.

• The federal debt in Canada, as a percentage of GDP, has fallen significantly over the past 20 years.

The Bank of Canada

• The Bank of Canada (the Bank) is the nation’s central bank.

• It was founded in 1934 and began operations in 1935 as a privately owned corporation.

• Responsibility for the affairs of the Bank of Canada rests with a Governing Council composed of the governor, the senior deputy governor, and four deputy governors.

Role and Functions

• The main role of the Bank is “to promote the economic and financial welfare of Canada”.

• To do so, the Bank regulates the money supply and acts to stabilize the Canadian economy by using monetary policy.

• The Bank administers monetary policy independently, without day-to-day intervention by the government.

  • Monetary policy: Designed to preserve the value of the Canadian dollar by keeping inflation low, stable, and predictable.

  • The Canadian financial system: The Bank works with a variety of agencies and market participants in Canada and abroad to promote and maintain the efficient operation of the financial system.

  • Physical currency: The Bank is responsible for designing, printing, and distributing Canadian bank notes.

  • Funds management: The Bank is the fiscal agent for the Government of Canada.

Monetary Policy

• Goal is to preserve the value of money in the economy by keeping inflation low, stable, and predictable.

• This goal helps to promote sustained economic growth and job creation.

• Since 1991, the Bank has acted to keep inflation between 1% and 3% by using inflation-control targets.

Canada’s Monetary Policy Framework

• The Bank’s key monetary policy tools are interest rates and the money supply.

Table 5.1 | Monetary Policy Tools in Action

• SPRAs are used by the Bank when it wants to push interest rates down.:

  • The Bank offers to lend on an overnight basis, that is, with an agreement that the loan be paid back one business day later.

  • The Bank purchases Treasury bills from another financial institution on an overnight basis.

    • Sale and Repurchase Agreements

      • An SRA is similar to an SPRA, except that the goal is to increase the interest rate. If overnight money is trading below the target, the Bank may believe that inflationary pressures in the economy will rise because it becomes too inexpensive to borrow money.
        Drawdowns And Redeposits

The federal government maintains accounts with the Bank and the chartered banks. Given its status as lender of last resort, the Bank can transfer funds from the government’s account at the Bank to its account at the chartered banks. Conversely, the Bank can transfer funds from the government’s account at the chartered banks to its account at the Bank. The Bank uses both strategies to influence short-term interest rates, either with a drawdown or a redeposit:

• A drawdown is the transfer of deposits to the Bank from the chartered banks, which effectively drains the supply of available cash balances from the banking system.

• Financial institutions consequently have less money available to lend to consumers and businesses, which causes interest rates to increase.

• A redeposit is a transfer of funds from the Bank to the chartered banks. This increase in deposits and reserves increases the money supply, which in turn decreases interest rates.

Challenges of Government Policy

• Fiscal and monetary policies may seem relatively straightforward. However, governments attempting to implement these policies can face the following challenges:

  • Timing lags

  • Political considerations

  • Future expectations

  • Coordination of federal, provincial, and municipal policies

  • High federal debt

  • Impact of international economies

Applying Fiscal and Monetary Policies