Chapter 4- Economic Principles
Raise the cost of capital of capital for business investments
investments need to earn greater return than the cost of the funds, so higher interest rates reduces the possibility of profitable investment and, in turn, business investment.
Disinflation
is a decline in the rate at which prices rise, meaning a decrease in the rate of inflation.
The balance of payments
is a detailed statement of a country's economic transaction with the rest of the world. The current account records the exchange of goods and services between Canadians and foreigners, the earnings from investment income, and net transfer such as foreign aid. The capital and financial account records financial flows between Canadians and foreigners, related investments by foreigners in Canada, and investments by Canadians abroad.
The Unemployment Rate
represents the share of the labour force that is unemployed and actively looking for work. U.E rate was 7.1% in 2013- Avg. in Canada over past 40 years is 7.7%.
Governments
set out to maximize the public good by spending on social programs (education, health care, employment training, military).
Consumers
set out to maximize their well-being, given resources like income.
Inflation
The higher the expected inflation rate, the higher the interest rate that must be charged by lenders to compensate for the erosion of the purchasing power of money.
The Law of Supply
The higher the price of a good, the greater the quantity supplied by producers.
The Law of Demand
The higher the price, the lower the quantity demanded by buyers, and the lower the price, the higher the demand.
Macroeconomics
focuses on the performance of the economy as a whole- limited natural resources, human effort and skill, and technology Unemployment, inflation, recessions, gov spending, tax, poverty, etc.
Discouraged Workers
individuals willing to work but cannot find jobs and have given up (for the past month). They are not included in the labour force.
Money acts as:
A medium of exchange- without money, goods would need to be exchanged for other goods. A unit of account- know exactly the price of good or service. A store of value (no expiration)
Leading indicators tend to peak and trough before the overall economy i.e., they are designed to anticipate emerging trends in economic activity. includes:
-Housing starts -Manufacturers' orders- indicate higher levels of consumer purchases -Commodity prices, which indicate demand for raw materials -Stock Prices- indicates changing levels of profits -The money supply, which indicates availability of liquidity and impacts interest rates.
Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy. include:
-Income -GDP -Industrial Production -Retail Sales Ex- Personal income is a good example because if it is rising, economic growth will typically follow.
Lagging Indicators are those which change after the economy as a whole changes. Includes:
-Unemployment -Private Sector P&E spending -Business loans and interest on such borrowing -Labour Costs -The inflation rate Ex- Unemployment is one of the more popular lagging indicators because a rising unemployment rate is an indication that the economy is doing poorly or that companies are anticipating a downturn in the economy.
Microeconomics
Analyzes the behaviour of consumers and firms and how prices are determined Determines how many goods to purchase, how much work to hire, etc.
Default Risk
As the risk of borrower default increases, lenders demand higher interest rates If the government is at risk of defaulting, interest rates rise for everybody (default premium).
A higher dollar makes:
Canadian exports more expensive in foreign market and imports cheaper in Canada.
Peak
Demand > Capacity, labour and product shortages cause increases in wages and inflation, interest rates rise and bond prices fall, business sales decline, stock market decline.
How is economic growth Measured?**
Economic growth is an economy's ability to produce greater levels of output over time and is expressed as the percentage change in a nation's GDP.
What is Economics?**
Economics is fundamentally about understanding the choices individuals make and how the sum of those choice affects our market economy Whether it is the purchase of groceries, a home or stocks, this interaction ultimately takes place within organized markets.
Commodity Prices
Since Canada is highly dependent on trade and natural resources, the demand for the Canadian Dollar is positively correlated to the demand for commodities. Increase in demand for commodities increases prices and the canadian dollar appreciates.
Recession (Contraction)
GDP decreases for 2 consecutive quarters, business failures outnumber start-ups, failing employment erodes income and confidence, consumers spend less and save more.
Growth in GDP is tied to:
Increase in population over time- even if the output of every worker remains constant, GDP would rise due to the growing workforce. Increases in the capital stock- as workers are provided with more equipment, individual productivity rises. Improvements in technology- innovation helps firms to make better use of resources and increase productivity.
Recovery
Increase in production meet demand, widespread layoffs cease, firms are not ready to make significant investment, unemployment remains high, wages pressures are restrained and inflation may decrease.
Determinants of Economic Growth
Increases in output per worker (or productivity) must originate from an increase in capital per worker or improvement in technology. Capital accumulation through savings alone cannot sustain growth- However, a higher savings rate can support a higher level of output per individual.
The Costs of Inflation
Inflation erodes the standard of living for those on a fixed income, it reduces the value of investments because loans are paid back in dollars that buy less, and it distorts the signal that prices send to the market.
Expansion
Inflation is stable, corporate profits are rising, more start-ups than bankruptcies, rGDP is expanding.
Trough
Interest rates fall, triggering a bond rally, inflation falls, consumers who postponed consumption spend at lower interest rates, stock price rally.
In a given year, if Canada buys more goods and services abroad than it sells, it will run a current account deficit
It will need to sell more assets to finance the spending, which means running a capital account surplus, or go into debt.
The Capital and Financial Account
Key difference between current and capital and financial account transactions is that the latter result in an acquisition of an asset and the right to any income it earns.
Demand and Supply of Capital
Large gov deficit or boom in business investment increases the demand for capital and forces the price of credit (interest rates) up (assuming supply of capital remains constant). In turn, higher interest rates encourage more saving from individuals, businesses and governments, which would reduce demand for borrowing and interest rates.
Economists use an indicator called the output gap to determine inflation pressures.
Measures the difference real GDP and potential GDP
The Nature of Money*
Money can be any object that is accepted as payment for goods and services, and that can be used to settle debts.
The nominal interest rate
One where the effects of inflation have not been removed= the higher the inflation, the higher the nominal interest rates will be.
Increases the cost of borrowing, customers are discouraged from spending
Particularly discouraged from buying houses and major durable goods, and encourages consumer to forgo spending today and save.
Improvements in long-term economic growth are attributed to improvements in productivity
Productivity growth has major implications for the overall wealth of an economy, as there is a direct relationship between the amount of output generated per worker and standard of living.
Participation Rate
Represents the share of the working age population (15+) that is in the labour fource. It was 66.5% in 2013- shows the willingness of people to enter the workforce.
Foreign Interest Rates
Since investors can move money in and out of Canada, foreign interest rates and financial conditions influence Canadian interest rates. Ex- A rise in interest rates in the U increases investors' returns on money invested there. Investors holding Canadian dollars and who would like to invest in the US will need to sell their Canadian dollars to purchase U.S dollar-denominated securities. This increases the supply of Canadian dollars on the foreign exchange market and places downward pressure on the value of the Canadian dollar. If the BoC would like to slow or reduce the fall in the value of the Canadian dollar, they can intervene and raise short-term interest rates, even if underlying conditions in Canada are unchanged. This will encourage investors to continue holding Canadian investments rather than switch to US dollar-denominated securities.
Example:
Suppose a machine made in Canada sells for $1000. With the Canadian dollar at US $0.90, it sells for US $900 in the US. If a similar product sells for $950 in the US, the Canadian manufacturer benefits at this exchange rate as the machine will sell for a lower price in the US market. If the exchange rate appreciates in value to US $0.95, the machine would now sell for US $950, making its manufacturer less competitive in the US market and decreasing sales and probably corporate profitability. Likewise, a US company that sold a similar machine for US $900 in the US would sell it for $1000 in Canada with the exchange rate at US $0.90, but for only $947.37 with the exchange rate at US $0.95 taking sales away from the Canadian company.
Central Bank Operations
The central bank controls short-term interest rates, with the objective of keeping inflation low and stable.
Inflation Differentials
The currencies of countries with consistently lower inflation rates rise, reflecting their increased purchasing power relative to other currencies.
Inflation
The difference in rGDP and nGDP growth
Demand and Supply*
The forces of demand and supply and the interaction between buying and selling decisions by consumers ultimately leads to market equilibrium, and this is the price at which we buy/sell goods and services.
Examples
The housing market in Asia is growing, so there is increased demand for Canadian forestry. As a result, demand for the Canadian dollar increases, which results in an increase in the price of the Canadian dollar (assuming the supply of money is constant) A corporation reports poor financial performance, and investors who own the stocks decide to sell common shares Supply of shares increases in the marketplace, resulting in a decrease in the price of shares.
Natural Unemployment Rate
The minimal level of unemployment, where the economy is operating close to full capacity. When the actual UE > natural, a surplus of workers in the market weakens labour bargaining power, which discourages wage gains, and keeps inflation in check. When actual UE < natural, shortage of workers leads to greater wage gains and higher inflation. Thus, the natural UE is viewed as the level of UE that is consistent with stable inflation.
The Decisions Makers*
The three main decision makers in the economy are consumers, firms, and governments.
Measuring GDP*
There are two ways to measure GDP
Various leading, lagging, and coincident indicators are used to analyze business conditions and current economic activity.
They are useful to show whether the economy is expanding or contracting. For example, the combination of higher new housing starts, new orders for durable goods, and an increase in furniture and appliance sales suggests an economy is moving from recovery to expansion.
By increasing the household income needed to service debt (mortgages), disposable income is reduced
This effect may be offset by the higher interest income earned by savers.
Inflation can all rise or fall due to shocks from the supply side of the economy- when the cost of producing output changes
When faced with higher costs of production, firms respond by raising prices and producing a small amount of their product, pushing inflation higher- known as cost-push inflation.
Sacrifice Ratio
a measure of the extent to which GDP must be reduced with increased unemployment to achieve a 1% decrease in inflation. Recent studies by the BoC suggest that the sacrifice ratio is as high as 5; that is 5% of output must be sacrificed to bring down inflation 1%.
Firms
aim to maximize profits by selling to consumers, governments or other firms.
Phillips Curve
can be used to gauge the potential causes of disinflation. Based on the theory that when UE is low, inflation is high, and vice versa. Lower UE is achieved in the short run by increasing inflation at a faster rate. Lower inflation is achieved at the cost of possible increased UE and slower GDP growth.
Consumer Price Index (CPI)
considered a measure of the cost of living in Canada, and can be used to measure the inflation rate. {(Current CPI- Previous CPI) / Previous CPI} x 100 = Inflation StatsCan picks a basket comprised of 600 different goods to reflect typical consumer spending.
Inflation
is a generalized, sustained trend of rising prices measured on an economy-wide basis. A one-time jump in prices caused by an increase in the price of a good or service is not inflation unless it leads to higher wages and other costs throughout the economy. likewise, a rise in the price of one product is not in itself inflation, but may just be a relative price change reflecting the increased scarcity of that product. Inflation decreases the value of money, and has a negative effect on living standards.
Deflation
is a sustained fall in prices where the annual change in the CPI is negative year after year. Although falling prices are generally good for the economy, a sustained fall in prices can have negative implications for corporate profits and the economy.
Real GDP
is the dollar value of all goods and services produced in a given year relative to a base year- measures changes in output. Real GDP tells us what would have happened to spending on goods and services if quantities had changed but prices had not changed. Ex- Real GDP in Canada was 1.661 trillion in 2012 and 1.695 trillion in 2013. Nominal GDP increased by 3.41% between 2012 and 2013, while the increase in Real GDP was somewhat lower at 2.05%. The difference between the nominal and real GDP of 1.36% is due to price changes. Real GDP is therefore the amount of output adjusted for the effects of inflation (or deflation) because it eliminates the impact of changes in the prices of goods and services on the amount of output produced during the year.
GDP
is the market value of all finished goods and services produced within a country in a given time period, usually annually or quarterly. Measuring the change provides a gauge for performance and health of the economy.
Exchange Rate
is the price of one currency in terms of another
The Expenditure Approach
measures GDP as the sum of personal consumption, investment, government spending, and net exports of goods and services. GDP = C + I + G + (X-M)
Income Approach
measures GDP as the total income earned producing those goods and services Wages for labour, rent for land, interest for capital goods, profits for entrepreneurs.
BoC
monitors the monetary aggregates (money in circulation) to ensure money growth is consistent with low inflation and long-term growth.
The Current Account
most important component is merchandise trade- the goods and services we produce and sell abroad and those we import from other countries.
Negative output gap
occurs when actual output is below potential output. Space capacity in the economy, under-utilized labour and plant can be called into service without impact wages and prices. Thus, inflation will fall or remain steady.
Positive output gap
occurs when rGDP > pGDP Above capacity- scarce labour fuels wage increases, and other strains on productive resources place upward pressure on inflation. If companies continue to operate above capacity, they can raise prices in response to strong demand, pushing inflation higher- this is called demand-pull inflation.
Structural
occurs when workers are unable to find work because they lack the necessary skills, do not live where jobs are available, or decide not to work for the wages offered. This type of unemployment is closely tied to changes in tech, international competition and government policy. Lasts longer than frictional because workers must retrain or relocate to find a job.
Nominal GDP
the dollar value of GDP, which does not account for pricing changes. Changes in Nominal GDP from year to year reflect both changes in the prices of goods and services and changes in the amount of output produced in a year. ex- According to statistics canada, nominal GDP in Canada was 1.819 trillion in 2012 and increased to 1.881 trillion in 2013- an increase of about 3.41%. Since GDP was higher in 2013 than it was in 2012, one or both of the following things happened during the year. 1) The economy expanded and produced more goods and services in 2013 than in 2012. 2) Prices increased and consumers had to pay more for goods and services in 2013 compared with 2012.
The real interest rate
the nominal interest rate minus the expected inflation. Ex- Nominal and historical real rates in Canada have slowly trended downwards over the last 30 years. Nominal interest rates are considerably lower than they were in the early 1980s. Real rates have fluctuated between 5% and 7% until recently when they dropped below 1%.
Cyclical
the result of fluctuations in the business cycle.
Frictional
the result of normal labour turnover.