Csc2 The Economy Ch 4

CSI Global Education Inc.

The Economy

CHAPTER 4: Economic Principles

2CSI Global Education Inc.

Economics in GeneralThe performance of the securities markets is strongly tied to the

overall performance of the economy.

• A growing and stable economy over time has a positive impact on the equity markets.

• Bond market activity is strongly tied to the level and uncertainty of inflation and interest rates.

• The economy has an impact on how many people work, how much they spend, how much product companies sell, and how high inflation and interest rates will be.

• These are the factors that determine investment returns.


OverviewMicroeconomics versus macroeconomics

Microeconomics:• The market behaviour of individual consumers and firms.• How the price levels creates or leads to market equilibrium.• The impact of minimum wage laws on the supply of labour and

company profit margins.• Taxes on imports and the impact on industry profitability.


OverviewMicroeconomics versus macroeconomics

Macroeconomics:

• The performance of the overall economy – the ‘big picture’.

• Measuring output through GDP and GNP.

• How changes in unemployment or inflation impact economic performance.

• How a nation’s standard of living has changed over the last business cycle.


OverviewThe main decision makers in the economy:

• Consumers

• Firms

• Government

What role do each play and how do they interact?


OverviewGoods Markets:

• firms decide what to produce

• sell their output of goods and services

Factor Markets:

• consumers sell their ‘factors of production’ labour

• earn wages used to buy goods & services

Where are these decisions coordinated?


Demand & SupplyThe interaction between demand and supply leads to marketequilibrium in the economy.

Market Demand

• consumers, all purchasers of goods and services

Market Supply

• suppliers of goods and services


Demand & Supply - Discussion

What role do price and quantity play for the: - Law of Demand- Law of Supply

Explain each using a real world example.


Demand & SupplyLaw of Demand

• as the price of a product rises, quantity demand falls

• as the price of a product falls, quantity demand rises

Law of Supply

• as the price of a product rises, quantity supplied rises

• as the price of a product falls, quantity supplied falls

What is the main trigger for market equilibrium to occur?


Measuring Economic Growth

Measuring the Economy

• Gross Domestic Product (GDP):Value of all goods and services produced within Canada’s borders

• Gross National Product (GNP):Value of all goods and services produced by Canadians anywhere in the world

What was Canada’s GDP for the most current year?


Measuring Economic GrowthGDP versus GNP

ABC, a Canadian company, manufactured $70m of output last year in the following way:

• $50m was manufactured in Canada

• $20m was manufactured in Sweden

What amount will be recorded as part of Canada’s GDP? GNP?


Measuring Economic GrowthGDP versus GNP

What amount will be recorded as part of Canada’s GDP? GNP?

Canada

GDP = $50m produced within Canada’s borders

GNP = $50m + $20m


Measuring Economic GrowthComponents of the expenditure approach:

• Consumption

• Investment

• Government Spending

• Net Exports

GDP = C + I + G + (X – M)


Measuring Economic GrowthHow does an economy grow?

Causes of GDP Growth:

• Population growth

• Rising productivity

• Technological innovation


Real GDP versus Nominal GDP• What does nominal GDP represent?

• How does Nominal GDP differ from Real GDP?

• Is an increase in Nominal GDP always good for the economy?


Real GDP versus Nominal GDP• Nominal GDP is based on current prices, or the prices that

prevailed in the same year- reflects the change in the size of GDP and the impact of price

changes

• Real GDP corrects for the effects of inflation- a better measure of the overall performance- a purer measure of changes in the amount of output produced

during the year- isolates the change in output attributed to price changes (or

inflation)


A Typical Business CycleGDP

Rising Trend in GDP

Expansion

Peak Contraction Recovery

ExpansionTrough

Time


The Business CycleDescribe the key features of each phase of the cycle:

• Expansion

• Peak

• Contraction

• Trough

• Recovery


The Business CycleExpansion

– Stable inflation, and the economy steadily expands

– Adequate inventory levels to meet consumer demand

– Rising corporate profits and stronger stock market activity

– Steady or falling unemployment rate

Peak– Demand begins to outstrip capacity and inflation increases

– Rising wages and interest rates

– Business sales decline, and inventory levels rise

– Stock prices fall and general market activity declines


The Business CycleRecession

– Level of economic activity declines

– Businesses postpone capital investments and profits fall

– Consumers spend less and increase saving

Trough– Bond market rallies as rates begin to fall

– Consumers start spending again

Recovery– GDP returns to its previous peak, & business investment rises

– Unemployment may remain high, but inflation is set to fall further


Economic IndicatorsLeading Indicator: Peak and trough before the overall

economy – anticipate emerging trends Example: housing starts

Coincident Indicator: Change at same time and in same direction as the economy – info on the current position of the economyExample: GDP, retail sales

Lagging Indicator: Change after the economy changes – used to confirm a business cycle patternExample: Unemployment rate


Interest RatesInterest is:

• Economic rent for a scarce resource (money)

• For business owners it is a component in the cost of capitalfor production

• For consumers it is the “price” of credit for consumption


Interest RatesInterest rates vary by:

• Duration/term of loan

• Conditions of the loan

• Creditworthiness

How do higher rates impact the economy?


Interest RatesHow do higher rates impact the economy?

• Increases the cost of capital for businesses and leads to lowerbusiness investment.

• Discourages consumer spending on durable goods and other commodities.

• May lead to a general economic slowdown.


Determinants of Interest Rates• Demand and Supply of Capital

• Default Risk

• Central Bank Activities/Credibility

• Foreign Developments – Interest Rates/Exchange Rate

• Inflation


InflationA generalized, sustained trend of rising prices.

- usually an indication of growth in the money supply- economic expansion- increase in demand without corresponding change in supply

Can lead to: - investors demand a rate of return that protects them from the

erosion of their purchasing power- pressure on wages and other variables

…Why are rising prices considered ‘bad’ for the economy?


Inflation & the Consumer Price IndexUsing the CPI to measure inflation:• Tracks the retail price of a basket of goods to reflect typical

consumer spending

• Measures the ‘average’ price level for a consumption bundle

• Compares the CPI in the current period relative to a base year toarrive at the inflation rate for the year

• If CPI is currently 130 and the base year was 120, what does this imply?


InflationCosts of Inflation

• Erodes standard of living for those on a fixed income

• Erodes purchasing power or forces investors to demand higher returns

• Higher interest rates slows growth

• Increases the cost of debt servicing to individuals, corporations and governments


Growth in the Money Supply• In the short-run, higher money growth lowers interest rates, and

increases economic activity

• In the long-run, money growth is fully reflected in changes in inflation

• If money grows 10% and the supply of goods and services grows 5%, inflation will be 5%.

• There is evidence that unemployment can be reduced in the short-run by increasing inflation at a faster rate (Phillips curve).


Growth in the Money SupplyThe Output Gap

• The difference between real GDP and potential GDP

• Potential GDP = what the economy is capable of producing when its existing inputs of labour, capital, and technology are fullyemployed at their normal levels of use. - (the BoC does estimate potential output levels)

Negative Output Gap:

• When actual output is below potential output - spare or excess capacity.

• Increased demand does not result in inflation.


Growth in the Money SupplyPositive Output Gap:

• Economy is operating above its potential: - actual output (GDP) > potential output

• Strong consumer demand for goods and services.

• When companies continue to operate above capacity, they can raise prices in response to this demand.

• leads to demand-pull inflation.

• A scarcity of resources can lead to cost-push inflation.


Disinflation vs. DeflationDisinflation Deflation

A decline in the rate at which prices rise – is a decrease in the rate of inflation.

A sustained fall in prices - the annual change in the CPI is negative year after year.

Prices are still rising, but at a slower rate.

Deflation is just the opposite of inflation.

Captured through the Phillips Curve and the sacrifice ratio.

Problem: sustained falling prices could lead to a decline in corporate profits.


Labour MarketsEconomic performance directly affects the labour market.

Indicators:

• Labour Force: sum of the working age population who areemployed or unemployed.

• Participation rate: the % of the working age population in thelabour force.

• Unemployment rate: the % of the labour force unemployedbut looking.


Types of UnemploymentCyclical

• fluctuates with the business cycle

Frictional

• result of normal labour turnover

• have the proper skills to find a new job

Structural

• when individuals can’t find jobs due to outdated skills


Labour Markets

• Is an unemployment rate of 0% possible? Why or why not?

• What stops the economy from moving to such a position?


The External Sector• Exports accounted for just over 44% of GDP in 2006.

• Interestingly:

– Canada exported about 80% of its goods to the U.S. and imported about 70% of its goods from the U.S.

• What this means: the performance of the Canadian economy is strongly tied to the performance of the U.S. economy.

• The balance of payments is used to track the economic transactions with the rest of the world over a given time period.


Current Account• Records the exchanges of goods and services between

Canadians and foreigners, the earnings from investment income, interest, and dividends and net transfers such as for foreign aid.

• Deficit implies Canadians are spending more on foreign goods than they are selling – imports are higher than exports.

• Surplus implies Canadians are selling more to foreigners than buying abroad – exports are higher than imports.

• There is a link with the capital account.


Capital Account• Records the financial flows between Canadians and foreigners

related to investments by foreigners in Canada and investments by Canadians abroad.

When a country runs a current account deficit, the shortfall financed from foreign sources by:

• Selling assets

• Borrowing funds

Both of these activities are captured through the capital account.


The Exchange RateWhy it’s important: • The external value of a nation’s currency impacts the volume of

trade.

• As the C$ rises in value against a trading partner the volume ofexports falls and the volume of imports rises.

• As the C$ falls in value against a trading partner, the volume of exports rises and the volume of imports falls.

– Can we explain these relationships using the current behaviour of the C$ vs. the US$?


The Exchange RateDeterminants of the Exchange Rate:• Inflation differentials

• Interest rate differentials

• Current account

• Economic performance

• Public debt and deficits

• Political stability

Economy & Finance

Csc2 The Economy Ch 4