Chapter 4 - The Economy

Question 1

What is the difference between microeconomics and macroeconomics?

Answer 1

Microeconomics is what individuals and households decide what to buy and how businesses decide what to produce and who to produce it for.
Macroeconomics focuses on employment levels, interest rates, inflation, government spending and overall health of the economy.

Question 2

What are some examples of microeconomic concerns?

Answer 2

• How are the prices for goods and services established?
• Why did the price of bread go up?
• How do minimum wage laws affect the supply of labour and company profit margins?
• How would a tax on softwood lumber imports affect growth prospects in the forestry industry?
• If a government places a tax on the purchase of mutual funds will consumers stop buying them?

Question 3

What are some examples of macroeconomic concerns?

Answer 3

• Why did the economy stop growing last quarter?
• Why have the number of jobs fallen in the last year?
• Will lower interest rates stimulate growth in the economy?
• How can a nation improve its standard of living?
• Why do stock prices rise when the economy is growing?
• How is inflation controlled?

Question 4

What two factors largely determine the price paid for any product?

Answer 4

Supply and Demand.

Question 5

Can you explain what an equilibrium price is?

Answer 5

At this price the number of buyers and sellers are in balance. In a state of market equilibrium, anyone who wants to buy the product can do so and anyone who wants to sell the product can do so.

Question 6

What is the difference between an intermediate good and a final good?

Answer 6

A final good is something purchased by the ultimate end user. An intermediate good is a product used in the manufacturing of final goods.

Question 7

Can you describe the income approach for measuring GDP?

Answer 7

The income approach starts from the idea that total spending on goods and services should equal the total income generated by producing all those goods and services.

Question 8

Can you describe the expenditure approach for measuring GDP?

Answer 8

The expenditure approach adds up everything that consumers, businesses and governments spend money on during a certain period. Including business investments and all the exports and imports that flow through the economy.

Question 9

Can you describe the production approach for measuring GDP?

Answer 9

Also know as the value-added approach.
Calculating and industry or sectors output and subtracting the value of all good and services used to produce the outputs.

Question 10

Can you identify each component of the following formula: GDP = C + I + G + (X - M)?

Answer 10

Consumer expenditure (C)
Business spending and investment (I)
Government spending (G)
Exports (X)
Imports (M)

Question 11

What is the difference between nominal and real GDP? Which measure gives a more accurate reading of production and why?

Answer 11

Nominal GDP is the dollar value of all goods and services produced in a given year at the prices from last year.
Real GDP removes the changes in output that are attributable to inflation and show how much GDP has grown soley based on productivity.

Question 12

Can you name the five phases of the business cycle and describe the characteristics of each?

Answer 12

Expansion - Period of significant economic growth and business activitiy.
Inflation is stable.
Business adjust inventory and invest in new capacity.
Corporate profits rise.
New business start ups outnumber bankruptcies.
Stock market activity is strong and markets typically rise.
Job creation is steady and the unemployment rate is steady or falling.

Peak - Top of the cycle.
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.
Business sales decline, unwanted inventory and reduced profits.
Stock market activity declines.

Contraction - Decline in economic activity. Two consecutive quarters considered a recession.

• businesses have unwanted inventory and declining profit. They reduce production, postpone investment, curtail hiring and might lay off employees
• business failures outnumber start-ups
• household income and consumer confidence erode
• consumers spend less and save more
• stock market prices fall lower

Trough - As contraction continues, falling demand and excess capacity curtail the ability of businesses to raise prices and of workers to demand higher salaries. Lowest point.

• interest rates fall, triggering a bond rally
• inflation falls
• consumers who postponed purchases are spurred by lower interest rates and begin to spend
• stock prices rally

Recovery - GDP returns to its previous peak.

• businesses that reduced inventories during contraction must increase production to meet new demand
• period of widespread layoffs is over
• businesses not yet ready to make new investment
• unemployment remains high

Question 13

What are some examples of leading, coincident and lagging indicators?

Answer 13

Leading indicators - tend to peak and trough BEFORE the overall economy. 
Examples: 
Housing starts
Manufacturers new orders
Commodity prices rises/falls
Average hours worked per week rises/falls 
Stock Prices change
Money supply

Coincident Indicators - Change approximately same time and same direction as whole economy.
Examples:
Personal income rising
GDP
Industrial production
Retail Sales

Lagging Indicators - Change AFTER the economy as a whole changes.

Examples:
Unemployment 
inflation rate
labour costs
private sector plant and equipment spending
business loans and interest on borrowing

Question 14

Describe how Statistics Canada judges a recession.

Answer 14

By the depth, duration and diffusion of the decline of business activity.
Depth - decline must be of substantial depth.
Duration - must last more than a couple of months.
Diffusion - must be a feature of the whole economy not just one sector.

Question 15

What does the participation rate represent?

Answer 15

The participation rate represents the share of the working-age population that is in the labour force. Shows the willingness of people to enter the work force and take jobs.

Labour Force / Working Age Population x 100

Question 16

How does Statistics Canada calculate the unemployment rate?

Answer 16

People not working but actively looking for work /labour force x 100

Question 17

Compare cyclical, seasonal, frictional, and structural unemployment?

Answer 17

Cyclical - tied to fluctuations in the business cycle.
Rises when the economy weakens and workers are laid off in response to lower sales; it drops when the economy strengthens again.

Seasonal - Some industries only operate part of the year.

Frictional - normal labour turnover that occurs when people enter and leave the work force and during ongoing creation and destruction of jobs.

Structural - reflects a mismatch between jobs and potential workers. Occurs when workers are unable to find work or fill available jobs because they lack the necessary skills, do not live where jobs are available or decide not to work at the wage rate offered by the market. Closely tied to changes in technology, international competition and government policy.

Question 18

How would you define a discouraged worker?

Answer 18

When job prospects are so poor that some people just drop out of the work force.

Question 19

Can you name and explain the determinants of interest rates?

Answer 19

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. Unless there is an equivalent increase in the supply of capital the price of credit also rises. In turn, higher interest rates may encourage everyone to save more. An increase in savings reduces demand for borrowing which then might reduce interest rates.

Default risk - If interest rates rise, consumers and businesses may have trouble paying back borrowed funds or default on loans. The greater the risk of default the higher the interest rate demanded by lenders.

Foreign interest rates and the exchange rate - Example - A rise in US interest rate increases returns on US investments. Investors holding CDN dollars wanting to invest in US must sell their CDN dollars to purchase US dollar securities. This increases the supply of CDN dollars on the foreign exchange market and places downward pressure on the value of the Canadian dollar. If Bank of Canada wants to slow the fall in value it can intervene and raise short term interest rates. This encourages investors to continue holding Canadian investments rather than switch to US securities.

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

Inflation - when inflation rate is expected to rise lenders charger higher interest rates to compensate for the erosion of the money’s purchasing power over the duration of the loan.

Question 20

What are three ways that higher interest rates affect the economy?

Answer 20

They reduce business investment.

They encourage saving.

They reduce consumption.

Question 21

What is an approximate method for determining the real interest rate?

Answer 21

The nominal interest rate minus the expected inflation rate. ie. You want a 6% return on your investment. If inflation is expected to be 3% you would only go ahead with your investment if you earn a nominal rate of 9%. 9-3=6

Question 22

Can you describe the formula for calculating the Consumer Price Index (CPI)?

Answer 22

CPI monitors how the average price of a basket of goods and services changes from month to month or year to year.
Prices are measured against a base year. Currently 2002 in Canada which is given a value of 100. If CPI is 134 then it goes that the basket of goods is 34% more expensive than in 2002.

Question 23

Can you list some of the costs of inflation?

Answer 23

• can erode standard of living especially people on a fixed income
• reduces the real value of investments such as fixed rate loans
• distorts price signals sent to market participants. Are price increases because of inflation or a change in supply and demand.
• accelerating inflation usually brings about rising interest rates and recession

Question 24

Can you describe the difference between deflation and disinflation?

Answer 24

Deflation is a sustained fall in prices - where CPI is negative year after year. Opposite of inflation.

Disinflation is the decline in the rate at which prices rise. Prices are still rising but at a slower rate.

Question 25

What is an exchange rate?

Answer 25

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

Question 26

Can you list and explain the determinants of the exchange rate?

Answer 26

Commodities - one of the strongest influences on the CDN exchange rate is the price level of commodities. Countries around the world that buy Canadian products need Canadian dollars to finance their purchases. As the demand for commodities increases, the demand for Canadian dollar also increases.

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. Higher domestic interest rates increase the return to lenders compared to other countries. This attracts capital and lifts the exchange rates because the foreign investor must buy Canadian dollars to invest.

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. When importing goods we must sell Canadian dollars and buy the currency of the country we are importing from. This increases the supply of Canadian dollars which causes downward pressure on the value of the currency.

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 debts and deficits are less attractive to foreign investors.

Political stability - investors seldom like to invest in countries with unstable or disreputable governments.