ECONOMICS Flashcards
FACTORS INFLUENCING INTEREST RATES
Inflation is the single largest factor influencing interest rates.
The Bank of Canada, the country’s Central Bank, will attempt to decrease inflation by raising interest rates which in turn will slow down spending.
Demand and supply of capital: An increased demand for capital in Canada may increase interest rates.
Foreign exchange and interest rates: The free flow of currencies globally means the Canadian dollar is bought and sold internationally. If there is a decrease in demand for the Canadian dollar money is flowing outside Canada and the Canadian dollar will decrease in value. If the Bank of Canada wants to stop the decrease it may react by raising interest rates to attract investors to invest in Canada. The Bank of Canada plays an active role in the foreign exchange market.
Example: If the one year interest rate on a bank deposit is 5% and the annualized inflation rate, as measured by the consumer price index is 2%, then the real interest rate is:
- *0.05 — 0.02**
- *1 +0.02**
= 0.03 / 1.02
= 0.0294 or 2.94%
HOW DOES INFLATION WORK?
If the Central Bank increases money supply at a rate which is greater than the actual growth in the quantity of goods and services produced, inflation will result. If money supply grows at 7% and the production of goods and services grows at 5% there will be 2% inflation.
CPI
Inflation is measured by the consumer price index (CPI) compiled by Statistics Canada. CPI measures the cost of living based on the price of a basket of 600 goods and services against a base year (currently 2002). If the cost of the basket in the year 2016 costs $1,050 versus $1,000 in the year 2015, inflation would be up 5% ($50 ÷ $1000 x 100).
TWO PROBLEMS WITH CPI?
Problems with the CPI include: the difficulty of representing the spending habits of all Canadians; accounting for changes in the quality of items demanded by consumers; and other factors. Critics suggest that CPI is overstating inflation by 0.5%.
CAUSES OF INFLATION?
To remember the causes of inflation:
Money growth
Output gap (Inflationary Gap)
Supply shortages
High employment
WHAT GDP MEASURES
GDP measures the total market value of all final goods and services produced in the country over a period of time, in dollars.
When we speak of GDP it is usually expressed as the annual growth rate compared to last year.
NOT INCLUDED IN GDP
Intermediate goods and raw materials are not included in GDP because it would result in double counting.
For example the inputs into an automobile, such as steel, labour, etc. are not included in GDP. The price the consumer pays for the final car includes the intermediate components.
WHAT GNP MEASURES?
GNP measures the total market value of all final goods and services produced from resources supplied by citizens of the country, e.g., Canadian nationals over a period of time. It focuses on what Canadians produced as opposed to GDP which focuses on what’s produced in Canada.
DIFFERENCE BETWEEN GDP & GNP
GDP is concerned with economic activity domestically whereas GNP focuses on activity generated by a country’s citizens at home and abroad.
Assume in 2016, GNP in the U.S. was $8,377 billion. Also in 2016, U.S. citizens earned $3 billion more abroad than foreigners earned in the U.S. We will call this figure a positive net income for Americans. What was GDP in the U.S. in 2016?
Answer:
$8,374 billion [$8,377 billion — $3 billion]. GDP reflects what is produced domestically and $3 billion should be deducted from the GNP figure.
GDP = Final goods and services produced domestically
GDP = Gross Domestic Income or Gross Domestic Expenditures (these are identities)
GNP = GDP + Income Nationals Earned Abroad (e.g., Interest and Dividends) — Income Foreigners Earned Domestically (e.g., Interest and Dividends). or:
GDP = GNP + Income Foreigners Earned Domestically — Income Nationals Earned Abroad.
TWO APPROACHES TO GNP / GDP
- Income (Output) Approach
- Expenditure Approach:
INCOME APPROACH
The Income (Output) Approach represents income earned from all the factors of production that went into the costs and profits of the final goods and services. This includes wages, rent, interest, profits and taxes.
For example if a consumer bought a car for $20,000 this consumption expenditure would equal the costs and income that went into wages, rent, interest, profit, taxes, etc. Wages and other compensation is the biggest component of GDP/GNP using the Income (Output) Approach.
EXPENDITURE APPROACH
The Expenditure approach represents what was spent in the economy over a period of time on final goods and services Expenditures include: consumption spending; investment spending; government spending; and net exports (exports-imports). Consumption spending is the biggest component under the Expenditure Approach.
THREE FACTORS THAT INCREASE
ECONOMIC ACTIVITY
Growth of GDP and GNP
There are three factors that create more economic activity:
1. An increase in the size of the labour force.
2. Increased productivity as the result of better training and education and more efficient equipment.
3. Innovations (technological advantages) affect the allocation of resources and create business opportunities.
NOMINAL AND REAL GDP
If both GDP and GNP measure economic activity, do higher growth rates of GDP and GNP always represent more economic activity? The answer is No.
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Recently Brazil’s annual inflation rate was over 50% but it also posted a nominal GDP growth rate of over 50%. By looking at the nominal GDP growth rate alone would dramatically overstate Brazil’s real GDP performance.
If GDP or GNP is expressed nominally, it does not take into account inflation and may overstate real growth. Therefore real GDP or real GNP takes into account inflation and reflects real growth. Using GDP as an example:
Nominal GDP = Economic activity stated in current dollars
Real GDP = Nominal GDP adjusted for Inflation
DEFLATING GDP
With the CPI in Canada increasing each year, nominal GDP is higher than real GDP.
When GDP is adjusted for inflation, real GDP is actually deflated in that it becomes a lower number.
Let’s examine this by assuming the total quantity of goods and services produced in Canada over two successive years, year 2015 and year 2016 is identical, namely the same quantity of automobiles were produced, the same number of televisions were produced, etc. Also assume that nominal GDP grew from $1 trillion to $1.1
trillion between 2015 and 2016. Since Nominal GDP represents the sum of prices x quantities, the 10% increase must be due to inflation because quantities produced are unchanged. Nominal GDP is adjusted to real GDP as follows:
Real GDP = Nominal GDP / 1+10%
and Real GDP = $1.1 trillion / 1.10
= $1 trillion
Real GDP for the year 2016 is $1 trillion, unchanged from the year 2015. Real GDP growth is unchanged.
FOUR RE-OCCURING ECONOMIC
FLUCTUATIONS
- Seasonal
- Cyclical
- Secular
- Random (unexpected) Occurrences
FOUR STAGES OF THE BUSINESS CYCLE
- TROUGH
- EXPANSION
- PEAK
- CONTRACTION
In this stage corporate profits are rising, unemployment is falling and the stock market is probably doing well. Inflation is rising moderately because of increased spending.
Government actions such as cutting taxes and interest rates, along with pent-up demand,will trigger business and consumer spending. In the EXPANSION STAGE corporate profits are rising, unemployment is falling and the stock market is probably doing well. Inflation is rising moderately because of increased spending. Confidence in the economy is also improving.
PEAK STAGE
The economy can no longer expand because it is operating at or near full capacity and is unable to cope with more demand. Labour shortages and insufficient supply creates inflation.
Higher interest rates result because the Federal Government wants to cut back excessive spending which is inflationary.
Consumer spending falls, especially on interest rate sensitive items, and a downturn begins.
Equate the peak to the word High: high employment; high inflation (relative to the trough); high interest rates (relative to the trough); high inventories based on expected future sales; and high consumer and business confidence based on the previous expansion.
CONTRACTION STAGE
Contraction (may lead to Recession) After a peak the economy has no where to go except downward.
Governments in developed countries will not tolerate high inflation rates which distorts the economy (e.g., inflation hurts people on fixed incomes but benefits speculators).
At the peak, due to high inflation, interest rates will be forced higher to curb inflation. This puts the economy into a contraction phase.
FOUR STAGES
People in Toronto are in a cycle. The saying “Torontonians Eat Potato Chips” will help you remember the four stages of the business cycle: Trough, Expansion, Peak and Contraction. (Also it doesn’t matter where you start in the business cycle because the sequence of stages never changes.)
TYPES OF UNEMPLOYMENT
There are three types of unemployment: Cyclical, Frictional and Structural.
CYCLICAL UNEMPLOYMENT
Caused when firms cut back their work force due to a downturn in the business cycle; e.g., Ford Motor Company lays off workers at their assembly plants due to a contraction in business
NATURAL UNEMPLOYMENT
Unemployment that is unavoidable and will exist even in good times (it is inherent in the structure of the economy).
NAIRU
The minimum natural unemployment rate (the rate that unemployment will not drop below) is the Non-Accelerating Inflation Rate of Unemployment (NAIRU).
TWO CAUSES OF NATURAL UNEMPLOYMENT
Two causes of natural unemployment are:
Frictional unemployment. This represents people between jobs who are employable, but who have not found acceptable employment; e.g. it takes time to do a proper job search.
- ii) Structural unemployment:** This is *where unemployment results because workers have outdated skills or skills I that are obsolete. This usually represents lost jobs due to automation (technological obsolescence). Many jobs
- *are lost to computers and advances in technology.**
AGGREGATE DEMAND CURVE
Aggregate Demand
The aggregate demand curve shows the relationship between the quantity of goods and services demanded and the price level, for the economy.
As the price level decreases, the quantity demanded increases. The aggregate demand curve is downward sloping as illustrated. The quantity demanded is on the horizontal axis and price is on the vertical axis.
FOUR FACTORS THAT SHIFT
AGGREGATE DEMAND CURVE
- REAL INCOMES
- REAL INTEREST RATES
- BUISNESS EXPECTATIONS
- EXPECTED RATE OF INFLATION
REAL INCOME
Real Income: There is a positive relationship between aggregate demand and real income. For example, if Mr. Smith’s real income (income adjusted for inflation) rises, he will be able to purchase more goods and services.
If real income rises in the economy, the demand for goods and services will rise for a given price level. This will cause a rightward shift in the aggregate demand curve
REAL INTEREST RATES
Real Interest Rates: A decrease in the real rate of interest expands current expenditures. (There is no great incentive for individuals to leave money in savings vehicles.)
Therefore, if real interest rates drop, there is a tendency to spend more money now, which will increase the aggregate demand for goods and services. This would cause the aggregate demand curve to shift to the right.
BUSINESS EXPECTATIONS
Expectations about future economic conditions affect current business decisions. If businesses are pessimistic, there is a decline in aggregate demand, which would cause a leftward shift in the aggregate demand curve. The opposite results if businesses are optimistic.
EXPECTED RATE OF INFLATION
The Expected Rate of Inflation: Expectations of an increasing inflation rate will increase current aggregate demand and shift the aggregate demand curve to the right. (“Buy now before prices go higher.”). Expectations of declining prices will discourage current spending (“Why buy now when prices could be lower next month?”)
AGGREGATE SUPPLY
The aggregate supply curve shows the relationship between the quantity of goods and services produced and the price level. If businesses can obtain a higher price for their products, they will certainly be induced to increase production or output.
The aggregate supply curve is upward sloping. The quantity supplied is on the horizontal axis and the price is on the vertical axis as illustrated. Several factors can affect and shift the aggregate supply curve.
SHIFTING THE SUPPLY CURVE
Supply of Labor and Capital.
The economy’s output possibilities are constrained by the supply of resources (labor supply, technology, etc.).
An increase in the supply of resources leads to lower resource prices and a decrease in the cost of producing goods and services. At a given price level, lower resource prices reduce costs and encourage producers to supply a larger output.
Thus, the aggregate supply curve shifts to the right i.e. this would shift aggregate supply from SS to SiSi. For example, if ABC Ltd. can reduce its labor costs, it may be willing to sell more products and services for a given price level. This would shift the supply curve to the right. A reduction in the supply of resources has the opposite effect: resource prices rise, costs of production rise, and output is reduced. The aggregate supply curve shifts to the left.
SHIFTING THE SUPPLY CURVE
TECHNOLOGY & PRODUCTION
Technology and Production. Advancements in technology and increases in productivity enable the production of a larger output from the existing resource base. Both short- and long-run aggregate supply curves will shift to the right. Declines in productivity will shift both short- and long-run supply curves to the left.
SHIFTING THE SUPPLY CURVE
INSTITUTIONAL FACTORS
Institutional Factors. This pertains to governmental policies and traditions in the economy. These factors influence productivity and the efficiency of resource use. Public policy that encourages efficiency by providing a stable economic environment may increase total aggregate supply. This would shift the supply curve to the right.
SHIFTING THE SUPPLY CURVE
SUPPLY SHOCKS
Supply Shocks. There are conditions where short-run aggregate supply may change without long-run aggregate supply being affected. One major reason this would occur would be supply shocks (surprise occurrences) that change the level of current output.
The Gulf War for example resulted in a sharp temporary cut in the oil supply with a corresponding rise in oil prices. When the war was over, supply conditions and price levels went back to normal.
LIST 6 LEADING INDICATORS
S Stock Prices
H Housing Starts
M Money Supply
M Manufacturers’ New Orders
A Average Hours Worked Per Week
C Commodity Prices
EXPLAIN LEADING INDICATORS
These indicators historically on average have tended to turn in advance of the general economy. They are often used to predict general changes in the economy and the business cycle.
THE MLI INDEX 9 COMPONENTS
The MLI index tracks the performance of these nine components:
I. The money supply (M l )
2. The stock market
3. Interest rate differential between corporations and government short term borrowings.
4. Commodity prices
5. Claims for Employment Insurance
6. The housing index
7. New orders for durable manufactured goods
8. The average workweek in manufacturing
9. The US leading indicator
EXPLAIN COINCIDENT INDICATORS
Coincident Indicators
Coincident indicators occur in tandem with the business cycle. They happen at the same time and reflect the same direction as the economy.
A coincident indicator historically on average has turned at the same time as the general economy.
COINCIDENT INDICATORS
Coincident indicators include:
i) GDP
ii) Retail sales
iii) Industrial production
iv) Personal income
You might remember to get a “GRIP” today on coincident indicators
G GOP
R Retail sales
I Industrial production
P Personal income
LEADING INDICATORS
STOCK PRICES
HOUSING STARTS
MONEY SUPPLY
MANUFACTURERS NEW ORDERS
AVERAGE HOURS WORKED PER WEEK
COMMODITY PRICES
LAGGING INDICATORS
UNEMPLOYMENT
INVENTORY
INTEREST RATES
INFLATION
EXAMLES OF AUTOMATIC STABILIZERS
Employment insurance, progressive tax system
DRAWDOWN
Bank of Canada withdraws cash from its accounts at the chartered banks.
Cash in the banking system decreases
Interest rates rise
REDEPOSIT
Bank of Canada deposits money back into the accounts at the chartered banks, increasing cash and money supply.
More cash in the money system
Rates will fall
SPRA
Special purchase and resale agreements
Bank of Canada will lend banks and dealers money overnight at a rate lower than the upper limit of the operating band
SPRAs will cause the overnight rate to fall
BoC / OPEN MARKET
BUYING SECURITIES
When BoC buys securities it pays cash and insreases the supply of money
List the 3 types of interest rates from lowest to highest
- Overnight Loan Rate
- Bank Rate
- Prime Rate
THE OVERNIGHT LOAN RATE
