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.
