The Economy

Question 1

How is economics defined, vis-à-vis the activities and actors within it?

Answer 1

• Economics is a social science that focuses on an understanding of production, distribution, and consumption of goods and services. More specifically, the focus is on how consumers, businesses, and governments make choices when allocating resources to satisfy their needs. The sum of those choices determines what happens in the economy. A market economy is an economic system where the decisions regarding investment, production, and distribution of goods and services are guided by the price signals created by the forces of supply and demand. The decisions made by consumers, businesses, and governments help to determine the proper allocation of resources.
• Example: with an increase in high-speed internet infrastructure and social media platforms, consumers have shifted their spending away from traditional video rental stores toward the convenience of online streaming service providers. This shift in consumer demand has resulted in falling profits and stock prices for publicly traded companies that catered to that market. In fact, one of the largest retailers in North America, which had at one time as many as 60,000 employees and more than 8,000 retail outlets, eventually filed for bankruptcy protection.

Question 2

What is the difference between macroeconomics and microeconomics, and what are some example questions that the two are concerned with?

Answer 2

• Microeconomics generally applies to individual markets of goods and services. It looks at how businesses decide what to produce and who to produce it for, and how individuals and households decide what to buy.
• Macroeconomics focuses on broader issues such as employment levels, interest rates, inflation, recessions, government spending, and the overall health of the economy. It also deals with economic interactions between countries in our increasingly connected global economy.

Question 3

How is any market or a market defined?

Answer 3

• The activity between consumers, businesses, and governments takes place in the various markets that have developed to make trade possible. A market is any arrangement that allows buyers and sellers to conduct business with one another. Most markets in the financial services industry are not physical. Interactions between buyers and sellers of securities, for example, are facilitated by intermediaries and conducted electronically.

Question 4

Thinking of investment opportunities as demand and supply?

Answer 4

• The price of a product is one of the most important factors to determine how much of that product people buy or sell in the marketplace. Everything has a price, and financial products and services are not exempt. Stocks, bonds, commodities, and currency all have visible prices that allow people to make investment decisions. Demand for and supply of a product in the marketplace largely determines the price paid for the product.
• The interaction that takes place between buyers and sellers in the market ultimately determines an equilibrium price for that product.
• Each investment you make in a company is an estimate on how the goods and services that company offers lines up on the demand and supply equilibrium. Will the goods and services that company offers increase in value? Does it have enough demand? Is it able to meet demand? So on and so forth. Things to keep in mind.

Question 5

Define GDP, the expenditure approach to calculating it, the equation, and nominal vs real GDP:

Answer 5

• Gross domestic product (GDP) is the total market value of all the final goods and services produced in a country over a given period. Economic growth is measured by the increase in GDP from one period to the next.
• The expenditure approach to calculating GDP adds up everything that consumers, businesses, and governments spend money on during a certain period. Included in the calculation are business investments and all the exports and imports that flow through the economy.
• GDP = C + I + G + (X – M) Where: C = consumer expenditures I = business spending and investment G = government spending X − M = the amount of exports (X) and imports (M) that consumers and businesses buy during the period
• Nominal gross domestic product (nominal GDP) is the dollar value of all goods and services produced in a given year at prices that prevailed in that same year. However, changes in nominal GDP from year to year can be misleading because they reflect not only changes in output but also changes in the prices of goods and services. To measure a nation’s true productivity in a year, we need to look at real gross domestic product (real GDP). This measure removes the changes in output that are attributable to inflation and allows us to see how much GDP has grown, based solely on productivity.

Question 6

What is the business cycle and what are its different stages?

Answer 6

• The economy tends to move in cycles that include periods of economic expansion followed by periods of economic contraction. These fluctuations, which directly affect the value of investments over time, are called business cycles.
• Expansion or growth in the economy is measured by the increase in real GDP while contraction is measured by a decrease in real GDP. The term cycle suggests a regular and predictable pattern, but in reality, fluctuations in real output are both irregular and unpredictable. This irregularity makes each business cycle unique. Nonetheless, a relatively typical sequence of events occurs over the course of a business cycle. This sequence of expansion, peak, contraction, trough, and recovery is illustrated in Figure 4.4.
  o Expansion: An expansion is a period of significant economic growth and business activity during which GDP expands until it reaches a peak.
  o Peak: The peak of the business cycle is the top of the cycle between the end of an expansion and the start of a contraction.
  o Contraction: A contraction is a decline in economic activity. The financial press might refer to this phase as negative GDP growth. If the contraction lasts at least two consecutive quarters, the economy is considered to be in recession.
  o Through: As contraction continues, falling demand and excess capacity curtail the ability of businesses to raise prices and of workers to demand higher salaries. The growth cycle reaches a trough, its lowest point.
  o Recovery: During recovery, GDP returns to its previous peak. The recovery typically begins with renewed buying of items such as houses and cars, which are sensitive to interest rates.

Question 7

What are leading, coincident, and lagging economic indicators, and provide examples of each category?

Answer 7

• Economic indicators provide information on business conditions and current economic activity. They can help to show whether the economy is expanding or contracting. For example, if certain key indicators suggest that the economy is going to do better in the future than had previously been expected, investors may decide to change their investment strategy
• • Leading indicators tend to peak and trough before the overall economy. They anticipate emerging trends in economic activity by indicating what businesses and consumers have actually begun to produce and spend. * Coincident indicators change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. * Lagging indicators change after the economy as a whole changes. These indicators are important because they can confirm that a business cycle pattern is occurring.
    o Leading indicators:
     Housing starts: When a permit is issued to build a house, it indicates that building supplies will be bought and workers will be hired. The owner will then spend more money on new appliances and furnishings.
     Manufactures new orders: New orders by manufacturers indicate expectations that consumers will purchase more items, such as automobiles and appliances.
     Commodity prices: Rising or falling commodity prices reflect rising or falling demand for raw materials.
     Average hours worked per week The average number of work hours rises or falls depending on the level of output, and therefore indicates changes in employment levels.
     Stock prices In general, changes in stock prices indicate changing levels of profit.
     The money supply The money supply represents available liquidity and therefore has an impact on interest rates.
    o Coincident indicators:
     Personal income GDP Industrial production Retail sales: When personal income is rising, people have more money to spend, which encourages an increase in GDP, industrial production, and retail sales.
    o Lagging indicators:
     Unemployment Inflation rate Labour costs Private sector plant and equipment spending Business loans and interest on such borrowing Unemployment is a key lagging indicator: Unemployment rates go up or down in response to other factors. For example, when businesses are confident that a recession or contraction is over, they start hiring again. The unemployment rate then falls and labour costs go up. Likewise, as the economy recovers, businesses can be expected to spend more on plants and equipment and borrow more money to fund growth

Question 8

What is the unemployment rate, how is it calculated, and how is tied to economic growth?

Answer 8

• The unemployment rate represents the share of the labour force that is unemployed and actively looking for work. This rate may rise when the number of people that are employed falls or when the number of people looking for work rises (or when both occur at once).
• Unemployment rate = not working but actively looking divided by labour force x 100
• In this figure, you can see a strong correlation between declining GDP that occurs in recessionary periods and increased unemployment.

Question 9

What are interest rates and how do they impact both the saver and borrower?

Answer 9

• Interest rates are an important link between current and future economic activity. For consumers who save rather than borrow for a major purchase, interest rates represent the gain made from deferring consumption. Conversely, for people that borrow, they represent the price of borrowing to buy something today rather than postponing the purchase.

Question 10

How do interest rates tend to affect the economy (3 ways)?

Answer 10

1. They reduce business investment: An investment should earn a greater return than the cost of the funds used to make the investment. Higher interest rates raise the cost of capital for investments and reduce the possibility of profitable investments. Therefore, businesses are less likely to invest. If a company borrows $1 million at a 5% interest rate, it pays $50,000 per year in interest, leaving $100,000 in net profit from an investment generating $150,000 annually. But if the interest rate rises to 10%, the interest cost increases to $100,000, reducing net profit to $50,000, making the investment less attractive and potentially leading the company to cancel or delay it.
2. They encourage saving: By increasing the cost of borrowing, higher interest rates discourage consumers from buying on credit, especially high-priced items such as houses, cars, and major furniture articles. Instead of choosing to borrow and pay off debt, they are content to put their money in savings.
3. They reduce consumption: Higher interest rates increase the portion of household income that is needed to service debt, such as mortgage payments, thereby reducing the income available to spend on other items. This effect is offset somewhat by the higher interest income earned by savers.

Question 11

What is the difference between nominal and real interest rates?

Answer 11

• Nominal interest rate is the stated rate on a loan or investment, without adjusting for inflation. It’s the percentage you see quoted by banks or on financial products. Real interest rate adjusts the nominal rate for inflation, showing the true purchasing power of your money.
• For example, if a bank offers a nominal interest rate of 5% on a savings account but inflation is 2%, the real interest rate is 3% (5% - 2%). This means your purchasing power actually increases by 3%.

Question 12

What is inflation, when does it occur, and how is it measured?

Answer 12

• Prices for goods and services can rise, fall, or remain unchanged, depending on the conditions in the market.
• Inflation occurs when prices follow a sustained rising pattern. As prices rise, money begins to lose its value, and a larger amount of money is needed to buy the same amount of goods and services.
• The inflation rate is the percentage of change in the average level of prices over a given period. The Consumer Price Index (CPI) is a widely used measure of inflation. The CPI monitors how the average price of a basket of goods and services, purchased by a typical Canadian household, changes from month to month or year to year. When calculating CPI, prices are measured against a base year. Currently, the base year used in Canada is 2002, which is given a value of 100. At the end of December 2023, the total CPI was 158.3, which indicates that the basket of goods in that year cost 58.3% more than it did in 2002.
  o Inflation rate = CPI current period – CPI previous period / CPI previous period x 100
  o Inflation rate for example = 154.5 – 146.8 / 146.6 = 0.052 x 100 = 5.2%

Question 13

What are the costs of inflation, or in other words, its negative impact?

Answer 13

• It can erode the standard of living of Canadians, particularly of people on a fixed income, for example, retired individuals who rely on a monthly government pension. Canadians who are able to increase their income in response to inflation, either through increased wages or changes to their investment strategy, are less affected.
• It reduces the real value of investments, such as fixed-rate loans, because the loans must be paid back in dollars that buy less. A borrower whose income rises with inflation will not be affected. However, lenders are likely to demand a higher interest rate on the money they lend during inflationary times.
• It distorts the price signals sent to market participants. As we discussed earlier, prices are set by supply and demand. When inflation is high, it is difficult to determine whether a price increase is simply inflationary or a genuine relative price that reflects a change in supply or demand.
• Accelerating inflation usually brings about rising interest rates and a recession. Therefore, high-inflation economies usually experience more severe expansions and contractions than low-inflation economies.

Question 14

Explain the relationship between inflation and unemployment via the Phillips curve?

Answer 14

• The Phillips curve shows an inverse relationship between inflation and unemployment:
• When unemployment is low, businesses compete for workers by offering higher wages, which increases workers’ spending power and drives up prices, leading to higher inflation.
• When unemployment is high, people have less money to spend, reducing demand for goods and services, which leads to lower inflation or even deflation.
• Key Takeaways:
  o To reduce unemployment in the short run, an economy might accept higher inflation because more people working means more spending, driving up prices.
  o To reduce inflation, an economy might face higher unemployment because lower spending slows economic growth and reduces demand for workers.

Question 15

What is international finance, what is comprised of, and how does developments in our trading partners economies’ impact Canada?

Answer 15

• International finance refers to Canada’s interaction with the rest of the world, including trade, investment, capital flows, and exchange rates. Canada is dependent on trade; exports of goods and services account for about a third of our GDP. Consequently, the economic performance of our trading partners directly affects Canada’s economy. When the economies of our trading partners are expanding, Canada’s economy also benefits. As trading partners increase their spending on goods, Canadian companies generally export more goods abroad. Conversely, Canadian exports fall when economic growth in our trading partners declines.

Question 16

What is the balance of payments including the current account and capital/financial account?

Answer 16

• The balance of payments is a detailed statement of a country’s economic transactions with the rest of the world over a given period (typically a quarter or a year). The balance of payments has two main components: the current account, and the capital and financial account.
• Current account This account records the import and export of goods and services between Canadians and foreigners, as well as net transfers such as for foreign aid. The current account is sometimes called the trade account in the financial press.
• Capital and financial account This account records financial flows between Canadians and foreigners, related to investments by foreigners in Canada and investments by Canadians abroad.
• Think of the current account as what we spend on things and the capital and financial account as what we use to finance this spending. During a given year, if Canada buys more goods and services from abroad than it sells, it will run a current account deficit for the year. It will need to sell more assets to finance the spending, which means running a capital and financial account surplus. Alternatively, it will go into debt.
  o If Canada runs a current account deficit (spending more on foreign goods/services than it earns), it must cover that by either: Selling assets (foreigners buy Canadian assets, bringing money in), or Borrowing money (foreigners lend to Canada, also bringing money in)

Question 17

Define exchange rates and how it impacts trade?

Answer 17

• The value of the Canadian dollar relative to other currencies influences the economy in a number of ways. The most important influence is through trade. A higher Canadian dollar relative to our trading partners makes Canadian exports more expensive in foreign markets and imports cheaper in Canada. When the Canadian dollar rises in value relative to a foreign currency, the dollar is said to have appreciated in value against that currency; conversely, when the Canadian dollar falls in value relative to a foreign currency, the dollar has depreciated in value against that currency.