2. Economics in General
The 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.
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3. Overview
Microeconomics 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.
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4. Overview
Microeconomics 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.
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5. Overview
The main decision makers in the economy:
• Consumers
• Firms
• Government
What role do each play and how do they interact?
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6. Overview
Goods 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?
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7. Demand & Supply
The interaction between demand and supply leads to market
equilibrium in the economy.
Market Demand
• consumers, all purchasers of goods and services
Market Supply
• suppliers of goods and services
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8. 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.
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9. Demand & Supply
Law 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?
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10. 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?
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11. Measuring Economic Growth
GDP 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?
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12. Measuring Economic Growth
GDP 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
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13. Measuring Economic Growth
Components of the expenditure approach:
• Consumption
• Investment
• Government Spending
• Net Exports
GDP = C + I + G + (X – M)
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14. Measuring Economic Growth
How does an economy grow?
Causes of GDP Growth:
• Population growth
• Rising productivity
• Technological innovation
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15. 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?
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16. 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)
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17. A Typical Business Cycle
GDP
Rising Trend in GDP
Expansion
Peak Contraction Recovery
Expansion
Trough
Time
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18. The Business Cycle
Describe the key features of each phase of the cycle:
• Expansion
• Peak
• Contraction
• Trough
• Recovery
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19. The Business Cycle
Expansion
– 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
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20. The Business Cycle
Recession
– 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
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21. Economic Indicators
Leading 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 economy
Example: GDP, retail sales
Lagging Indicator: Change after the economy changes – used
to confirm a business cycle pattern
Example: Unemployment rate
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22. Interest Rates
Interest is:
• Economic rent for a scarce resource (money)
• For business owners it is a component in the cost of capital
for production
• For consumers it is the “price” of credit for consumption
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23. Interest Rates
Interest rates vary by:
• Duration/term of loan
• Conditions of the loan
• Creditworthiness
How do higher rates impact the economy?
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24. Interest Rates
How do higher rates impact the economy?
• Increases the cost of capital for businesses and leads to lower
business investment.
• Discourages consumer spending on durable goods and other
commodities.
• May lead to a general economic slowdown.
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25. Determinants of Interest Rates
• Demand and Supply of Capital
• Default Risk
• Central Bank Activities/Credibility
• Foreign Developments – Interest Rates/Exchange Rate
• Inflation
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26. Inflation
A 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?
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27. Inflation & the Consumer Price Index
Using 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 to
arrive at the inflation rate for the year
• If CPI is currently 130 and the base year was 120, what does this
imply?
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28. Inflation
Costs 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
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29. 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).
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30. Growth in the Money Supply
The 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 fully
employed 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.
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31. Growth in the Money Supply
Positive 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.
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32. Disinflation vs. Deflation
Disinflation Deflation
A decline in the rate at which A sustained fall in prices - the
prices rise – is a decrease in the annual change in the CPI is
rate of inflation. negative year after year.
Prices are still rising, but at a Deflation is just the opposite of
slower rate. inflation.
Captured through the Phillips Problem: sustained falling prices
Curve and the sacrifice ratio. could lead to a decline in
corporate profits.
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33. Labour Markets
Economic performance directly affects the labour market.
Indicators:
• Labour Force: sum of the working age population who are
employed or unemployed.
• Participation rate: the % of the working age population in the
labour force.
• Unemployment rate: the % of the labour force unemployed
but looking.
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34. Types of Unemployment
Cyclical
• 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
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35. Labour Markets
• Is an unemployment rate of 0% possible? Why or why not?
• What stops the economy from moving to such a position?
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36. 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.
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37. 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.
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38. 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.
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39. The Exchange Rate
Why 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 of
exports 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$?
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40. The Exchange Rate
Determinants of the Exchange Rate:
• Inflation differentials
• Interest rate differentials
• Current account
• Economic performance
• Public debt and deficits
• Political stability
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