- decision makers Factors of production $ - consumers -companies
- capital - labour S -government
- natural resources
Equilibrium D Q
Economic Growth Gross Domestic Product - GDP - value of all goods & services produced in country in year - final goods
GDP = C + G + I + (X-M) C = consumption G = government expenditures I = investment > in plant, machinery, inventory, housing X-M = exports – imports = gross domestic income = gross domestic expenditures
Real GDP - GDP after removing inflation E.g. if 6%^ in GDP and 2% inflation - real GDP ^ 4%
Growth - economy has grown over time - but not always smoothly
- have periods of growth and periods of recession (2 quarters of declining real GDP) - results from 1) in population 2) in capital stock 3) technological innovation
Short Run - Figure 2.2, p. 2-9 - fluctuations - actual vs. potential output
Business Cycle - has 5 phases - see graphs page 2 Expansion - economy steadily growing Peak - final stage of expansion Contraction - level of economic activity declining Trough - final stage of contraction Recovery - economy recovering - GDP reaches its previous peak
>> soft landing
Economic Indicators Leading Indicators - anticipate economic change – peak & trough before the economy
- e.g. housing starts, manufacturing new orders, commodity prices, stock prices, average hours worked - Composite Leading Indicator - index of 10 leading indicators
Coincident Indicators - change at approximately the same time as the economy
- e.g. GDP, industrial production, personal income
Lagging Indicators - change after the economy has changed
- e.g. capital spending, unemployment rate, inventory levels, inflation
Long Run
- growth rates - Table 2.5 p. 2-14 - GDP per capita
- determinants of economic growth
The Economy - 2 Economic Scenario PEAK PEAK - D > S – high interest rates, inflation, wages - slowing growth in employment, capital expenditures, inventory - declining confidence EXPANSION - increasing inventory, profit, capital expenditures - inflation low but rising, unemploy steady & declining CONTRACTION - rapid decline in econ activity (GDP) - high inventory - decline profits, confidence - layoffs RECOVERY -increasing prod’n, demand, profit - increasing consumer confidence
TROUGH
- low output, sales, confidence - low interest rates, inflation
- inventory bottoming, excess mfg capacity
Investment Decisions PEAK - stop buying stocks – prices not rising fast enough PEAK - - sell equity (cyclicals first) buy ST debt (highest interest rate) EXPANSION - buy energy & resource stocks CONTRACTION - interest rates decline Sell ST bonds - bond prices increase Buy LT bonds (greatest potential for capital gains) RECOVERY - possible equity pullback - if price recovery out of sync with economy
TROUGH
-sell bonds because prices increased due to decline interest rates - buy stocks - cyclicals first
- stock prices anticipate recovery in corporate profits
The Economy - 3
Interest Rates - effect on economy >>if i - raise the cost of capital - reduce disposable income
Determinants of Interest Rates
Inflation & Inflation Expectations
Foreign Interest Rates Demand & Supply of Capital Default Risk Maturity Risk
Central Bank Activities/Credibility Exchange Rate -
expectations & interest rates
- Figure 2.5 p. 2-18
discourage consumer spending
Inflation
- Figure 2.6 p. 2-21
- measured by CPI - cost of living >>> shopping basket of 600 goods & services - costs - erodes std of living if on fixed income - reduces real value of investments - distorts price signals - causes in interest rates --- may lead to recession - causes - 1) MS 2) demand pull D > S (output gap) 3) cost push - supply side changes
- output gap
- Figure 2.7 p. 2- 22
Real GDP % Potential GDP Time
Disinflation - decrease in inflation rate costs? - Philips Curve - Sacrifice ratio
Deflation - sustained fall in prices - negative change in CPI costs?
Unemployment - Labour Force Survey - 50,000 households across Canada - participation rate
- unemployment rate
- Figure 2-8, p. 2-25
- types of unemployment - cyclical - structural - frictional -seasonal - NAIRU - 6 ½ % to 7% in Canada
The Economy - 4
EXTERNAL Balance of Payments - all financial transactions with rest of world in a year Current Account - Merchandise Trade (X - M) - Investment income - Travel & Tourism - Services
Capital Account - Direct Investment (build or buy a business) - Portfolio Investment (stocks, bonds) - International Reserve Transactions
Exchange Rate - trade-weighted exchange rate - value of $C against major currencies, based on % trade with each - Figure 2.9 p. 2-31
- floating rate - fixed rate
- Bretton Woods system
Determinants of the Exchange Rate
Inflation Differentials Interest Rate Differentials Current Account Economic Performance Public Debt & Deficits Terms of Trade Political Stability
Economic Theories - Rational Expectations - Keynesian - Monetarist - Supply-Side
Fiscal Policy - spending & taxation - impact on economy - debt-to-GDP ratio Figure 2.10 p. 2-41
- automatic stabilizers - change automatically >> counter changes in the business cycle eg. EI payments, taxes
- counter-cyclical fiscal policy - try to offset economic fluctuation & business cycle - Keynesian policy
- debt vs deficit
The Economy - 5 Bank of Canada Duties Regulate credit & currency
Control & protect external value of $
Use monetary policy (money supply & interest rates) to achieve economic stability Promote the country's economic welfare Functions Issue bank notes
Act as government's fiscal agent
- Financial advisor - Debt management
- CI&S - Canada Investment & Savings – retail debt
- Administer gov't cash accounts
Conduct monetary policy
Manager of currency & gold reserves
Monetary Policy - managing the supply of money -- most important role of Bank of Canada - 1 to 2 year time lag
objective - economic growth without inflation
- 1995 - 2006 - target range for CPI 1% to 3% (want to be in middle of range) - moderate growth in money supply moderates inflation
cannot have inflation if money supply not increasing
Monetary Conditions Index -- monitors interest rates & exchange rate
Tools to implement monetary policy - BOC implementation of monetary policy is transmitted through the overnight rate - changes to target for Overnight Rate Cash Management
Cash Settlement - LVTS -- Large Volume Transfer System - Track receipts & payments through the day - BOC sets zero-settlement limit - Participants balance at close of day - use open market operations if don’t - ACSS – Automated Clearing Settlement System - paper based
Drawdowns & Redeposits - transfer of GOC deposits between accounts at BOC & direct clearers - drawdown >> move cash to BOC - redeposit >> move cash to direct clearers
Open Market Operations
- Special Purchase & Resale Agreements (SPRA) - to keep rates down
- Upward pressure on i rates - D for funds pressure on i rates
- BOC buys securities & agrees to resell next day >> puts money in system
- Sale & Repurchase Agreements (SRA) - to keep rates up
- downward pressure on i rates – too much liquidity S pressure on i rates - BOC sell securities & agrees to repurchase the next day >> takes money from system
Changes in the Bank Rate
- upper limit of \"operating band\" - changes announced by B of C - monetary policy designed to keep rate within band
i
The Operating Band Bank Rate - 0.5% operating band - overnight rate within band Rate for positive balances (BR – 0.5%)
Economy - 6
ECONOMICS QUESTIONS
A. If you observed the following economic conditions, in which phase of the business cycle is the economy operating? 1) High wage and inflation increases _____________ 2) Business investing in new capacity _____________ 3) High inventory & declining profits _____________
4) Reduced consumer spending & declining profits ______________ 5) Falling interest rates spur consumer spending ______________ 6) Stock market activity is strong _____________ 7) Inventory levels bottom _____________ 8) Growth with little inflation pressure _____________ 9) Firms can expand without adding capacity ______________ 10) Unemployment increases _____________ 11) Bond prices increase _____________ 12) Sell bonds/start buying stocks _____________ 13) Stop buying stocks _____________
B. For each of the following, indicate whether it is a leading, lagging or coincident indicator 1) Housing starts ______________ 2) Inflation ______________ 3) Composite leading indicator ______________ 4) GDP ______________ 5) Capital spending ______________ 6) Stock prices ______________ 7) Money flows ______________ 8) Industrial production ______________ 9) Unemployment ______________ 10) Personal income ______________ 11) Manufacturing new orders _______________ C. Which of the following is a likely economic result of an increase in interest rates? 1) Business capital spending will increase ______ 2) Consumers will save more _____ 3) Housing starts will increase ______ 4) Increased borrowing costs ______
5) Consumers will have more money to spend ______ 6) Appliance sales will increase ______
7) Companies will have less money to spend __________ D. Indicate whether the following will result in an increase/decrease/no change in interest rates: 1) Inflation rate is reduced _________ 2) Company undertakes a large, risky project _____________ 3) Government is pursuing a balanced budget and is perceived to be fiscally responsible ________ 4) US interest rates are increased____________ 5) This bond has a term to maturity of 25 years _______________ 6) Inflation pressures begin to mount in the economy______________ 7) The Federal Reserve maintains current rates as expected ______________ 8) The economy is sliding into a recession ________________
E. Which of the following is an economic impact of inflation?
1) Increase the standard of living of those on fixed incomes ______ 2) Reduces social inequity _______
3) Wage increases usually match inflation _______ 4) Results in lower interest rates _______
5) Distorts market supply/demand signals _____
6) Reduces the real value of debt repayments ________
7) Moderates the severity of business cycle fluctuations ________
Economy - 7
F. Identify whether the following are examples of structural, cyclical, seasonal or frictional unemployment:
1) Auto parts workers are laid off due to declining auto sales ___________
2) A 55 year old worker in the garment industry is laid off when the plant closes & cannot find other work ______ 3) GM shuts its plant for 2 weeks in the summer for scheduled maintenance _____________
4) Carpenters are laid off because of a housing slowdown resulting from higher interest rates ________ 5) A computer technologist takes 2 months holiday before looking for a new job __________ 6) Unemployment rate is 8% but jobs are unfilled due to lack of skilled workers ___________ 7) Cod fishery is closed in Newfoundland due to dwindling cod supplies ___________ 8) The Ministry of Natural Resources lays off forest fire fighters in September _________ G. Identify whether the following are Current or Capital Account & which category
1) Canada sells wheat to Russia _____________________
2) Royal Bank pays bond interest to foreign investors ________________ 3) Japanese tourists golf in Banff ________________
4) Canadian engineering firm designs a bridge in Thailand _______________ 5) Canadian company buys a U.S. competitor ___________________ 6) U.S. firm builds a plant in Canada _________________ 7) German investors buy Canadian Tbills _________________ 8) Canadian students spend March break in Daytona ___________
9) Canadian company buys computer components from Taiwan _____________
H. What effect would the following have on Canadian exchange rates?
1) US interest rates increase and Canadian rates are unchanged ___________ 2) Exports of natural resources increase substantially ____________
3) Government debt levels are perceived to be excessive ______________ 4) Inflation rates are much higher than major trading partners _____________ 5) Large payments to foreign debt holders are paid this quarter _____________ 6) The government substantially increased corporate tax rates ___________ 7) Canada has a large Current Account surplus ____________ 8) A weak minority government is elected federally _________ I. For each of the following, indicate whether it is monetary policy, fiscal policy or fiscal agent.
1) The Bank of Canada increases the bank rate _____________ 2) The capital gains taxes are reduced ____________
3) A government of Canada bond issue is redeemed at maturity ________
4) The Bank of Canada uses SPRAs to reduce interest rate pressure __________ 5) Interest on government debt is paid when due____________
6) On April 15th, government accounts at the chartered banks are increased____________
7) Grants are announced to encourage construction projects in high unemployment areas _________ 8) CPP deductions are increased ____________ J. What impact would the following actions have on interest rates & money supply. 1) BOC undertakes an SPRA ________ ________________ 2) Operating band increases ________ ________________ 3) BOC drawsdown GOC balances ________ ________________ 4) An SRA is undertaken ________ ________________ 5) A Special is undertaken ________ ________________
Economy – 8 The Economy Review
1) The business cycle has _____ phases. Economic activity is declining in the ____________ phase and is increasing
steadily in the __________ phase. The top of a cycle is the ___________. An investor should buy ________ near the trough of the cycle because they are expecting ___________________. An investor should buy _______________ at or just after the peak because they are expecting _______________.
2) Two quarters of declining real GDP is considered to be a __________________. A leading indicator changes
______________________. Two leading indicators are ________________ and ______________. A lagging
indicator changes __________________. Two lagging indicators are _____________ and ____________. Long term growth results from ______________, _____________________ and ________________________.
3) Canadian financial transactions with the rest of the world are summarized in the ________________. There are two
major classifications: _________________ and ____________________.
4) If there is strong upward pressure on short-term interest rates, the Bank of Canada will use _________________ to
reduce interest rates. The Bank _______ securities and agrees _______________. If there is strong downward
pressure on short-term interest rates, the Bank of Canada will use _________________________ to increase interest rates. The Bank _____________ securities and agrees ___________________. The Bank Rate is set as ___________________________.
5) What is the relationship between output gap and demand-pull inflation?
6) Describe the pattern of business cycle expansions & contractions over the past 30 years.
7) If an investor observed an economic situation of low output & sales, excess manufacturing capacity & inventories
appeared to be bottoming, what phase of the business cycle is indicated? What investment strategies should be pursued?
8) If it is observed that inflation is low but rising and inventory and profits are increasing, what part of the business cycle
is indicated? What investment strategy should be followed?
9) Indicate whether the following are true or false. If false, state why.
a) The Phillips Curve concept states that inflation & unemployment move in opposite directions. b) Keynesian economics focuses on monetary policy. c) Inflation is a leading indicator.
d) Inflation expectations are one of the key factors affecting interest rates. e) One cause of inflation is an increase in the money supply.
f) If Canada sells lumber to the U.S., this transaction would be recorded in the merchandise trade section of the Current
Account.
g) Inflation distorts market supply/demand signals
h) A 5-year bond has higher maturity risk than a 10-year bond
i) Sears Canada has a higher default risk than the Province of Ontario. j) Canada has a lower default risk (country risk) than the U.S.
k) A large Current Account surplus would have a positive impact on the $C
l) Inflation rate differentials between 2 countries is a significant factor in exchange rate changes. m) Increases in inflation rates discourage consumer spending.
n) At the peak of the business cycle, investors should buy short-term debt.
o) One characteristic of the contraction phase is rapidly declining economic activity p) The recovery phase is characterized by declining consumer confidence. q) The peak is characterized by declining confidence.
r) The overnight rate is usually slightly higher than the Bank Rate s) The lower end of the operating band is 0.5% below the Bank Rate t) The Bank Rate is changed on specific dates
u) The LVTS is outside the zero-settlement limit set by the BOC
v) Under the zero-settlement limit, participants must balance by 8 a.m. (before the start of the day) w) With an SRA, the BOC tries to keep interest rates down
x) With an SPRA, the BOC buys securities & agrees to resell them in 2 days.
y) In a draw down, the BOC moves GOC cash balances to a direct clearer account. z) The Monetary Conditions Index monitors interest rates & the exchange rate. aa) EI payments are examples of automatic stabilizers
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