CANADIAN

SECURITIES
Chapter 4
Overview of Economics
Agenda
• Define Economics
• Define economics and describe the process for achieving market equilibrium.

• Measuring Economic Growth

• Describe the process for measuring gross domestic product and productivity gains in the
economy.

• The Business Cycle

• Differentiate between business cycle phases and economic indicators used to analyze
• current and long-term economic growth.

• The Labour Market

• Compare and contrast labour market indicators and the types of unemployment.
Agenda
• The Role of Interest Rates
• Describe how interest rates affect the performance of the economy.

• The Impact of Inflation

• Describe the process for measuring gross domestic product and productivity gains in the
economy.

• International Finance and Trade

• Analyze how trade between nations takes place through the balance of payments and
via the exchange rate.
Introduction
Economic news and events are announced regularly:
- monetary policy reports from the Bank of Canada
- quarterly gross domestic product estimates
- fluctuations in the value of the Canadian exchange rate relative to our trading partners
- monthly data on employment and housing starts
- employment numbers

In such a market, prices are determined by demand and supply for goods and services by
consumers, investors, and governments where an exchange takes place at an equilibrium price
CHAPTER 4
Defining Economics
Defining Economics
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.
Consumers

Market

Firms Government
Defining Economics
• Microeconomics: 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.
Defining Economics
• 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.
Defining Economics
Defining Economics – Decision Makers
The three broad groups that interact in the economy include consumers, businesses, and
governments:
• Consumers set out to maximize their satisfaction and well-being within the limits of their
available resources, which might include income from employment, investments, or other
sources.
• Businesses set out to maximize profits by selling their goods or services to consumers,
governments, or other firms.
• Governments spend money on education, health care, employment training and the
military. They oversee regulatory agencies, and they take part in public works projects,
including highways, hydro-electric plants, and airports.

The decisions these groups make, and the ways they interact with each other, ultimately
affect the state of the economy.
Defining Economics - Markets
Transactions (consumers, business, government) take place in a Market.

The price that is paid when a transaction occurs is the Equilibrium Price: When
supply and demand meet
Defining Economics – Supply,
Demand, Equilibrium
Equilibrium Price: At this price, the number of buyers and sellers are in balance. In a
state of market equilibrium, anyone who wants to buy the product can do so, and
anyone who wants to sell the product can do so.
Defining Economics – Supply,
Demand, Equilibrium
Equilibrium Price: At this price, the number of buyers and sellers are in balance. In a
state of market equilibrium, anyone who wants to buy the product can do so, and
anyone who wants to sell the product can do so.
 MEASURING
ECONOMIC GROWTH
Measuring Economic Growth
• Economic growth occurs when an economy is able to produce more output over
time.
• By measuring this growth, we can better understand the overall health of the
entire economy (standard of living)

How do we measure economic growth/progress?

GROSS DOMESTIC PRODUCT (GDP)

(but it is not the only way. See HDI for example)
Gross Domestic Product
• Gross domestic product (GDP) is the total market value of all the final goods
and services produced in a country over a given period.

Gross: Total Market Value

Domestic: produced within a county
Product: Final goods and services

• Economic growth (progress) is measured by the increase in GDP from one period
to the next.
Human Development Index - 2019

Source: http://hdr.undp.org/en/content/2019-human-development-index-ranking
Gross Domestic Product
There are three generally accepted ways of measuring GDP: the expenditure
approach, the income approach, and the Production Approach (Also known as the
Value-Added approach)

Both methods set out to give an approximation of the monetary value of all the final
goods and services produced in the economy. The two approaches generally
produce the same number.
Gross Domestic Product
Income approach This approach starts from the idea that total spending on goods
and services should equal the total income generated by producing all of those
goods and services. GDP using the income approach adds up all of the income
generated by this economic activity.
Gross Domestic Product
• Expenditure approach The more common way of calculating GDP is to add up
everything that consumers, businesses, and governments spend money on during
a certain period. Included in the calculation are business investments and all of the
exports and imports that flow through the economy.
Gross Domestic Product

C = Quantity x Price Transactions in the

I = Quantity x Price market
G = Quantity x Price At equilibrium
(X-M) = Quantity x Price price
Gross Domestic Product
Production Approach (Value Added Approach): calculates an industry or sector’s output
and subtracts the value of all goods and services used to produce the outputs.
Recall that “Gross domestic product (GDP) is the total unduplicated value of the goods and services produced in the
economic territory of a country or region during a given period”.

For each industry, this involves first determining its output and then subtracting the goods and services that
were used up in the process of generating that output. The goods and services that are used up are
referred to as intermediate consumption (or simply inputs). The difference between an industry’s output and
its intermediate consumption is its gross value added.

The GDP at market prices is obtained by adding taxes less subsidies on products to the sum total of value
added for all industries.

For example, if the computer industry produced a total of $5 billion in computers and spent $2 billion on goods and
services to produce the computers, the value added to GDP by the computer industry would be $3 billion. Adding up
the value added contributions of the various economic sectors produces a country’s total GDP for
the measurement period.
https://www150.statcan.gc.ca/n1/pub/13-607-x/2016001/175-eng.htm
Nominal GDP vs Real GDP
• Increases in GDP is a generally reflect an increase in standard of living…
BUT
• GDP is based on QUANTITY and PRICE of C,I,G, (X-M)
SO
• if the increase in GDP is simply the result of higher prices, then the cost of living
increases but the standard of living does not improve.

• Economists’ term for the condition of rising prices is inflation.

Nominal GDP vs Real GDP
• 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.

An increase in nominal GDP can occur in the current year compared to the previous year for
either, or both, of two reasons:
1. The economy expanded, and more goods and services were produced in the current year
than in the previous year; thus, the nation was more productive.
2. Prices increased, and consumers had to pay more for goods and services in the current
year than they did in the previous year; thus, the nation experienced inflation.

Therefore, changes in Nominal GDP can be misleading

Nominal GDP vs Real GDP
• 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.

Approximate Real GDP: Nominal GDP – Inflation

Real GDP: [(1+ Nominal GDP) / (1+ CPI)] - 1

If nominal GDP rose from $110 billion to $119 billion and inflation was 2.2%, what was
the real GDP?
Nominal GDP vs Real GDP
Productivity
• Economists use the term productivity to describe output (e.g., GDP) per unit of input (e.g.,
the labour and capital used to produce the goods and services).
• When productivity increases, more of something is produced with less expenditure,
creating a net benefit for the economy.
• There is a link between growth in real GDP and productivity gains. If the ultimate goal is to
improve productivity, how does an economy achieve this outcome?
• Growth in GDP results from a variety of factors, but a few key factors contribute to gains in
productivity:
• Technological advances
• Population growth
• Improvements in training, education, and skills
These factors contribute to growth in GDP and make nations wealthier.
THE BUSINESS
CYCLE
The Business Cycle
• 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.
The Business Cycle
The Business Cycle
The term cycle suggests a regular and predictable pattern, but in reality, fluctuations
in real output are both irregular and unpredictable.
Nonetheless, there is a sequence: expansion, peak, contraction, trough, and recovery
The Business Cycle – Expansion
An expansion is a period of significant economic growth and business activity during
which GDP expands until it reaches a peak. An economic expansion is characterized
by the following activities:
• Inflation, and therefore the prices of goods and services, is stable.
• Businesses adjust inventories and invest in new capacity to meet increased
demand and avoid shortages.
• Corporate profits rise.
• New business start-ups outnumber bankruptcies.
• Stock market activity is strong and the markets typically rise.
• Job creation is steady and the unemployment rate is steady or falling.
The Business Cycle – Peak
The peak of the business cycle is the top of the cycle between the end of an
expansion and start of a contraction. A peak is characterized by the following
activities:
• Demand begins to outstrip the capacity of the economy to supply it.
• Labour and product shortages cause wage and price increases, and inflation rises
accordingly.
• Interest rates rise and bond prices fall, which dampens business investment and
reduces sales of houses and other big-ticket consumer goods.
• Business sales decline, resulting in accumulation of unwanted inventory and
reduced profits.
• Stock prices generally begin to fall along with falling profits, and stock market
activity declines.
The Business Cycle – Contraction
A contraction is a decline in economic activity. The financial press might refer to this phase
as negative GDP. If the contraction lasts at least two consecutive quarters, the economy is
considered to be in recession. A contraction is characterized by the following activities:
• Economic activity begins to decline, and real GDP decreases.
• Faced with unwanted inventories and declining profits, firms reduce production, postpone
investment, curtail hiring, and may lay off employees.
• Business failures outnumber start-ups.
• Falling employment erodes household income and consumer confidence.
• Consumers react by spending less and saving more, which further cuts into sales and
further fuels the contraction.
• Stock market activity is low.
The Business Cycle – Trough
As contraction continues, falling demand and excess capacity curtail the ability of
firms to raise prices and of workers to demand higher salaries. The growth cycle
reaches a trough, its lowest point. A trough is characterized by the following
activities:
• Interest rates fall, triggering a bond rally.
• Inflation falls.
• Consumers who postponed purchases during the contraction are spurred by lower
interest rates and begin to spend.
• Stock prices rally.
The Business Cycle – 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. A recovery is characterized by the following activities:
• Firms that reduced inventories during the contraction must increase production to
meet new demand.
• They are typically still too cautious to hire back significant numbers of workers, but
the period of widespread layoffs is over.
• Firms are not yet ready to make significant new investment.
• Unemployment remains high, wage pressures are restrained, and inflation may
decline further.
Economic Indicators
Economic indicators provide information on business conditions and current
economic activity. They can help to show whether the economy is expanding or
contracting
• 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
Economic Indicators
Economic Indicators
Identifying Recessions
Economic recession: Traditionally defined as a period which real GDP decreases (its
growth rate is negative) for two consecutive quarters.
LABOUR MARKET
Why is Unemployment a Problem
Unemployment results in

 Lost incomes and production

 Lost human capital

• The loss of income is devastating for those who bear it. Unemployment benefits
create a safety net but don’t fully replace lost wages, and not everyone receives
benefits.
• Prolonged unemployment permanently damages a person’s job prospects by
destroying human capital.
Defining the Labour Market
Statistics Canada defines the working age population as people 15 and over. It
further divides this population into three groups:
• Those who are unable to work
• Those who are not working by choice
• The labour force
Labour Market Indicators
There are two key indicators that describe activity in the labour market:
• The participation rate represents the share of the working-age population that is
in the labour force. This rate is an important indicator because it shows the
willingness of people to enter the work force and take jobs.

Participation Rate = Labour Force

X 100
Working Age Population
 Labour Market Indicators
• 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 = Unemployed

Labour Force X 100

**Remember that Unemployed are those Not Working but Actively Looking for Work (still in the Labour Force) **
Labour Market Indicators
Canadian Labour Market
• In Canada, the participation rate has increased since the 1960s, primarily because
of the increased participation of women in the work force.
• The current participation rate is about 66%, compared to 55% in the early 1960s.
• The participation rate is a key measure of the productivity of a society.
• A society where only 50% of the working-age population is willing to work is not as
productive as a society where 70% of the working-age population is willing to
work.
Canadian Labour Market
Flaws in measurement?
• It does not address the fact that some people are unemployed for a short time, whereas
others are unemployed for long periods
• The average duration of unemployment varies over the business cycle; it is typically shorter during an
expansion and longer during a recession

• At times, job prospects are so poor that some unemployed people simply drop out
of the labour force and become discouraged workers, people who are available to
work but have given up their search because they cannot find jobs.
• If too many workers become discouraged workers, the unemployment rate actually falls because the
people in this segment of the population are no longer considered part of the labour force, and
therefore are not considered unemployed.

• Many people who are part of the labour force are considered underemployed.
These are people who are working part-time, often at jobs that do not make good
use of their skills, when they would rather be working full-time.
• Because the people in this group have jobs, the unemployment rate is lower than it would be if these
people were unemployed. However, the low rate does not reflect the nation’s loss of productivity.
Types of Unemployment
There are four general types of unemployment: cyclical, seasonal, frictional, and
structural.
Types of Unemployment
Types of Unemployment
• Frictional and structural factors in the economy will always exist. Therefore, the
unemployment rate can never fall to zero, not even in times of healthy economic
growth. The minimal level, below which unemployment does not drop, is called
the natural unemployment rate.

• At this level of unemployment, the economy is thought to be operating at close to

its full potential. At that level, all resources, including labour, are fully employed.
Further employment growth is achieved either through increased wages to attract
people into the labour force, which fuels inflation, or by more fundamental
changes to the labour market that remove impediments to job creation.
Unemployment and Full Employment
Real GDP and Unemployment Over the Cycle

• Potential GDP is the quantity of real GDP produced at full employment.

• Potential GDP corresponds to the capacity of the economy to produce output on a
sustained basis.
• Real GDP minus potential GDP is the output gap.
• Over the business cycle, the output gap fluctuates and the unemployment rate
fluctuates around the natural unemployment rate.
 THE ROLE OF
INTEREST RATES
Interest Rates
Current Economic Activity Future Economic Activity

 Consumers who save: interest rates represent the gain made from deferring
consumption
 People who borrow: interest rates represent the price of borrowing to buy something
today rather than postponing the purchase
 Businesses: interest rates represent one component of the cost of capital

***Interest rates are essentially the price of credit***

 Interest Rates
• Changes in interest rates reflect, and affect, the demand and supply for credit and
debt, which has direct implications for the bond and money markets
• Changes in interest rates through monetary policy decisions made by the Bank of
Canada also have broad implications for the entire economy

Eg. Interest rates rise > cost of borrowing increases > higher borrowing costs >
 Lead to negative impact on business profits > may cause share prices to drop
 Reduce consumption and investment

**Note that while increasing GDP by increasing borrowing increases economic conditions, it can become significantly problematic for
individual households (and businesses) if they have too much debt and not enough savings. A financial advisor should be aware of these
conflicts when discussion investment and wealth planning opportunities.
How do Interest Rates Effect the
Economy
Higher interest rates have a negative effect on growth prospects. Conversely, lower
interest rates can provide a positive environment for economic growth.

Higher Interest Rates:

• Reduce Business Investment: An investment should earn a greater return than the
cost of the funds used to make the investment.
• Encourage Savings / Reduce Consumption: Consumers save and pay down debt
instead of spending

Lower Interest Rates: have the opposite effect on GDP.

Determinants of Interest Rates
A broad range of factors influences interest rates. Some of those factors are
described below:
• Demand and Supply of Capital
• Default Risk
• Foreign Interest rates and the exchange rate
• Central Bank Credibility
• Inflation
Expectations
Investment decisions are forward-looking because any decision to purchase a
security is based on an expectation about its future return
• Increased optimism in the market can generate a rise in stock prices
• Pessimism can stall economic growth, and thus decrease share prices

The expectation of future prices (inflation) is a big determinant of interest rates

• The Bank of Canada makes considerable effort to maintain credibility in its
commitment to lower the inflation rate (Monetary Policy)
• Nominal vs Real Interest Rates: Real = Nominal - Inflation
 Negative Interest Rates
A negative interest rate occurs when the interest rate charged on borrowed funds is less than
zero.
In a negative interest rate environment, banks may charge their customers for keeping deposits
in their account or a bank may pay a customer to take a loan.
A negative interest rate is an unusual scenario, most likely to occur when monetary policy has
already moved interest rates to zero or near zero, but further economic stimulus is required.
When a central bank pushes interest rates into negative territory, thereby charging commercial
banks to store their deposits with the central bank, the commercial banks have an incentive to
lend more money, which in turn may stimulate economic growth.
THE IMPACT OF
INFLATION
Inflation
Inflation is an important economic indicator for because it is the rate at which the
real value of wealth (and purchasing power) is eroded.
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.

• Inflation is a sustained trend of rising prices on goods and services across the
economy over a period.
• In contrast, deflation is a general decrease in prices across the economy.

***A ONE TIME JUMP IN PRICES IS NOT INFLATION***

Measuring Inflation
The inflation rate is the percentage of change in the average level of prices over a
given period.

The Consumer Price Index (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.
Inflation is an important economic indicator for securities markets because it is the
rate at which the real value of an investment is eroded

Example: Assume that you have decided to invest $100,000 today for one year, on
which you will receive a 7% return. However, the inflation rate is expected to be 3%
over the course of the year, so your real rate of return will only be 4%.
Measuring Inflation
Example:
Inflation Rate = CPI Current Period – CPI Previous Period
CPI Previous Period
Measuring Inflation
• In recent history, Canada’s inflation rate reached a high of 12.2% in 1981 and fell as
low as –0.9% in July 2009. The rate declined dramatically in both the early 1980s
and 1990s based on monetary policy actions taken by the Bank of Canada.
Cost of Inflation
• It can erode the standard of living of Canadians, particularly of people on a fixed
income.
• It reduces the real value of investments, such as fixed-rate loans, because the
loans must be paid back in dollars that buy less.
• It distorts the price signals sent to market participants (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
• Initiatives by the government to lower inflation often result in higher interest rates
and higher unemployment.
Causes of Inflation – Supply and
Demand
If demand for all goods and services is higher than what the economy can produce,
prices will increase as consumers compete for too few goods
• This typically occurs as we move from an expansion towards the peak phase of the
business cycle.
• Output expands and consumer income rises, which leads to strong consumer
demand for goods and services
• If businesses have trouble meeting this higher demand, prices begin to rise
• higher and continued consumer demand pushes inflation higher

DEMAND PULL INFLATION

Causes of Inflation – Supply and
Demand
Inflation can also rise or fall due to shocks from the supply side of the economy—
that is, when the costs of production change
• When faced with higher costs of production from higher wages or increases in the
price of rawmaterials…
• …firms respond by raising prices or producing fewer products
• The higher costs push inflation higher.

COST PUSH INFLATION

Deflation / Disinflation
• Disinflation is a decline in the rate at which prices rise (i.e., a decrease in the rate
of inflation). Prices are still rising, but at a slower rate.
• Deflation is a sustained fall in prices, where the annual change in the CPI is
negative year after year. Deflation is simply the opposite of inflation
Costs of Deflation / Disinflation
There is an inverse relationship between inflation and unemployment
• When unemployment is low, inflation tends to be high
PHILLIPS CURVE
• When unemployment is high, inflation tends to be low

According to this theory (Phillips Curve), we can make the following conclusions:
• Lower unemployment is achieved in the short run by increasing inflation at a
faster rate.
• Lower inflation is achieved at the cost of possibly increased unemployment and
slower economic growth.
Costs of Deflation / Disinflation
 Costs of Deflation / Disinflation
GDP is currently $1,000,000. If the government has targeted an ideal range for
inflation of 2% but currently inflation is 5%, the government will attempt to lower
inflation by 3% to meet it’s target. Which of the following scenarios will the
government have to accept?
Phillips Curve: Unemployment : Inflation is -2 : 1.5
A) GDP increases to $1,100,000 with increased unemployment
B) GDP decreases to $900,000 with increased unemployment
C) A decrease in GDP with a corresponding increase in the unemployment rate
D) A 10% increase in the unemployment rate with a corresponding reduction in
GDP
Solution: Inflation needs to be reduced by 3%. => -3/1.5 = -2
Philips Curve (-2x-2) : (-2x1.5) = 4:-3 => if inflation drops 3%, unemployment will rise by 4%, GDP will be negatively effective.
 INTERNATIONAL
FINANCE AND TRADE
Costs of Deflation / Disinflation
• International finance refers to Canada’s interaction with the rest of the world,
including:
• Trade
• Investment
• Capital flows
• Exchange rates

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.
The Balance of Payments
The balance of payments is a detailed statement of a country’s economic
transactions with the rest of the world
The Balance of Payments
• 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.

As an analogy, when you spend more than you earn, you make up the difference by
either borrowing money or selling something of value, and then using the proceeds
to pay off the debt.
Exchange Rates
• The foreign exchange market includes all the places in which one nation’s currency
is exchanged for another, at a specific exchange rate.
• The exchange rate is the current price of one currency in terms of another.

For example, at a given time, it might cost $0.74 U.S. dollars to buy one Canadian
dollar, while at the same time it would cost $1.35 Canadian dollars to buy one U.S.
dollar (1/0.74).
Exchange Rates
A higher Canadian dollar relative to our trading partners makes Canadian exports
more expensive in foreign markets and imports cheaper in Canada (X-M)
A lower Canadian dollar relative to our trading partners makes Canadian exports
less expensive in foreign markets and imports more expensive in Canada (X-M)

Appreciation :When the Canadian dollar rises in value relative to a foreign currency
Depreciation: When the Canadian dollar falls in value relative to a foreign currency
Determinants of Exchange Rates
• Commodities
• Inflation
• Interest Rates
• Trade
• Economic Performance
• Public Debt and Deficits
• Political Stability
QUESTIONS?
Thank you