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SECTION 2 THE ECONOMY 4 Overview of Economics 5 Economic Policy © CANADIAN SECURITIES INSTITUTE  Overview of Economics 4 CHAPTER OVERVIEW T...

SECTION 2 THE ECONOMY 4 Overview of Economics 5 Economic Policy © CANADIAN SECURITIES INSTITUTE  Overview of Economics 4 CHAPTER OVERVIEW This chapter provides an introduction to economics, wherein you will learn about the effect of microeconomic and macroeconomic environments on the financial markets. You will learn how economic growth is measured, and how certain factors determine the health of the economy and help predict the direction the markets might take. You will also learn to understand the indicators that influence investment decision-making, including the phases of the business cycle, the condition of the labour market, and the current state of interest rates. Finally, you will learn to analyze the effect of international economics on the domestic investing environment. LEARNING OBJECTIVES CONTENT AREAS 1 | Define economics and describe the process for Defining Economics achieving market equilibrium. 2 | Describe the process for measuring gross Measuring Economic Growth domestic product and productivity gains in the economy. 3 | Differentiate between business cycle phases The Business Cycle and economic indicators used to analyze current and long-term economic growth. 4 | Compare and contrast labour market The Labour Market indicators and the types of unemployment. 5 | Describe how interest rates affect the The Role of Interest Rates performance of the economy. 6 | Describe inflation and the impact it has on the The Impact of Inflation economy. 7 | Analyze how trade between nations takes International Finance and Trade place through the balance of payments and via the exchange rate. © CANADIAN SECURITIES INSTITUTE 4 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. balance of payments labour force business cycle lagging indicators coincident indicators leading indicators Consumer Price Index macroeconomics cost-push inflation market economy cyclical unemployment microeconomics deflation natural unemployment rate demand negative interest rates demand-pull inflation nominal gross domestic product discouraged workers nominal interest rate disinflation participation rate economic indicators Phillips curve economics productivity equilibrium price real gross domestic product exchange rate real interest rate final good seasonal unemployment frictional unemployment structural unemployment gross domestic product supply inflation underemployed interest rates unemployment rate © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 3 INTRODUCTION Economic news and events are announced regularly, including 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, and monthly data on employment and housing starts. To make wise decisions, investors and advisors should consider the impact these events could have on markets and individual investments. To understand economics is to understand the choices people make and how the sum of those choices affects the production, distribution, and consumption of goods and services. Whether it is the purchase of groceries, a home, or stocks and bonds, the interaction between consumer choices and participants in the economy takes place in an organized market. In such a market, prices are determined by demand and supply for goods and services by consumers, businesses, and governments. An example of an organized market is the Toronto Stock Exchange, where investors come together to buy and sell securities. Millions of transactions carried out each day create a market and establish an equilibrium price for these securities. The buyer and seller of a security clearly have different views about the security. Generally, the buyer believes it will go up in value; the seller believes it will go down. It is likely that some type of economic analysis went into their decisions to buy or sell. Our goal in this chapter is to provide you with a basic understanding of the key economic variables that affect the state of our economy and, consequently, the investment decisions of market participants. As a participant in the securities industry, you should pay daily attention to economic events and consider their impact on individual investments. DEFINING ECONOMICS 1 | Define economics and describe the process for achieving market equilibrium. 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. Ultimately, the interaction between these market participants determines what we pay for a good or service, or for a stock, bond, or mutual fund. 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. © CANADIAN SECURITIES INSTITUTE 4 4 CANADIAN SECURITIES COURSE      VOLUME 1 MICROECONOMICS AND MACROECONOMICS Economics comprises two areas of study: microeconomics and macroeconomics: 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. Some of the contrasts between the two areas are shown in Table 4.1. Table 4.1 | Microeconomics and Macroeconomics Microeconomic Concerns Macroeconomic Concerns How are the prices for goods and services Why did the economy stop growing last quarter? established? Why has the number of jobs fallen in the last year? Why did the price of bread go up? Will lower interest rates stimulate growth in How do minimum wage laws affect the supply of the economy? labour and company profit margins? How can a nation improve its standard of living? How would a tax on softwood lumber imports affect growth prospects in the forestry industry? Why do stock prices rise when the economy is growing? If a government places a tax on the purchase of mutual funds, will consumers stop buying them? How is inflation controlled? THE 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 businesses. 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, hydroelectric plants, and airports. The decisions these groups make, and the ways they interact with each other, ultimately affect the state of the economy. THE MARKET 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 5 DEMAND, SUPPLY, AND MARKET EQUILIBRIUM 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. Two general economic principles help to explain the interaction between demand and supply (assuming other factors remain constant): 1. The quantity demanded of a good or service is the total amount consumers are willing to buy at a particular price during a given period. The higher the price, the lower the demand; and the lower the price, the higher the demand. 2. The quantity supplied of a good or service is the total amount that producers are willing to supply at a particular price during a given period. The higher the price of a good, the greater the quantity supplied. The interaction that takes place between buyers and sellers in the market ultimately determines an equilibrium price for that product. At this price, the number of buyers and sellers is 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. The figure and table below show how market equilibrium in the market for a particular product is established based on demand by consumers and supply by producers. Figure 4.1 shows that the equilibrium price of a particular product is $2,000, and the quantity supplied is 200 units. If the producer tries to sell the product at a higher price, it will have unsold inventory. If the price is set too low, demand for the product will not be satisfied, and the supplier would be able to increase the price. Figure 4.1 | Equilibrium in the Market for a Product Supply $3,000 Equilibrium Point Price $2,000 $1,000 Demand 0 200 500 Quantity Table 4.2 lists the quantities demanded and the quantities supplied at each price level. The one price that ensures a balance between the quantity demanded and the quantity supplied is $2,000. This intersection yields an equilibrium price of $2,000 and an equilibrium supply of 200 units. © CANADIAN SECURITIES INSTITUTE 4 6 CANADIAN SECURITIES COURSE      VOLUME 1 Table 4.2 | Equilibrium in the Market for a Product Price Quantity Demanded (Units) Quantity Supplied (Units) $1,000 500 0 $1,500 350 100 $2,000 200 200 $2,500 150 300 $3,000 10 450 EXAMPLE Demand and supply are equal forces in regulating the price of financial instruments. Consider the following two scenarios: The housing market in Asia is growing rapidly, which results in increased demand for Canadian lumber products. The demand for Canadian dollars rises because manufacturers in Asia need to purchase products from Canada with Canadian dollars. The increased demand results in an increase in the price of the Canadian dollar. Investors see the increased demand for Canadian lumber and choose to invest in companies exporting lumber, which causes the stock price of the company to increase. If a corporation reports poor financial performance, investors who own stock in the company may decide to sell their common shares. The increased supply of the company’s common shares in the marketplace results in a decrease in the price of the shares. MEASURING ECONOMIC GROWTH 2 | Describe the process for measuring gross domestic product and productivity gains in the economy. 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. 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. Economic growth is measured by the increase in GDP from one period to the next. DID YOU KNOW? A final good is something purchased by the ultimate end user. Intermediate goods are products used in the manufacture of final goods. For example, a computer is a final good, whereas the computer chip inside it is an intermediate good, because it is a part of the computer. Only the market value of the computer, the final good, is included in GDP. If the market value of all the computer chips were added together with the market value of all the computers, GDP would be overstated. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 7 Monthly and quarterly GDP reports are used to keep track of the short-term activity within the market, whereas annual reports are used to examine trends, changes in production, and fluctuations in the standard of living. THREE METHODS TO MEASURE GDP There are three generally accepted ways of measuring GDP: the expenditure approach, income approach, and production approach. These methods set out to give an approximation of the monetary value of all the final goods and services produced in the economy. The three approaches generally produce the same number. Expenditure approach 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. Income approach The income approach starts from the idea that total spending on goods and services should equal the total income generated by producing all those goods and services. GDP using the income approach adds up all the income generated by this economic activity. Production approach The production approach, also known as the value-added approach, calculates an industry or sector’s output and subtracts the value of all goods and services used to produce the outputs. 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. Figure 4.2 illustrates the more common expenditure approach formula to calculating GDP. Figure 4.2 | Expenditure Approach to Calculating Gross Domestic Product 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 DID YOU KNOW? What is the purpose of M in the expenditure approach GDP formula? The C, I, and G factors are tallies of all goods and services purchased by consumers, businesses, and governments, and each tally includes expenditures on imports. So rather than try to exclude import transactions each time an imported product or service is purchased, it is easier to add all of the consumption in the formula and then subtract imported goods and services to factor out expenditures on goods produced outside of Canada. Since exports are added to GDP, and exports are the opposite of imports, the formula groups X and M together and refers to this part of the formula as net exports. © CANADIAN SECURITIES INSTITUTE 4 8 CANADIAN SECURITIES COURSE      VOLUME 1 REAL AND NOMINAL GROSS DOMESTIC PRODUCT In general, when a nation produces more goods and services, its standard of living improves. However, 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 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. 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. 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. EXAMPLE Assume the financial press reports that nominal GDP grew by 4.4% last year and prices rose by 1.1%. Is this a good outcome for the economy? In nominal terms, the economy grew by 4.4%, which is a good amount of economic growth. However, when we adjust by 1.1% for the effect of rising prices, real economic growth was actually 3.3% (4.4% − 1.1%). The nation was more productive this year than last, but not as much as the nominal GDP might lead you to believe. However, what if the financial press reported that nominal GDP grew by 2.4% last year, whereas prices rose by 3.1%? Is this bad news for the economy? In nominal terms, the economy grew by 2.4%, but if we adjust by 3.1% for inflation, we see that the economy actually shrank by approximately 0.7% (2.4% − 3.1%). Real GDP growth therefore was negative, which means that the nation was actually less productive last year than the year before. PRODUCTIVITY AND DETERMINANTS OF ECONOMIC GROWTH 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 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 9 THE BUSINESS CYCLE 3 | Differentiate between business cycle phases and economic indicators used to analyze current and long-term economic growth. 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. This concept is illustrated in Figure 4.3, which shows the annual percentage growth of GDP in Canada over several decades. In this diagram, we can see that real GDP has grown on average by about 3.4% since the 1960s. However, growth has not been uniform over that time. It was most rapid in the 1960s, but several periods of negative growth occurred over the past three decades. During years in which growth was negative, our GDP declined. Note that the annual chart reflects the impact of the worldwide pandemic that affected Canadian and other economies around the world starting in the first quarter of 2020. Figure 4.3 | Annual Growth Rate in Canada’s Real Gross Domestic Product 8 7 6 5 4 Growth % 3 2 1 0 -1 -2 -3 -4 -5 -6 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Year Source: Statistics Canada PHASES OF THE BUSINESS CYCLE 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. © CANADIAN SECURITIES INSTITUTE 4 10 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 4.4 | Phases of the Business Cycle Rising Trend in GDP Peak Peak Co nt on ra ct si ion an E xp Peak A Co n y nt io ver ra s ct an co io GDP A E xp Re n Co on nt y rac ver si an on ti co A E xp Re Trough y ver co Re Trough Trough Time 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 rise in 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. 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. 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 11 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. 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. A contraction is characterized by the following activities: Economic activity begins to decline, and real GDP decreases. Faced with unwanted inventories and declining profits, businesses 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 price falls lower. DID YOU KNOW? We live in a global economy. We export and import billions of dollars in goods and services each day. Therefore, Canadian consumers and businesses are affected by the state of the economy of our trading partners. For example, if the United States is in a contraction or recession, Canada’s exports to the United States decline, which has a negative impact on our GDP. When major U.S. customers stop buying products and paying bills, Canadian export companies are directly affected. Canadian companies may then struggle to repay their loans, and the risk of lending money to them increases. Therefore, lenders charge higher interest rates, which further increases the companies’ struggle to remain profitable. TROUGH 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. 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. 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: Businesses 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. © CANADIAN SECURITIES INSTITUTE 4 12 CANADIAN SECURITIES COURSE      VOLUME 1 Businesses are not yet ready to make a significant new investment. Unemployment remains high, wage pressures are restrained, and inflation may decline further. When the economy rises above its previous peak, at point A in Figure 4.4, another expansion has begun. 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. 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. Economic indicators are classified as leading, coincident, or lagging: 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. Examples of the different types of indicators are described in Table 4.3. Table 4.3 | Using Economic Indicators 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. Manufacturers’ 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 The average number of work hours rises or falls depending on the level of output, per week 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. Coincident Indicators Personal income When personal income is rising, people have more money to spend, which GDP encourages an increase in GDP, industrial production, and retail sales. Industrial production Retail sales © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 13 Table 4.3 | Using Economic Indicators Lagging Indicators Unemployment Unemployment is a key lagging indicator. Unemployment rates go up or down Inflation rate 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 Labour costs then falls and labour costs go up. Likewise, as the economy recovers, businesses Private sector plant can be expected to spend more on plants and equipment and borrow more money and equipment spending to fund growth. Business loans and interest on such borrowing IDENTIFYING RECESSIONS Statistics Canada judges a recession by the depth, duration, and diffusion of the decline in business activity. Its judgment is based on the following criteria: Depth The decline must be of substantial depth. For example, marginal declines in output can be merely statistical errors. Duration The decline must last more than a couple of months. For example, bad weather alone can cause a temporary decline in output. Diffusion The decline must be a feature of the whole economy. For example, a strike in a major industry can cause GDP to decline, but that lone incident does not constitute a recession for the whole country. DID YOU KNOW? Recent Economic Slowdowns and Recessions in Canada DATES DURATION * April 2001 to September 2001 5 months July 2008 to July 2009 12 months March 2020 to August 2020 6 months In March 2020, Canada’s real GDP fell by more than 7% for the month as a result of the worldwide pandemic. Canada’s GDP finished 2020 5.4% lower than the previous year. In the first quarter of 2021, Canada’s real GDP growth rate was 1.38%. Canadian GDP has grown significantly since the second quarter of 2020. * Technically, this was a growth slowdown or downturn, not a recession. Source: Adapted from Statistics Canada, www.statcan.gc.ca. © CANADIAN SECURITIES INSTITUTE 4 14 CANADIAN SECURITIES COURSE      VOLUME 1 THE LABOUR MARKET 4 | Compare and contrast labour market indicators and the types of unemployment. Statistics Canada defines the working-age population as people 15 years of age and older. It further divides this population into three groups: Those who are unable to work Those who are not working by choice The labour force The working population that falls under each of those three groups is identified in Table 4.4. Table 4.4 | The Working Age Population Unable to work Not working by choice The labour force People institutionalized in: Full-time students People who are working Psychiatric hospitals Homemakers People who are not working but are actively looking for work Correctional facilities Retirees Discouraged workers LABOUR MARKET INDICATORS There are two key indicators that describe activity in the labour market: the participation rate and the unemployment rate. 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 workforce and take jobs. 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). Both of these rates are calculated as follows. Labour Force Participation Rate = ´ 100 Working Age Population Not Working but Actively Looking for Work Unemployment Rate = ´ 100 Labour Force © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 15 EXAMPLE Assume that a country has 25 million people of working age. Of those 25 million, 19 million are working and 1 million are not working but are actively looking for work. The remaining 5 million people are not working and not actively looking for work. Some people in this group are students, some are retired, and some are discouraged and have stopped looking for work. Using these figures to calculate the country’s participation rate, you would enter the numbers into the following equation as follows: Labour Force = 19 M + 1M = 20 M 20 M Participation Rate = ´ 100 = 80% 25 M The unemployment rate is defined as the share of the labour force that is unemployed and actively looking for work. Using these figures to calculate the country’s unemployment rate, you would enter the numbers into the following equation as follows: 1M Unemployment Rate = ´ 100 = 5% 20 M In Canada, the participation rate has increased since the 1960s, primarily because of the increased participation of women in the workforce. For the past decade, Canada’s participation rate averaged approximately 65.5%. 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. Figure 4.5 shows the patterns in the annual Canadian unemployment rate since the 1960s. In general, the upward trend with large fluctuations corresponds to the trend and stages of the business cycle. In this figure, you can see a strong correlation between declining GDP that occurs in recessionary periods and increased unemployment. Though the monthly unemployment rate in Canada jumped from 5.6% in February 2020 to 7.8% in March and to 13.0% in April as a result of measures taken against the worldwide pandemic, the annual unemployment rate dropped to 5.8% in December 2023. © CANADIAN SECURITIES INSTITUTE 4 16 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 4.5 | Annual Unemployment Rate in Canada (%) 14 14 13 13 12 12 11 11 10 10 9 9 8 8 Unemployment Rate (%) 7 7 6 6 Growth % 5 5 4 4 3 3 2 2 1 1 0 0 -1 -1 -2 -2 -3 -3 -4 -4 -5 -5 -6 -6 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Year Legend: Unemployment Rate Growth Source: Statistics Canada Some detractors argue that flaws exist in the way unemployment is measured. For example, 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 17 Detractors also argue that 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. Cyclical As the name suggests, cyclical unemployment is tied directly to fluctuations in the unemployment business cycle. It rises when the economy weakens, and workers are laid off in response to lower sales; it drops when the economy strengthens again. Seasonal Some industries operate only during part of the year. For example, farmhands are hired unemployment to pick fruits and vegetables only during the months of June to October. In the winter months, seasonal unemployment is a regular occurrence in such industries. Frictional Frictional unemployment consists of the normal labour turnover that occurs when unemployment people enter and leave the workforce, and during the ongoing creation and destruction of jobs. Even in the best of economic times, people can be out of work for various reasons, including having recently finished school, having quit a job, having been laid off from work, or having been fired. This type of unemployment is a normal part of a healthy economy. It declines when jobs are matched more efficiently to potential workers. Structural Structural unemployment reflects a mismatch between jobs and potential workers. unemployment It occurs when workers are unable to find work or fill available jobs because they lack the necessary skills, do not live where jobs are available, or decide not to work at the wage rate offered by the market. This type of unemployment is closely tied to changes in technology, international competition, and government policy. It typically lasts longer than frictional unemployment because workers must retrain or possibly relocate to find a job. 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. MEASURING GROWTH How do you measure economic growth, and what are the key factors that influence that growth? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 4 18 CANADIAN SECURITIES COURSE      VOLUME 1 THE ROLE OF INTEREST RATES 5 | Describe how interest rates affect the performance of the economy. 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. For businesses, interest rates represent one component of the cost of capital—that is, the cost of borrowing money. Therefore, the rate of growth of the capital stock, which determines future output, is related to the current level of interest rates. Interest rates are essentially the price of credit. 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. For example, when interest rates rise, the cost of borrowing also increases. Higher borrowing costs can have a negative impact on the profits of businesses that need to borrow, which in turn may cause their share prices to fall. DETERMINANTS OF INTEREST RATES A broad range of factors influences interest rates. Some of those factors are described below: Demand and supply A large government deficit or a boom in business investment raises the demand for of capital capital and forces interest rates to rise. Therefore, unless there is an equivalent increase in the supply of capital, the price of credit also rises. In turn, higher interest rates may encourage government, businesses, and consumers to save more. An increase in savings may reduce demand for borrowing, which in turn may reduce interest rates. Default risk If interest rates rise, consumers and businesses may have trouble paying back borrowed funds or default on loans. The greater the risk of default, the higher the interest rate demanded by lenders. If the central government is at risk of defaulting on its debt, interest rates rise for everybody. This additional interest rate is referred to as a default premium. Foreign interest rates Because Canada has an open economy, investors are free to move their money and the exchange rate between Canada and other countries. Therefore, foreign interest rates and financial conditions can also influence Canadian interest rates. For example, a rise in the U.S. interest rate increases returns on U.S. investments. Investors holding Canadian dollars wishing to invest in the United States must sell their Canadian dollars to purchase U.S. dollar-denominated securities. This activity increases the supply of Canadian dollars on the foreign exchange market and places downward pressure on the value of the Canadian dollar. If the Bank of Canada decides to slow or reduce this fall in value, it can intervene and raise short-term interest rates, even if underlying conditions in Canada are unchanged. This measure encourages investors to continue holding Canadian investments rather than switch to U.S. dollar-denominated securities. Central bank Central banks of different countries (including the Bank of Canada) exercise their credibility influence on the economy by raising and lowering short-term interest rates. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 19 Inflation When the inflation rate is expected to rise, lenders charge higher interest rates to compensate for the erosion of the money’s purchasing power over the duration of the loan. One of the Bank of Canada’s main responsibilities is to keep inflation low and stable. When commitment to low inflation has been credible and long-established, interest rates drop to compensate for the risk of rising inflation. HOW INTEREST RATES AFFECT 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 tend to affect the economy in the following ways: They reduce business An investment should earn a greater return than the cost of the funds used to make the investment 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. 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. They reduce Higher interest rates increase the portion of household income that is needed to service consumption 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. EXPECTATIONS AND INTEREST RATES 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, whereas pessimism can stall economic growth, and thus decrease share prices. Government economic policies also have an impact on people’s expectations. For example, the Bank of Canada makes a considerable effort to maintain credibility in its commitment to lower the inflation rate. The role of expected inflation is particularly important in determining the level of nominal interest rates. As we discussed earlier, the difference between nominal GDP and real GDP is the effect of inflation. The concept here is the same. The nominal interest rate is one where the effect of inflation has not been removed. The rate charged by a bank on a loan is the nominal interest rate, as is the quoted rate on an investment such as a guaranteed investment certificate or Treasury bill. Other things being equal, the higher the rate of inflation, the higher the nominal interest rate. In contrast, a good estimate of the real interest rate is the nominal interest rate minus the expected inflation rate. EXAMPLE Assume that you need to earn a real rate of return of 6% from your investments to fund your retirement goals. If inflation is expected to be 3%, you will only go ahead with your investment plans if you can earn a nominal rate of return of 9% (6% + 3%). © CANADIAN SECURITIES INSTITUTE 4 20 CANADIAN SECURITIES COURSE      VOLUME 1 DIVE DEEPER If you want to learn more about the real interest rate, search online for the Fisher Equation. Subtracting the inflation rate from the nominal rate provides a rough approximation of the real interest rate, and is a good estimation for the purposes of this course. The Fisher Equation provides a more complex and precise formula. 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 accounts or a bank may pay a customer to take a loan. The latter seems almost too good to be true since under negative interest rates, the borrower does not have to make any interim interest payments over the term of the loan (only makes periodic payments related to principal amortization), and is only required to repay a discounted amount of the total original loan at maturity. 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. NEGATIVE INTEREST RATES IN THE U.S. AND CANADA Prior to 2020, negative interest rates prevailed mostly in some EU countries and in Japan. The U.S. appeared immune to negative interest rates up until aggressive monetary and fiscal policy programs were launched in response to the potential debilitating effects of the COVID-19 pandemic on the U.S. economy, in general, and U.S. unemployment levels, in particular. However, on March 25, 2020, history was made in the U.S. when both the one- and three-month U.S. Treasury bills traded at negative yields for the first time. As of May 2020, negative interest rates in the U.S. had not appeared again. In Canada, none of the Bank of Canada’s administered rates had reached negative territory. Due to various fundamental factors, Canadian interest rates are normally higher than their U.S. equivalents. This provides a buffer if (or when) negative interest rates appear in Canada. Of course, there is always the risk that U.S. government bond market yields could move into negative territory. Depending on the size and extent of this move, Canada would also end up with negative interest rates, which would start with Treasury bills and possibly extend to short- and mid-term government bonds. THE IMPACT OF INFLATION 6 | Describe inflation and the impact it has on the economy. Prices for goods and services can rise, fall, or remain unchanged, depending on the conditions in the market. 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 caused by an increase in the price of oil or by the introduction of a new sales tax, for example, is not true inflation. The true definition of inflation requires that prices continue to increase. Likewise, a rise in the price of one product is not in itself inflation; it may merely reflect the increased scarcity of that product. 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 21 EXAMPLE Last year, you estimated that you would need $3,000 to live on each month. However, with increasing inflation, you are now finding that you need $3,200 per month to buy the same things that once cost you $3,000. Unfortunately, if your income does not increase at the same rate, your standard of living will soon deteriorate. 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%. DID YOU KNOW? The Nature of Money Money can be defined as any object that is accepted as payment for goods and services and that can be used to settle debts. Its function as a medium of exchange is essential. Without money, goods and services would need to be exchanged with other goods and services, in a form of the barter system. Money acts as a unit of account, allowing us to determine the exact price of a good or service. Money also represents a store of value. It does not have an expiration date. Consumers can decide to save it for use in the future. The more stable the value of money, the better it can act as a store of value. 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) 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. The following equation uses CPI to calculate the inflation rate: CPI Current Period - CPI Previous Period Inflation Rate = ´ 100 CPI Previous Period EXAMPLE Assume that total CPI at the end of the previous year was 146.8, and at the end of this year it was 154.5. In such a scenario, the inflation rate for that time period would be calculated as follows: 154.5 - 146.8 Inflation Rate = = 0.052452 ´ 100 = 5.2% 146.8 © CANADIAN SECURITIES INSTITUTE 4 22 CANADIAN SECURITIES COURSE      VOLUME 1 DID YOU KNOW? Statistics Canada currently monitors the retail price of a fictional basket of goods that comprises 600 different goods and services. Each item in the basket is weighted to reflect typical consumer spending. In this way, the CPI represents a measure of the average of the prices paid for this basket of goods and services. Statistics Canada has the difficult task of creating a fictional basket of goods and services that is representative of the typical Canadian household. Its goal is to make the relative importance of the items included in the CPI basket the same as that of an average Canadian household. However, it is almost impossible to construct a basket that is representative of the needs of all consumers. For example, the spending patterns of a family with young children are not the same as the spending patterns of a retired couple. 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. The inflation rate also dropped to a negative value of −0.2% in April 2020 and −0.4% in June 2020 as a result of the effects of the coronavirus pandemic. Figure 4.6 shows the annual inflation rate in Canada dating back to the 1960s. Figure 4.6 | The Annual Inflation Rate in Canada 13 12 11 10 9 8 Inflation Rate % 7 6 5 4 3 2 1 0 -1 -2 -3 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Year Source: Bank of Canada © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 23 THE COSTS OF INFLATION Inflation imposes many costs on the economy for the following reasons: 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. Initiatives by the government to lower inflation often result in higher interest rates and higher unemployment. Both changes have a negative impact on economic growth. We explore this topic in detail in the section on monetary policy in Chapter 5. THE CAUSES OF INFLATION An important determinant of inflation is the balance between supply and demand conditions in the economy. 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 toward the peak phase of the business cycle. In such cases, 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. In this way, higher and continued consumer demand pushes inflation higher. This state of affairs is called demand-pull inflation. 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 raw materials, businesses respond by raising prices or producing fewer products. The higher costs push inflation higher. This state of affairs is called cost-push inflation. DEFLATION AND DISINFLATION Although costs are normally associated with rising inflation, a falling rate of inflation can also have a negative impact on the economy. 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. Falling prices are generally preferred over rising prices. Goods and services become cheaper, and our income has more buying power than it used to. Although this is true in the short term, there are negative consequences of deflation. COSTS OF DEFLATION AND DISINFLATION In general, there is an inverse relationship between inflation and unemployment. When unemployment is low, inflation tends to be high; when unemployment is high, inflation tends to be low. This relationship is described by the Phillips curve. According to this theory, 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. © CANADIAN SECURITIES INSTITUTE 4 24 CANADIAN SECURITIES COURSE      VOLUME 1 Some economists believe that the impact of sustained falling prices eventually leads to a decline in corporate profits. As prices continue to fall, businesses must sell their products at lower and lower prices. Businesses cut back on production costs and wage rates, and if conditions worsen, lay off workers. For the economy as a whole, unemployment rises, economic growth slows, and consumers shift their focus from spending to saving. Ultimately, declining company profits negatively impact stock prices. OTHER INFLATIONARY ENVIRONMENTS Although inflation, deflation, and disinflation represent most inflation scenarios, historically, two additional environments come under consideration when required. These are defined in Table 4.5. Table 4.5 | Stagflation and Hyperinflation Stagflation High inflation rate Slowing rate of economic growth Hyperinflation Extremely high inflation rate (defined as greater than 50% per month) Occurs infrequently Generally limited to underdeveloped economies Many economists view the 1972 to 1982 period as a stagflation environment for most western economies. Stagflation is primarily attributed in this case to the combination of high inflation brought on by the two Arab oil embargoes in the 1970s coupled with the sub-par economic growth that resulted. The potential for stagflation in western economies has become a greater concern recently. Some analysts fear that the aggressive fiscal and monetary policies applied during the Covid-19 crisis will result in high inflation accompanied by slower economic growth. Hyperinflation is frequently associated with the Weimar Republic in the early 1920s. However, a more recent example is Venezuela, where the country’s central bank estimated that the inflation rate exceeded 53,000,000% between 2016 and 2019. INTEREST RATES AND INFLATION How do interest rates and inflation affect the economy? Complete the online learning activity to assess your knowledge. INTERNATIONAL FINANCE AND TRADE 7 | Analyze how trade between nations takes place through the balance of payments and via the exchange rate. 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. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 25 This relationship holds true within Canada as well. When Canada experiences growth and income rises, we spend more on goods and services, both domestic and imported. THE BALANCE OF PAYMENTS 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 This account records financial flows between Canadians and foreigners, related to account investments by foreigners in Canada and investments by Canadians abroad. Balance of payments transactions incur a supply, or demand, of foreign currency and a corresponding supply, or demand, of Canadian currency. Current account outflows might be used to buy foreign goods or to pay interest on debt held by foreigners thus creating a demand for foreign currency to make those payments. Canadian dollars are offered in exchange for this foreign currency unless there is a corresponding demand for Canadian dollars. 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. 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. THE EXCHANGE RATE Buying foreign goods or investing in a foreign country requires the use of another currency to complete the transactions. Likewise, when foreign buyers purchase Canadian goods or invest in Canadian assets, they need Canadian dollars. 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 $0.80 U.S. dollars to buy one Canadian dollar, while at the same time it would cost $1.25 Canadian dollars to buy one U.S. dollar (1/0.80). THE EXCHANGE RATE AND THE CANADIAN DOLLAR 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. © CANADIAN SECURITIES INSTITUTE 4 26 CANADIAN SECURITIES COURSE      VOLUME 1 EXAMPLE Let’s assume that a machine made in Canada sells for $1,000 in Canada. With the exchange rate of the Canadian dollar at $0.80 U.S., the machine will sell for $800 in the United States. If a similar product sells for $850 in the United States, the Canadian manufacturer benefits because, at the current exchange rate, the machine will sell for a lower price than its competitor in the U.S. market. However, let’s assume that the exchange rate appreciates in value to US$0.90. The machine will now sell for US$900, making the Canadian manufacturer less competitive in the U.S. market. Sales, and corporate profitability, would likely then decrease. Figure 4.7 shows the exchange rate between Canada and the United States from 1975 to 2023. The figure shows an almost consistent depreciation of the Canadian dollar against the U.S. dollar from about 1976 to 2002, other than a brief period in the late 1980s when it appreciated for several years. This downward trend reversed beginning in early 2003, as the currency rose steadily against the U.S. dollar. In fact, the Canadian dollar traded above par (US$1.00) in 2007 for the first time since the mid-1970s. In recent years, however, the Canadian dollar has undergone a substantial depreciation against the U.S. dollar. Figure 4.7 | How the Canadian Dollar Has Traded Against the U.S. Dollar 1.2 1.1 1.0 US$ 0.9 0.8 0.7 0.6 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Year Source: Bank of Canada DETERMINANTS OF EXCHANGE RATES Many economists and analysts, including those employed at the Bank of Canada, pay close attention to the currency exchange rate to predict its direction. Some countries fix the value of their currency so that it is constant in comparison to their major trading partner. Canada, however, allows its currency to float freely. Generally, the Bank of Canada does not intervene to support the Canadian dollar, but it might choose to intervene to slow down and stabilize the rate of change in the exchange rate. The following factors are widely accepted as influencing the exchange rate, although the weight ascribed to each factor is widely debated: © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      OVERVIEW OF ECONOMICS 4 27 Commodities One of the strongest influences on the Canadian exchange rate is the price level of commodities. Canada is heavily dependent on the export of natural resources to other countries, including commodities such as lumber, base metals, crude oil, and wheat. Countries around the world that buy Canadian products need Canadian dollars to finance their purchases. As the demand for commodities increases, the demand for Canadian dollars also rises. Inflation Over time, the currencies of countries with consistently lower inflation rates rise, reflecting their increased purchasing power relative to other currencies. Interest rates Central banks can influence the value of their exchange rate by raising and lowering short-term nominal interest rates. Higher domestic interest rates increase the return to lenders relative to other countries. This attracts capital and lifts the exchange rate because the foreign investor must buy Canadian dollars to invest. Lower interest rates have the opposite effect. However, the impact of higher interest rates is reduced if domestic inflation is also much higher or if other factors are driving the currency down. Trade When we export goods and services, other countries must buy Canadian dollars to pay for the goods, which increases the demand for, and value of, Canadian dollars. When importing goods we must sell Canadian dollars and buy the currency of the country we are importing from. This increases the supply of Canadian dollars, which causes downward pressure on the value of the currency. Economic performance A country with a strongly growing economy may be more attractive to foreign investors because it improves investment returns and attracts investment capital. Public debts and Countries with large public-sector debts and deficits are less attractive to foreign deficits investors. Political stability Investors seldom like to invest in countries with unstable or disreputable governments, or those at risk of disintegrating politically. Therefore, political turmoil in a country can cause a loss of confidence in its currency and what is known as a flight to quality, a rush to exchange the country’s currency to that of more politically stable countries. CASE SCENARIO Can you help answer questions raised by Manny about the labour market? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 4 28 CANADIAN SECURITIES COURSE      VOLUME 1 SUMMARY In this chapter, we discussed the following key aspects of economics: The three main decision makers in the economy are consumers, businesses, and governments. Demand and supply are the forces that determine market equilibrium. GDP is the market value of all finished goods and services produced within a country within a given time. GDP is measured using three approaches: The expenditure approach, where GDP is the sum of personal consumption, investment, government spending, and net exports The income approach, where GDP is the total income earned through the production of all goods and services The production approach, where GDP is the sum of all output less the value of all goods and services purchased to produce the output The five phases in a typical business cycle are recovery, expansion, peak, contraction, and trough. Leading, lagging, and coincident economic indicators are used to analyze the current state of the economy. Improvements in long-term economic growth are attributed to improvements in productivity. The participation rate is the share of the working-age population that is in the labour force. The unemployment rate represents the share of the labour force that is unemployed and actively looking for work. The four types of unemployment are cyclical, frictional, seasonal, and structural. Interest rates are influenced by demand for and supply of capital, default risk, central bank operations, foreign interest rates, and inflation. Higher interest rates lead to slower economic growth, whereas lower rates encourage growth. Inflation is a sustained trend of rising prices measured on an economy-wide basis. It is measured using the CPI. Rising inflation reduces the real value of investments; it typically brings about rising interest rates and slower economic growth. A country’s balance of payments is a detailed statement of its economic transaction with the rest of the world. The exchange rate is the price of one currency in terms of another, which is determined by inflation and interest rate differentials, economic performance, public debt and deficits, and political stability. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 4 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 4 FAQs. © CANADIAN SECURITIES INSTITUTE  Economic Policy 5 CHAPTER OVERVIEW In this chapter, you will learn about economic policy, both fiscal and monetary, and the impact of government policy decisions on the investment landscape. In this context, you will learn about the roles and functions of the Bank of Canada and the challenges that governments face in setting their economic policies. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the components of fiscal policy and Fiscal Policy their impact on economic performance. 2 | Explain the roles and functions of the Bank The Bank of Canada of Canada. 3 | Analyze how the Bank of Canada implements Monetary Policy and conducts monetary policy. 4 | Summarize the challenges governments face The Challenges of Government Policy when implementing fiscal and monetary policy. © CANADIAN SECURITIES INSTITUTE 5 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. balanced budget Lynx Bank Rate monetary policy basis points national debt budget deficit overnight rate budget surplus overnight repo drawdown overnight reverse repo fiscal agent Payments Canada fiscal policy redeposit © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      ECONOMIC POLICY 5 3 INTRODUCTION Once a year, typically in February, the federal minister of finance announces the government’s budgetary requirements. The statement serves as the government’s annual fiscal policy score card of spending and taxation measures. Not far from Parliament Hill, the Bank of Canada uses monetary policy to maintain balance in the economy. The government also exerts influence over interest rates and the exchange rate toward that goal. The government operates largely independently from the Bank of Canada. However, they both share the goal of creating conditions for long-term, sustained economic growth. This chapter explores fiscal and monetary policy, particularly from the standpoint of making investment decisions. For example, if the economy is moving through expansion into the peak phase of the business cycle, what monetary policy initiative is the Bank of Canada likely to consider? If the economy has been stalled in recession and unemployment continues to rise, what fiscal policy initiative is the federal government likely to consider? Given your understanding of their likely course of action in each situation, what investments or strategies would you pursue? Economic policy and the policy decisions made by the federal government and the Bank of Canada are key factors in making investment decisions. Therefore, it is important that you understand the difference between fiscal and monetary policy, and that you can explain how policy actions affect the financial markets. Your knowledge in this area will help you make investment decisions based on current economic conditions, and on the likely impact that fiscal and monetary policy decisions may have on those investments. FISCAL POLICY 1 | Describe the components of fiscal policy and their impact on economic performance. Fiscal policy informs government decisions around the use of its spending and taxation powers. A government’s fiscal policy influences economic activity, employment levels, and sustained long-term growth. Most fiscal policy is a balancing act between taxes and spending. There are differing views about the effectiveness of fiscal policy. Both federal and provincial governments implement certain elements of fiscal policy. The federal government is responsible for services including national defence, employment insurance, pension income for seniors and the disabled, veterans’ affairs, foreign affairs, and indigenous and northern affairs. Provincial governments are responsible for other services including health care, education, securities regulation, and various social services. However, both the federal and provincial governments share some level of responsibility for those areas. A large segment of federal spending consists of transfer payments to the provincial governments to help pay for such shared responsibilities. THE FEDERAL BUDGET The government’s revenue comes primarily from different forms of taxation. The government’s budget balance is equal to that revenue less total spending. The federal budget contains projected spending, revenue, surplus or deficit, and debt for the coming fiscal year, which runs from April 1 to March 31, plus at least one subsequent year. The government’s proposed annual budget has one of the following three possible positions: Proposed Annual Budget Budget Position Revenue > Spending = Budget surplus Revenue < Spending = Budget deficit Revenue = Spending = Balanced budget © CANADIAN SECURITIES INSTITUTE 5 4 CANADIAN SECURITIES COURSE      VOLUME 1 The national debt consists of accumulated past deficits minus accumulated past surpluses in the federal budget. When the government runs a deficit, it must borrow from the capital markets to finance the national debt. The amount of the surplus or deficit each year, along with the current national debt, are the most important numbers in the budget. These amounts indicate the extent to which the government will be borrowing in the coming year and the impact it will have on the capital markets. Governments finance deficits by issuing debt instruments such as bonds and Treasury bills in the capital markets. Some of the national debt may also mature in that year and must therefore be refinanced. Government borrowings comprise these two amounts: refinanced debt and new debt. Capital markets have a finite amount of capital. Therefore, when a government borrows significantly from the capital markets, less capital remains for businesses to borrow.