CSC Volume 1 (ch 4) - canadian securities chapter 4 PDF

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CSC Volume One Chapter 4 Economic Principles Foundation of Economics  Economics is a fundamentally about understanding the choices individuals make and how the sum of those choices determines what happens in our market economy  A market economy describes all of the activities related to producing and consuming goods and services, and how the decisions made by individuals, firms and governments determine the proper allocation of resources  Economics is divided into two main topic areas: microeconomics & macroeconomics  Microeconomics  Analyzes the market behaviour of individual consumers and firms  Looks to answer such questions as:  How prices are determined, how prices determine the production, distribution, and use of goods and services  Macroeconomics  Focuses on the performance of the economy as a whole  It looks at the broader picture and to the challenges facing society as a result of the limited amounts of natural resources, human effort and skills, and technology  Focuses on such important issues as unemployment, inflation, recessions, government spending and taxation, poverty and inequality, budget deficits and national debts  The Decision Makers  There are three main groups that interact in the economy 1. Consumers – set out to maximize their satisfaction or well-being within the limitations of their available resources – income from employment, investments or other sources 2. Firms – set out to maximize profits by selling their goods or services to consumers, governments or other firms 3. Governments – spend money on education, health care, employment training and the military  Factors of production  Are the resources that these decision makers use to produce goods and services and include labour, natural resources, capital and entrepreneurship  Capital – includes the tools, machinery and instruments used to produce goods and services  The Market – the activity between consumers, firms 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  Within any market, there is a circular flow of goods and services and factors of production, between consumers and firms

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Foundation of Economics (continued)  Demand and Supply  The price paid for a good or service is determined by the interaction between demand and supply  Consumers decide how much of a good or service to buy, while suppliers decide how much of a good or service to sell in the market  The quantity demanded of a good or service is the total amount consumers are willing to buy at a particular price during a given time period  Law of Demand – the higher the price of a good or service the lower its demand, while the lower the price the higher its demand, other factors held constant  Supply – 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 time period  Law of Supply – the higher the price of a good, the greater the quantity supplied  Market Equilibrium  Occurs when the buying decisions of consumers and the selling decisions of producers balance themselves out  In other words, equilibrium occurs when the price consumers are willing to pay for a good matches the price at which producers are willing to supply it Economic Growth  Is an economy’s ability to produce greater levels of output over time and is expressed as the percentage change in a nation’s gross domestic product (GDP) over a given period  By measuring growth, we can better gauge the performance and overall health of the entire economy  Productivity and Determinants of Economic Growth  Since the industrial revolution, the GDP of industrialized economies has tended to grow over time  Growth in GDP results from a variety of factors: among the more important:  Increases in population over time. Even if the output of every worker remained constant, GDP would rise due to the growing work force  Increases in the capital stock. As more workers are provided with additional equipment and as their skills have been improved with better training and education, individual productivity rises  Improvements in technology. Technological innovation helps firms and workers to recombine existing resources of land, capital and labour in new and increasingly productive ways.

The Business Cycle

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Real GDP in Canada has grown on average by about 3.5% since the 1960s In fact, growth was the most rapid in the 1960s and slowest during the 1980s Economic fluctuations present a recurring problem for policy makers as downturns in economic growth are directly related to rising unemployment Such fluctuations in output and employment are called the business cycle Phases of the Business Cycle  Expansion o In times of normal growth, the economy is steadily expanding o Inflation is stable, businesses have adjusted inventories to meet higher demand and are investing in new capacity to meet increased demand to avoid shortages o Corporate profits are rising, new business start-ups outnumber bankruptcies, and stock market activity is strong o Job creation is steady and the unemployment rate is steady or falling o Overall, the growth rate of real GDP is rising during an expansion  Peak o In the final stages of the expansion, demand begins to outstrip the capacity of the economy to supply it o Labour and product shortages cause wage increases and inflation to rise o As a result, interest rates rise and bond prices fall o This begins to dampen business investment and reduce sales of houses and big-ticket consumer goods o Business sales decline, resulting in accumulation of unwanted inventory and reduced profits o Stock prices fall and stock market activity declines  Contraction o The economy contracts, or is in recession, when the level of economic activity actually begins to decline – e.g., real GDP decrease o Firms faced with unwanted inventories and declining profits reduce production, postpone investment, curtail hiring and may lay off employees o Business failures outnumber start-ups o Falling employment erodes household income and confidence o Consumers react by spending less abd saving more, which further cuts into sales, fuelling the recession  Trough o As the recession continues, falling demand and excess capacity curtail the ability of firms to raise prices and of workers to demand higher salaries and inflation falls o Interest rates follow, triggering a bond rally o The through is reached when consumers who postponed purchases during the recession are spurred by lower interest rates to begin satisfying some of their pent-up demand o Stock prices rally

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Phases of the Business Cycle (continued)  Recovery o During the recovery, GDP returns to its previous peak o The recovery typically begins with renewed buying of interest ratesensitive items like houses and cars o Firms that reduced inventories during the recession must increase production to meet the new demand o They are typically still too cautious to hire back significant numbers of workers, but the period of widespread layoffs is over o Capacity utilization, or the degree to which businesses are making use of their production power, remains low, so firms are yet ready to make significant new investment o Since unemployment remains high, wage pressures are restrained and inflation may decline further o When the economy rises above its previous peak, another expansion has begun

Economic Indicators  Are statistics or data series that are used to analyze business conditions and current economic activity  They can help to show whether the economy is expanding or contracting  Leading Indicators  Tend to peak and through before the overall economy  They are designed to anticipate emerging trends in economic activity  Are the most useful and widely used of the economic indicators since they anticipate change by indicating what businesses and consumers have actually begun to produce and spend  E.g., housing starts and manufactures’ new orders, especially for durables (which indicate expectations of higher levels of consumer purchases of such items as automobiles and appliances)  Composite Leading Indicator o Statistics Canada combines 10 leading indicators into a single index of leading indicators 1. S&P/TSX Composite Index 2. Real Money Supply (M1) 3. US Composite Leading Index (attempts to anticipate American demand for Canadian exports) 4. New Orders for Durable Goods 5. Shipments to Inventory Ratio – Finished Goods 6. Average Work Week 7. Employment in Business and Services 8. Furniture and Appliance Sales 9. Sales of Other Retail Durable Goods 10. House Spending Index (includes housing starts and house sales)

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Economic Indicators (continued)  Coincident Indicators  Are those which 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  Personal income is a good example because if it is rising, economic growth will typically follow  Other coincident indicators include: o GDP o Industrial production o Retail sales  A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle  Lagging Indicators  Are those which change after the economy as a whole changes  These indicators are important because they can confirm that a business cycle patter in occurring  Unemployment is one of the more popular lagging indicators because a rising unemployment rate is an indication that the economy is doing poorly or that companies are anticipating a downturn in the economy  Other examples o Private sector plant and equipment spending o Business loans and interest on such borrowing o Labour costs o The level of inventories o Inflation rate Identifying Recessions  A popular definition of a recession is at least 2 consecutive quarters of declining growth in real GDP  However, Statistics Canada and the US National Bureau of Economic Research describe a recession differently  Statistics Canada judges a recession by the depth, duration, and diffusion of the decline in business activity  The decline must be if substantial depth, since marginal declines in output may be merely a statistical error  The duration must be more than a couple of months, since bad weather alone can cause a temporary decline in output  The decline must be a feature of the whole economy  Soft landing – in recent years, the term has been used to describe a business cycle phase when economic growth slows sharply but does not turn negative, while inflation falls or remains low

The Canadian Labour Market

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When the economy is strong, so is the demand for labour Employment rises, the unemployment rate falls, and workers win bigger wage raises and/or non-wage benefits Conversely, when the economy weakens, so does the demand for labour, and wage demands are restrained Statistics Canada divides the population into two groups: The Working-Age Population (those individuals aged 15 years and older) and those too young to work Labour Force – according to Statistics Canada, the sum of the working-age population who are either employed or unemployed  In 2006, of the 26.2 million Canadians included as part of the working-age population o 17.6 million were part of the labour force o 8.6 million likely consisted of full-time students and those retired from working Labour Market Indicators  Participation Rate o Represents the share of the working-age population that is in the labour force o It is an important indicator because it shows the willingness of people to enter the work force and take jobs o Has followed a mostly upward trend over the last 40 years in Canada, rising from 54% in the early 1960s to its current level of 67.5% in 2007  Unemployment Rate o Represents the share of the labour force that is unemployed and actively looking for work o May rise either because the number of employed fell or the number of people entering the work force looking for work rose, or both o Average unemployment rate in Canada over the past 40 years has been 7.7%  Discouraged Workers – are those individuals that are available and willing to work but cannot find jobs and have not made specific efforts to find a job within the previous month, and so are not included as part of the labour force o The disappearance of these “discouraged unemployed workers” can produce an artificially low unemployment rate

Types of Unemployment  There are three general types of unemployment: 1. Cyclical Unemployment  Is tied directly to fluctuations in the business cycle  It rises when the economy weakens and firms lay off workers in response to lower sales  It drops when the economy strengthens again Types of Unemployment (continued) 6

2. Frictional Unemployment  Is the result of normal labour turnover, from people entering and leaving the work force and from the ongoing creation and destruction of jobs  Even in the best of economic times, people are looking for work because they have finished school, quit, been laid off or been fired from their most recent job  This is a normal part of a healthy economy 3. Structural Unemployment  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 offered by the market  This type of unemployment is closely tied to changes in technology, international competition and government policy  Typically lasts longer than frictional unemployment because workers must retrain or possibly relocate to find a job  The distinction between frictional and structural unemployment is sometimes difficult to determine o With frictional unemployment, unemployed workers have the required skill levels to fill a job vacancy o With structural unemployment, however, unemployed workers looking for work do not possess the needed skills to find a job Full Employment or Non-Accelerating Inflation Rate of Unemployment (NAIRU)  The existence of frictional and structural factors in the economy prevents unemployment from falling to zero  This means that even in times of healthy economic growth, there is a level below which unemployment will not drop without causing other negative economic effects  This minimal level of unemployment is called the above or also the natural unemployment rate  At this level of unemployment, the economy is thought to be operating at close to its full potential or capacity such that all resources, including labour, are fully employed  The Bank of Canada and the Department of Finance estimate Canada’s natural unemployment rate somewhere between 6.5% - 7%  This natural unemployment rate is often viewed as the level of unemployment that is consistent with stable inflation, which is why it is an important number with respect to monetary and fiscal policy decisions

Interest Rates

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Are an important link between current and future economic activity For consumers, interest rates represent the gain from deferring consumption from today to tomorrow via saving For businesses, interest rates represent one component of the cost of capital, the cost of borrowing money Determinants of Interest Rates  Demand and Supply  A large government deficit or a boom in business investment raises the demand for capital and forces up the price of credit (interest rates), unless there is an equivalent increase in the supply of capital  In turn, the higher interest rate may encourage people to save more  Default Risk  The greater the risk that borrowers may default, the higher the interest rate demanded by lenders  If the central government is at risk of defaulting on its debt, interest rates rose for everybody  This additional interest rate is referred to as a “default premium”  Central Bank Operations  The Bank of Canada exercises its influence on the economy by raising and lowering short-term interest rates  However, it has much less impact on longer-term rates especially bond yields  Its influence on bond yields results more from the credibility of its long-term commitment to low inflation rather than any direct influence over long-term bond yields  Foreign Interest Rates and the Exchange Rate  Since Canada has an open economy and investors are free to move their money between Canada and other countries, foreign interest rates and financial conditions influence Canadian interest rates Nominal Interest Rate  Is one where the effects of inflation have not been removed  For example, the rate charged by a bank on a loan, or the quoted rate on an investment such as a Guaranteed Investment Certificate (GIC) or Treasury bill  Other things being equal, the higher the rate of inflation, the higher the nominal interest rate will be Real Interest Rate  In contrast to the nominal interest rate, it is the nominal interest rate minus the expected inflation rate over the term of the loan

Money and Inflation  Money makes the market go around and is used to purchase goods and services

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Inflation occurs when prices are rising This is problematic because as prices rise, money begin to lose its value - that is, more money is needed to buy the same amount of goods and services, and this has a negative effect on living standards Money Aggregates  The amount of money in circulation can be measured in a variety of ways  As one way, of monitoring economic activity, the Bank of Canada looks primarily at changes in the growth rate of M1 and M2+, when conduction monetary policy because these aggregates provide information about changes that are occurring in the economy  M1 gives information on the future level of production in the economy  M2 and M2+, provide a useful leading indicator of the rate of inflation  By monitoring these aggregates, the Bank strives to keep the rate of money growth consistent with low inflation and long-term growth  M1 o Currency (Bank of Canada notes and coin) held outside of banks o Personal chequing accounts o Demand deposits at chartered banks held by individuals & businesses  M2 = M1 plus the following o Personal savings deposits at chartered banks o Non-personal notice deposits at chartered banks  M2+ = M2 plus the following o Deposits at trust and mortgage and loan companies o Deposits at credit unions and caisses populaires o Life insurance company individual annuities o Money market mutual funds  M2++ = M2+ plus the following o Canada savings Bonds (CSBs) o Non-money market mutual funds  M3 = M2 plus the following o Non-personal term deposits at chartered banks o Foreign currency deposits at chartered banks

Inflation  In an economy-wide sense is defined as a generalized, sustained trend of rising prices 9

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Consumer Price Index (CPI)  Is one of the most widely used indicators of inflation and is considered a measure of the cost of living in Canada  Statistics Canada tracks the retail price of a shopping basket comprised of 600 different goods and services, each weighted to reflect typical consumer spending  When calculating CPI, prices are measured against a base year, which at the moment is 2002, and this base year is given a value of 100  The total CPI was 111.5 at the end of 2007, which indicates that the basket of goods costs 11.5% more than it did in 2002  The CPI is an important economic indicator because it is used in the calculation of the inflation rate, which is the percentage change in the price level from one year to the next  Inflation formula o CPI current period – CPI previous period --------------------------------------------------X 100 CPI previous period 111.5 – 109.1 ---------------109.1

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= 0.021998 X 100 = 2.20% inflation rate 

The Costs of Inflation  It erodes the standard of living of those on a fixed income and those who lack wage power  Reduced the real value of investments such as fixed-rate ...