csc chapter #4
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economy falls into 3 categories fo decision makers
- 1. consumers
- 2. firms.
- 3. governments
factors of production
sold in markets
includes: labour, natural resoources, capita; and entrepreneurship.
Final output is goods and services sold in a market economy
examines choices by economic agents and how their choices interact in a market economy.
how demand and supply interact to determine prices and levels of production of goods and services in an economy.
Law of Demand
the PRICE for a given product INCREASES, the QUANTITY demanded of the product DECLINES.
Law of Supply
the PRICE of a product INCREASES, the QUANTITY of that product supplied INCREASES
prices where quantity demanded equals the quantity supploed
PRICE is referred to as the EQUALIBRIUM PRICE
deals with ecomic behaviour at the aggregate level.
* focuses on issues such as unemployment, inflation, economic growth, and government policies
GDP- Gross Domestic Product
the value of all final goods and services produced in a country in a given year.
* it must equal to gross domestic income, which will be the same for gross domestic expenditure.
income earned by labour (wages and salaries), business (corporate profits. lenders (interest), government (taxes)
- C= Consumer Spending
- G= Government Spending
- I = investment in household residences, business investment inventories and capital equipment
- (X-M)= foreigner's spending on Canadian exports -minus- Canadian's spending on foreign exports
GNP- Gross National Product
- Value of all goods and services produced by Canadians at home or abroad.
- GNP= GDP+ Income from canadians investments abroad- Income to foreign holders of Canadian Investments
level of output in prices prevailing in that year.
A gross domestic product (GDP) figure that has not been adjusted for inflation.
level of output after adjusting for increase in price level.
* economic growth is measured by Real GDP because it considers inflation
Ex. nominal GDP= 5% [(105-100)/100] if inflation is 3% Real GDP is 2%= 5% - 3%
Growth of Real GDP (3 factors)
- 1. increase in population
- 2. increase in capital stock
- 3. technological innovation
normal fluctuations in long term growth which has a series of patterns. PHASES of Business Cycle...
- 1. Expansion
- 2. Peak
- 3. Recession
- 4. Through
- 5. Revocery
- Normal Growth Stage
- 1. stable inflation
- 2. rise in corporate profits
- 3. increased job start-ups and reduced bankruptcies
- 4. increasing inventories and investments by business to deal with increased demand
- 5. strong stock market activity
- 6. job creation and falling unemployment
- 1. Demand has begun to outstrip economic capacity
- 2. increasing inflationary pressures, leads to increasing interest rates and falling bond prices
- 3. Investment and sales od durables fall and eventually stock market activity and stock prices decline
- 1. TWO consecutive quarters of negative growth
- StatsCan. depth, duration & diffusion of decline in business activity
- 1. Near the end of a recessionary period
- 2. falling demand
- 3. excess capacity leads to drops in prices and wages.
* the decline in inflation leads to falling interest rates, which will begin to rally the economy.
The period of time it takes for GDP to return to its previous peak.
Initiated with an increase in demand for interest rate sensitive items like... houses, cars, and durable goods and spreads througn the economy.
Another expansionary phase is said to begin once GDP passes its previous peak
When economic growh declines sunstantially BUT DOES NOT return negative and inflation remains in check.
When the economy is growing at strong rate, the Fed will try to engineer a soft landing by raising interest rates enough to slow the economy down without putting it into recession
generally change before changes in overall economic activity.
- * useful for predicting the future direction of the economy.
- 1. Housing starts
- 2. manufactuerer's new orders, especially for durables
- 3. spot commodity prices
- 4. average hours worked per week
- 5. stock prices
- 6. money flows
Statistics Canada's Composite Leading Indicators...
- 1. S&P/ TSX Composite Index
- 2. Realy Money Supply- M1
- 3. U.S. Composite Leading Index
- 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. housing spending index
change in conjuction with changes in overall economic activity
* USEFUL for identifying changing points in the business sycle adter they have occured
INCLUDES- GDP, industrial production, personal income and retail sales
Change after changes in overall economic activity have taken place.
- 1. business investment spending
- 2. the unemployment rate
- 3. labour costs
- 4. inventory levels
- 5. inflation.
Labour Market Indicators
- 1. Participation Rate
- 2. Unemployment Rate
measures the percentage of the working age population that is in the labour force, either working or looking for work.
measured as the percentage of the labour force that is looking for but hasn't found employment.
Types of unemployment...
- 1. Cyclical
- 2. Frictional Unemployment
- 3. Structual employment
arises due to temporary hirings or layoffs that me attributable to the business cycle
unemployment caused by people in the job 'transition' stages
caused by workers being unable to find work because they do not possess the neccesary skills
FRICTIONAL and STRUCTUAL is caused by...
- 1. regulations such as minimum wage laws
- 2. strengths of union in negotiating wages
- 3. welfare and employment insurance plans that reduce workers' incentive to work
- 4. technological changes that make new skills neccessary
Natural or full employment unemployment rate or NAIRU- non-accelerating inflationrate of unemployment.
fristional and structural unemployment will exist in an economy even if it is healthy
they represent the price of credit.
* Determined by supply and demand
High Interest Rates tend to
1. Raise the cost of capital to firms, which reduces business investment
2. Discourage consumer spending such as durable goods
3. Reduce disposable income available for net borrowers due to hhigher debt servicing charges
Key Interest Rate Determinants...
- 1. Inflation
- 2. Foreign Development and Exchange Rate
- 3. Demand and Supply of capital
- 4. Default Risk
- 5. Central Bank Operations
- 6. Central Bank Credibility.
Key Interest Rate Determinants- INFLATION...
Rates rise to compensate lenders for loss in purchasing power as inflation rises
Key Interest Rate Determinants- FOREIGN DEVELOPMENT and EXCHANGE RATE...
Foreign Interest rates and Domestic exchnage rates affect the demand for Canadian debt instruments.
Key Interest Rate Determinants- DEMAND and SUPPLY of CAPITAL...
Government deficits or increases in investment spending cause an increase in demand for capital, which increases rates unless there is a corresponding increase in savings
Key Interest Rate Determinants- DEFAULT RISK of the borrower...
The greater the risk of default, the greater the rate that must be paid to borrow funds.
Key Interest Rate Determinants- Central Bank Operations...
The Bank of Canada can affect short-term rates directly and may affect long-term rates less directly through its credibility of commitment to controlling inflation.
Key Interest Rate Determinants- Central Bank Credibility...
When government establish a credible, long-term commitment to maintan low inflation, lower interest rates are possible, since there is less need to compensate lenders for the risk of rising inflation.
How are Interest Rates determined?
they are based on future expectations on future levels of inflation.
This is because the real interest rate equals the nominal interest rates minus expected inflation. Real Rates were historically in the 5% to 7% range however the have fallen to 1.5%, recently
What is MONEY?
they serve as 'medium of exchange' for transactions.
It serves as a 'unit of account' which establishes the relative values on items.
Represents a 'store of value' since it contains no expiration date.
What are the.. Measures of Money Supply
- 1. M1
- 2. M2
- 3. M2+
- 4. M2++
- 5. M3
- 1. currency held outside the bank
- 2. personal accounts
- 3. demand deposits at banks held by business and people
- 1. M1
- 2. personal savings accounts
- 3. non personal notice deposits
- 1. M2
- 2. deposit at trusts
- 3. mortgage loan companies, credit unions, casisses populaires
- 4. money market mutual funds
- 5, insurance annuities
- 1. M2+
- 2. Canada Savings Bonds
- 3. non-money market mutual funds
- 1. M2
- 2. Non-personal fixed term deposits
- 3. foreign currency deposits of residents booked in Canada
What is the CPI- Consumer Price Index
measure of Inflation.
Tracks the price of a given 'typical' basket of goods and services
What is the cost of a Basket?
it is related to a base year cost, which is presently 2002.
it may overstate the true level of inflation by failing to capture improved quality of the 'basket' and consumers' tendencies to switch to less expensive items.
How do you calculate the INFLATION RATE
- the percentage change in the CPI level over a given period.
- CPI is 145 today and it was 140 last year.
- ---the inflation rate over the last year was 3.57%
What is INFLATION
general decline in the value of money due to a sustained trend of rising prices.
An important factor affecting securities markets, because it ERODES THE REAL VALUE OF LONG-TERM INVESTMENTS.
What are the COSTS asssociated to INFLATION?
1. erodes the standard of living on a fixed income, can aggravate social inequities.
2. reduced the real value of investments such as fixed-rate loans, since they are paid back in dollars that are worth less.
3. distorts signals to economy participants that are normally given through asset prices
4. accelerating inflation generally causes increase in interest rates, which may lead to reccessionary periods.
When does INFLATION occur.
when demand for goods and services exceeds or grows faster than supply.
What is the OUTPUT GAP
refers to the difference between the potential full capacity level of output from actual output.
What is the DEMAND PULL INFLATION
When Actual output is neal full capacity, increased demand will lead to inflation.
When does COST PUSH INFLATION OCCUR
When prices rise or fall due to changes in the cost of production
- such as the increase in production costs that occurs when oil prices rise significantly.
What is the Phillips Curve?
inflation moves in the opposite direction of unemployment in the short run
and also increases in the money supply fuel inflation.
What are the INDICATORS for changes of INFLATION?
- 1. commodity and wholesale prices
- 2. wage settlements
- 3. bank credit.
- 4. exchange rate movements
What is Disinflation
decreases in inflation.
Why does DISINFLATION occcur
- the cost arise because of the Phillips Curve relationship,
- which suggest that declines in inflation tend to cause an increase in unemploymnet, as well as a corresponding slowing of economic growth.
Evidense of DISINFLATION and SACRIFISE RATIO
Sac Ratio measures the extent to which GDO must be reduced with increase unemployment to achieve a 1% decrease in the inflation rate, with estimates ranging as high as 5 (which implies that 5% od output must be sacrificed to reduce inflation by 1%
1988 to 1994 inflation fell 4% to 0.2% but unemployment rose 7.8% to 10.4%
When does DEFLATION occur
sustained fall in prices (CPI is negative)
cheap goods in short run it will affect corporate profits and in turn will turn in layoffs and increase unemployment which leads to overall decline in economic growth.
Decreasing interest rates my offsett but rates can be lowered to an extent.
What is included in the BALANCE OF PAYMENTS and what is it for
Current account and Capital account
it allows Canada to interact with other countries
What is the Current Account
records all payments between Canadians and foreigner for goods, services, interest and dividends (similar to an Income Statement)
it includes investment income, services and transfer of funds (ex. foreign aid and or wealth brought to canada by immigration)
What is the most important item in the current account?
Merchandise trade- determines the amount imported and exported by a country.
What is a Capital Account
reflects new equity and debt financing by Canada with foreigner (Similar to a Balance Sheet)
- Major components
- - direct investment in assets or companies
- - portfolio investment in debt (t-bills or bonds)
- - international reserve transaction currency markets
How do coutnries finance current account deficits
a country must issue foreigners an IOU like a bond or t-bill and/ or sell domestic assets as land or coampnies to foreign interests.
implies that current account deficits require capital account surpluses since two accounts must balance
What is the Exchange Rate
affects the economy by TRADE.
a high exchange rate would tend to lower Canada's trade balance.
What are some factors that affect the Exchnage rate trade.
1. lower inflation rates may offset the impact on foreign trade of a higher exchange rate, due to the lower associated costs.
What is the trade-weighted exchnage rate
measures the value of the Canadian dollar against 10 major currencies, based on the proportion of our traded maintained with each of those countries
What are Exchnage Rate Systems
- 1. Floating Systems
- 2. Fixed exchange rate system
What is the Floating System
allow the exchange rate to be freely determeined in foreign exchnage market
What is the Fixed exchange rate system
central bank 'pegs' the domestic currency against another currency or composite of other countries.
Can be achieved by forcing all purchases and sales of domestic currency to be handled only through its own banks, at its price.
What is created if a country does not have a FIXED EXCHANGE RATE SYSTEM
Can be costly and distortive to the operation of the economy and typically leads to the development of black markets.
What should a country do with a Fixed exchange rate system
Maintaining a fixed exchange rate by central bank to buy and sell currency in the open market and adjust interest rates as required to maintain a certain exhcnage rate range.
This approach requires the maintenance of a sizeable foreign exchnage reserve that must be utilized when the currency faces substantial market pressues.
What is the advantage of a Fixed exchange rate system in accordance with INFLATION
used to assist with high inflation countries in 'importing' the stability of the coutnry to which it pegs its currency; however it restricts the local monetary authority's ability to deal with interest rates at the local level.
Factors that affect the exchange rate
- 1. Inflation differentials
- 2. interest rate differentials
- 3. current account.
- 4. economic performance
- 5. public debt and deficits
- 6. term of trade
- 7. political stability
What is Inflation differential (factors that affect the exchnage rate)
coutrnies with lower inflation tend to appreciate through time to reflect their increased purchasing power relative to other countries
what is Interest Rate Differentials (factors that affect the exchnage rate)
Higher interest rates tend to attract more capital and make a currency value increase, provided the difference is not merely a reflection of higher inflation
What is current account (factors that affect the exchnage rate)
Countries that continually run deficits will have excess demand for foreign currencies, which puts downward pressure on the domestic currency.
What is the Economic Performance (factors that affect the exchnage rate)
A strong economy attracts investment capital by offereing higher returns and thus leads to more favourable exchange rates
What is the Public debt and deficits (factors that affect the exchnage rate)
Countries with large debts are less attractive to foreign investors because
1. higher incentive to allow inflation to grow and repay in cheaper dollars.
2. rely on foreign investment
3. debt accumulation affects the country's ability to repay
What is the Term of Trade
this is the ratio of export prices o import prices an increase which suggest increased demand for the local currency
What is the Political Stability (factors that affect the exchnage rate)
Capital tends to exhibit a 'flight to quality' particularly in time of increase uncertainty, which implies that instability exerts downward pressure on exchnage rates
What is Canada's Foreign Exchange reserve and what do they do?
Its called the Exchange Funbd Account
it is a federal government account that is managed by Bank of Canada and it is made up of foreign currencies, gold and reserves in the IMF
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