Chapter 4 – The Economy

Investors & advisors should consider impact economic events could have on markets & individual investments
Prices in markets  determined by demand & supply for goods & services by consumers, businesses & gov’ts
Equilibrium price: price at which the quantity demanded equals the quantity supplied

 TSX  investors buy & sell securities – millions of transactions carried out each day create a market &
establish equilibrium price
 Buyer & seller of security have diff views about the security
o Buyer believes it will go up in value o Seller believes it will go down

4.1 Defining Economics

Economics: social science that is concerned w/ a understanding of production, distribution, and consumption
of goods and services

 Focus on how consumers, businesses, and gov’ts make choices when allocating resources to satisfy their
needs
 ^ sum of these choices determines what happens in the economy
Market economy: economic system where decisions regarding investment, production & distribution of
goods & services are guided by price signals created by the forces of supply & demand

 Decisions made by consumers, businesses, & gov’ts (market participants) help determine allocation of
resources
 Interaction btwn market participants determines what we pay for a good/service, for a stock, bond, or
mutual fund

Microeconomics and Macroeconomics

Economics has 2 areas of study
1. Microeconomics: analyzes market behaviour of individual consumers & firms, how prices are
determined, and how prices determine product, distribution, and use of goods & services
a. How individuals and households decide what to buy
2. Macroeconomics: focuses on performance of the economy as a whole
a. Looks at broader picture and to the challenges facing society as a result of the limited amounts
of natural resources, human effort, and skills, and tech
b. Ex/ employment levels, interest rates, inflation, recessions, gov’t spending, and overall health of
economy
i. Interest rates: proportion of loan calculated as interest that is payable by the borrower
aka cost of credit
ii. Inflation: generalized, sustained trend of rising prices
c. Deals w/ economic interactions btwn countries in our connected global economy

Microeconomic Concerns Macroeconomic Concerns

How are the prices for goods and services
established?
Why did the price of bread go up?
How do minimum wage laws affect the supply of
Why did the economy stop growing last quarter?
Why have the number of jobs fallen in the last year?
Will lower interest rates stimulate growth in the
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 labour and company profit margins?
How would tax on softwood lumber imports affect
growth prospects in the forestry industry
If a gov’t places a tax on the purchase of mutual
funds, will consumers stop buying them?
economy?
How can a nation improve its standard of living?
Why do stock prices rise when the economy is
growing?
How is inflation controlled?

The Decision Markets

3 groups that interact in the economy: consumers, businesses, and governments:

 Consumers set out to maximum their satisfaction & well-being within the limits of their available
resources  include from employment, investments & other sources
 Businesses set out to maximize profits by selling their goods/services to consumers, gov’ts or other
businesses
 Gov’t spend money on education, health care, employment training and the military
o Oversee regulatory agencies  take part in public works projects  highways, hydro-electric
plants, and airports
Decisions made by 3 ^ groups & ways they interact w/ each other = affect state of economy

The Market
Activity btwn consumers, businesses, & gov’ts take places in various markets that make trade possible
Market – any arrangement that allows buyers & sellers to conduct business w/ one another

 Interactions btwn buyers & sellers of securities are facilitated by intermediaries & conducted
electronically

Demand, Supply, and Market Equilibrium:

Price of product  determine how much of that product people buy/sell in the marketplace
Everything has a price including financial products & services

 Stocks, bonds, commodities, and currency all have visible prices that allow people to make investment
decisions
Demand for and supply of a product in marketplace determine price paid for the product

 Demand: quantity demanded of a good or service based on a particular price during a given period
o Lower the price, higher the demand
 Supply: quantity supplied of a good/service based on a particular price during a given period of time
o Higher the price of a good/service, the greater the quantity of supply

Economic principles that help explain interaction btwn demand & supply (assuming other factors remain
constant)
1. Quantity demanded of a good/service is the total amt consumers are willing to buy at a particular price
during a given period
a. Higher the price, the lower the demand

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 b. Lower the price, higher the demand
2. Quantity supplied of a good/service is the
total amt that producers are willing to
supply @ a particular price during a given
time period
a. Higher price of a good, greater the
quantity supplied
Interaction btwn buyers & seller determines
equilibrium price for that product

 This price= buyers & sellers are in balance

o Anyone who wants to buy product
can do it
o Anyone who wants to sell
product can do it
 Producer sell product @ higher price =
unsold inventory
 Price too low = demand for product not
satisfied
o Supplier would be able to increase price

4.2 Measuring Economic Growth

Economy able to product more output over time = economic growth

 Understand overall health of entire economy

Gross Domestic Product

Gross domestic product (GDP): value of all goods & services produced in a country in a year

 Total market value of all the final goods and services produced in a country over a year
o Final goods: finished product, one that is purchased by the ultimate end user
o Intermediate goods: products used in manufacture of final goods
o Only market value of the final good is included in GDP
o Including intermediate good value = overstating GDP
 Economic growth is measured by increase in GDP from one period to the next
Monthly + quarterly GDP reports  keep track of short-term activity within the market
Annual reports  used to examine trends, changes in product & fluctuations in the standard of living

Three Methods to Measure GDP:

3 accepted ways of measuring GDP that give an approximation of the monetary value of all final goods &
services produced in the economy (produce the same number):
1. Expenditure approach – adds everything that consumers, business and gov’ts spend money on during a
certain period
a. Including business investments & all exports & imports that flow through the economy
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 2. Income approach – total spending on goods & services should equal the total income generated by
producing all those goods and services
a. Adds up all the income generated by ^ economic activity
3. Production approach (i.e., value added approach) – calculated an industry/sector’s output & subtracts
the value of all goods & services used to product the outputs
a. Ex/ computer industry produced total of $5 billion in computers & spent $2 billion on goods &
services to produce the computers
i. Value added to GDP by computer industry is $3 billion
ii. Adding up the value-added contributions of various economic sectors produces country’s
total GDP for measurement period
Expenditure Approach to Calculating Gross Domestic Product:
GDP = C + I + G + (X – M)

 C – consumer expenditures
 I – business pending and investment
 G – gov’t spending
 X – M - amt of exports (X) and imports (M) that consumers & businesses buy during the period
o Purpose of M
 C, I, G are tallies of all goods & services purchased by consumers, business & gov’ts
 Includes expenditures on imports
 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
 Exports are added to GDP  exports are the opposite of imports
 Formula groups X and M together = net exports

Real and Nominal Gross Domestic Product:

Nation produces more goods & services = standard of living improves

 Increase in GDP is result of higher prices  cost of living increases but standard of living doesn’t
improve
Rising prices = inflation

Nominal gross domestic product (nominal GDP): GDP based on prices prevailing in the same year not
corrected for inflation aka current dollar or chained dollar GDP

 Changes in nominal GDP from year to year = misleading b/c reflects changes in output & changes in
prices of goods & services
Increase in nominal GDP can occur in current year compared to previous year for either, or both of two
reasons:
1. Economy expanded = more goods & services were produced in the current year than in previous year =
nation was more productive
2. Prices increased = consumers had to pay more for goods & services in the current year than they did in
the previous year = nation experienced inflation

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Real gross domestic product (real GDP): GDP adjusted for changes in the price level aka constant dollar
GDP

 Measure a nation’s true productivity in a year

 Measure removes the changes in output that are b/c of inflation & sees how much GDP has grown based
only on productivity
Example:

 Nominal GDP grew by 4.4% last year and prices rose by 1.1%
o Nominal terms  economy grew by 4.4% = good economic growth
o Adjust by 1.1% for effects of rising prices – real economic growth was 3.3% (4.4%-1.1%)
o Nation more productive this year than last
 Nominal GDP grew by 2.4% last year and prices rose by 3.1%
o Nominal terms  economy grew by 2.4%
o Adjust by 3.1% for inflation – economy shrank 0.7% (2.4%-3.1%)
o Real GDP is negative = nation less productive last year than the year before

Productivity and Determinant of Economic Growth

Productivity: amt of output per worker used as a measure of efficiency w/ which people and capital are
combine in the output economy

 Productivity gains = improvement in standard of living  as labour, capital, etc produce more = greater
income
 Output (GDP) per unit of input (labour & capital used to produce the goods and services)
 Productivity increase = more produced w/ less expenditure = net benefit for economy
 Link btwn growth in real GDP and productivity gains
 Gains in productivity = growth in GDP
Key factors that contribute to gains in productivity:

 Technological advances
 Population growth
 Improvements in training, education, and skills
^ factors contribute to growth in GDP & makes nations wealthier

4.3 The Business Cycle

Business cycles: recurrence of periods of expansion and recession in economic activity

 Expansion: phase in business cycle – increasing corporate profits = increasing share prices, increase
in demand for capital for business expansion = increase in interest rates
 Each cycle is expected to move through 5 phases
o Trough
o Recovery
o Expansion: see above
o Peak
o Contraction (recession): downturn in economy – lead to recession if prolonged

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  Understanding of relationship btwn business cycle and security prices  investor or fund manager
would select an asset mix to maximize returns
o Asset mix: percentage distribution of assets in a portfolio among the 3 major asset classes
 Cash and equivalents
 Fixed income
 Equities

Phases of The Business Cycle

Expansion/growth in economy – measured by increase
in real GDP
Contraction in economy – measured by decrease in real
GDP
We live in global economy

 Export & import billions of dollars in goods and

services
 Canadian consumers & businesses affected by
state of economy of our trading partners
Sequence of events in business cycle:
1. Expansion 4. Trough
2. Peak 5. Recovery
3. Contraction

Expansion:
Period of significant economic growth & business activity – GDP expands until it reaches a peak
Economic expansion is characterized by the following activities:

 Inflation – rise in prices of goods & services – is stable

 Businesses adjust inventories & invest in new capacity to meet increased demand & avoid shortages
 Corporate profits rise
 New business start-ups outnumber bankruptcies
 Stock market activity is strong & markets typically rise
 Job creation is steady & unemployment rate is steady or falling
o Unemployment rate: percentage of the work force that is looking for work but unable to find
jobs

Peak:
Peak of business cycle is top of cycle btwn the end of expansion & start of contraction
Peak is characterized by the following activities:

 Demand begins to outstrip the capacity of economy to supply it

 Labour & product shortages cause wage & price increase – inflation rises accordingly

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  Interest rates rise & bond prices fall
o Dampen business investments & reduce sales of houses & other big-ticket consumer goods
 Business sales decline = accumulation of unwanted inventory & reduced profits
 Stock prices begin to fall along w/ falling profits & stock market activity declines

Contraction:
Decline in economic activity – aka negative GDP
Contraction last 2 consecutive quarters – economy considered to be in recession
Contraction is characterized by following activities:

 Economic activity begins to decline – real GDP decreases

 Unwanted inventories & declining profits = businesses reduce production, postpone investment, curtail
hiring, may lay off employees
 Business failures outnumber start-ups
 Failing employment erodes household income & consumer confidence
 Consumers react by spending less and saving more
o Cuts into sales and fuels contraction
 Stock market price falls lower

Trough:
Contraction continues – falling demand & excess capacity curtail ability of businesses to raise prices & of
workers to demand higher salaries
Growth cycle reaches a trough – lowest point
Trough is characterized by following activities:

 Interest rates fall – triggering bond rally

 Inflation falls
 Consumers who postponed purchases during contraction are spurred by lower interest rates & begin to
spend
 Stock prices rally

Recovery:
GDP returns to its previous peak
Beings w/ renewed buying of items (i.e., houses & cars) that are sensitive to interest rates
Recover characterized by following activities:

 Businesses that reduced inventories during contraction must increase production to meet new demand
o Too cautious to hire back significant numbers of workers – period of widespread layoffs = over
 Businesses are not yet ready to make significant new investment
 Unemployment remains high, wage pressures are restrained, and inflation may decline further

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Economic Indicators
Economic indicators: stats or data series that are used to analyze business conditions and current economic
activity

 Provide info on business conditions & current economic activity

 Show if economy is expanding or contracting
Economic indictors classified as leading, coincident, or lagging:

 Leading indicators: selection of statistical data that indicates highs and lows in business cycle ahead
of the economy as a whole
o Relate to employment, capital investment, business starts & failures, profits, stock prices,
inventory adjustment, housing starts and certain commodity prices
o Peak and trough before overall economy
o Anticipate emerging trends in economic activity by indicating what businesses & consumers
have begun to product and spend
 Coincident indicators: statistical data that change at approximately the same time and in the same
direction as the economy as a whole
o Providing info about the current state of the economy
 Lagging indicators: selection of statistical data that indicate highs and lows in the business cycle
behind the economy as a whole
o Relate to business expenditures for new plant and equipment, consumers’ instalment credit,
short-term business loans, overall value of manufacturing and trade inventories
o Change after economy as a whole change
o Important b/c can confirm that a business cycle pattern is occurring

Examples:
Leading Indicators:

 Housing starts – permit issued to build house = indicates that building supplies will be bought &
workers will be hired
o Owner spend more money on new appliances and furnishings
 Manufacturers’ new orders – new orders by manufacturers = indicate expectations that consumers will
purchase more items ex/ automobiles & appliances
 Commodity prices – rising/falling commodity prices reflect rising/falling demand for raw materials
 Average hours worked per week – avg number of work hours rises/falls depending on the level of
output = indicate changes in employment levels
 Stock prices – changes in stock prices = changing levels of profits
 The money supply – represents available liquidity = impact on interest rates

Coincident Indicators:

 Personal income  Industrial production

 GDP  Retail sales

 Person income rising – ppl have more money to spend = encourages increase in GDP, industrial
production & retail sales

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Lagging Indicators:

 Unemployment  Private sector plant and equipment

 Inflation rate spending
 Labour cost  Business loans and interest on such
borrowing

 Unemployment rate goes up/down in response to other factors

o Ex/ businesses confident recession/contraction is over – start hiring again
o Unemployment rate falls = labour costs g up
o Economy recovers, businesses can be expected to spend more on plants & equipment and to
borrow more money to fund growth

Identifying Recessions
Stats Canada judge recession by the depth, duration and diffusion of the decline in business activity:
1. Depth – decline must be of substantial depth
a. Ex/ marginal declines in output could be statistical errors
2. Duration – decline must last more than a couple of months
a. Ex/ bad weather can cause temporary decline in output
3. Diffusion – decline must be a feature of whole economy
a. Ex/ strike in major industry can cause GDP to decline but does not constitute a recession for
whole country

4.4 The Labour Market

Statistics Canada defines working age population as people 15 years and older

 Divides population into 3 groups

o Those who are unable to work
o Those who are not working by choice
o The labour force
 Labour force: sum of population aged 15 years and over who are either employed or
unemployed – working & unemployed but looking for work
Discouraged workers: 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

Labour Market Indicators

2 key indictors to describe activity in labour market:
1. Participation rate: share of working age population (15 & older) that is in labour market/force, either
working/looking for work
a. Aka limit on return is paid by an issuer to an investor
b. Shows willingness of people to enter the work force and take jobs
2. Unemployment rate: share of labour force that is unemployment and actively looking for work

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 a. Rate may rise when number of people employed falls/when number of people looking for work
rises (or when both occur at once)

Canada participation rate increased b/c of participation of women in workforce

Participation rate is key measure of productivity of a society (higher % the better)
Declining GDP  occurs in recessionary periods, increased unemployment (strong correlation)
Arguments for flaws existing in way unemployment is measured:

 Doesn’t address that some people are unemployed for short time, and some for long periods
 Avg duration of unemployment varies over business cycle – shorting during expansion and longer
during a recession
 Job prospects so poor – unemployed ppl drop out of labour force and become discouraged workers
o People who are available to work but have given up their search b/c they can’t find jobs
o Too many people become discouraged workers – unemployment rate falls b/c ppl in this
segment of the population are not considered part of labour force – not considered unemployed
 People who are part of the labour force are considered underemployed
o Underemployed: people who are working part-time, at jobs that don’t make good use of their
skills, when they would rather be working full-time
o Ppl in this group have jobs – unemployment rate is lower than it would be if these ppl were
unemployed
o Low rate doesn’t reflect nation’s loss of productivity

Types of Unemployment
4 types of unemployment: cyclical, seasonal, frictional, and structural
Cyclical unemployment: amt of unemployment that rises when economy softens, firms’ demand for labour
moderates and some firms lay off workers in response to lower sales

 Drops when economy strengthens again

 Tied to fluctuations in business cycle
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Seasonal unemployment: unemployment that results from a company/industry that only operates during
specific seasons of the year
Frictional unemployment: unemployment that results from normal labour turnover, from people entering
and leaving the workforce and from ongoing creation and destruction of jobs

 People can be out of work for various reasons  recently finished school, quit a job, been laid off from
work, been fired
 Normal and part of healthy economy
 Declines when jobs are matched more efficiently to potential workers
Structural unemployment: unemployment that results when workers are:

 Unable to find work or fill available jobs b/c they lack the necessary skills
 Do not live where the jobs are available
 Decide not to work at the wage rate offered by the market
 Mismatch btwn jobs & potential workers
 Tied to changes in tech, international competition and gov’t policy
 Lasts longer than frictional unemployment b/c workers must retrain/relocate to find job
Frictional & structural factors in economy will always exist

 Unemployment rate can never be zero

Natural unemployment rate: aka full employment unemployment rate  economy is thought to be
operating at close to its full potential/capacity

 All resources are fully employed

 Further employment growth – achieved through
o Increased wages to attract ppl into labour force = fuels inflation
o Fundamental changes to labour market that remove impediments to job creation

4.5 The Role of Interest Rates

Ppl who saves instead of borrow for major purchase – int rates represent gain made from deferring
consumption
Ppl who borrows – int rate represent price of borrowing to buy something today rather than postponing the
purchase
Business – int rates = one component of cost of capital – cost of borrowing

 Rate of growth of capital (determines future output)  related to current level of int rates
Interest rates  price of credit

 Changes affect demand & supply for credit & debt

 Has direct implications for bond and money markets
Changes in int rates through monetary policy decisions (by Bank of Canada) affect entire economy

 Int rate increase  cost of borrowing increase

o Higher borrowing costs = negative impact on profits of businesses that need to borrow = cause
share prices to fall

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Determinants of Interest Rates
Demand and Supply of Capital:

 Large gov’t deficit/boom in business investment raises demand for capital = force int rates to inc
o Unless equivalent inc in supply of capital  price of credit rises
o Higher int rates  encourage gov’t, businesses, and consumers to save more
o Increase in saving = reduced demand for borrowing = reduce int rates

Default Risk:

 Int rate inc  consumers & businesses have trouble paying back borrowed funds/default on loans
 Greater risk of default – higher the int rate demanded by lenders
 Central gov’t is at risk of defaulting on its debt  int rates rise for everybody
 Additional int rate called default premium
Foreign Interest Rates and The Exchange Rate:

 Investors free to move their money btwn Canada and other countries
 Foreign int rates & financial conditions influence Canadian int rates
 Cx selling Canadian dollars to purchase in foreign market b/c of interest rate inc = inc supply of
Canadian dollars on foreign exchange market
o Decr value of Canadian dollar
o Bank of Canada decide to slow/reduce fall in valye can raise short-term int rates
 Encourages investors to continue holding Canadian investments rather than foreign
market investments
Central Bank Credibility:

 Central banks of diff countries (including Bank of Canada) exercise influence on economy by
raising/lowering short-term int rates
Inflation:

 Inflation rise = lenders charge higher int rates to compensate for erosion of money’s purchasing power
over duration of loan
 Bank of Canada’s responsibility  keep inflation low & stable
 Commitment to low inflation has been credible & long-established  int rates drop to compensate for
risk of rising inflation

How Interest Rates Affect The Economy

Higher int rate = negative effect on growth prospects
Lower int rate = positive environment for growth
Higher int rate affect economy in following ways:

 Reduce business investment  investment should earn greater return than cost of funds used to make
the investment
o Higher int rates raise cost of capital for investments & reduce possibility of profitable
investments

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 o Businesses less likely to invest
 Encourage saving  increase cost of borrowing – higher int rate discourage consumers from buying on
credit especially high prices items (house, car, furniture)
o Content to put their money in savings
 Reduce consumption  higher int rates increase portion of household income that is needed to service
debt (mtg pmts)
o Reducing income available to spend on other items
o Effect is offset somewhat by higher int income earned by savers

Expectations and Interest Rates

Optimism in market  generate rise in stock price
Pessimism  stall economic growth – decrease share prices
Gov’t economic policies have impact on people’s expectations
Nominal interest rate: quoted or stated rate on an investment/loan

 Allows for comparisons but does not take into account the effects of inflation
 Rate charged by a bank on a loan is the nominal int rate
 Quoted rate on investment (i.e., GIC or T-bill)
 Higher the rate of inflation  higher nominal int rate
Real interest rate: nominal rate of interest minus the percentage change in consumer price index (CPI)
(i.e., rate of inflation)

 CPI: price index which measures cost of living by measuring prices of a given basket of goods – used as
an indicator of inflation

4.6 The Impact of Inflation

Inflation  sustained trend of rising prices on goods & services across the economy over a period

 Occur when prices follow a sustained rising pattern

 Prices rise = money lose value – larger amt of money needed to buy same goods and services
 Important economic indicator for securities markets b/c rate at which real value of investment is
eroded
o Ex/ invest $100,000 today for 1 year  will receive 7% return, inflation rate expected at 3%
over course of the year = real rate of return will be 4%
Deflation  sustained fall in prices where the consumer price index is negative

Measuring Inflation
Inflation rate is % of change in avg lvl of prices over a given period
Consumer Price Index (CPI) is used to measure inflation
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  Monitors avg price of basket of goods and services, purchased by Canadian household changes from
month to month or year to year
Calculating CPI  prices measured against a base year

 Currently base year used in Canada is 2002  given a value of 100

o Ex/ end of Dec 2019 CPI was 136.4  basket of goods in that year cost 36.4% more than it did in
2002

The Costs of Inflation:

Inflation imposes many costs on economy for following reasons:

 Erode standard of living of Canadians  especially for ppl on a fixed income

o Ex/ retired individuals who rely on monthly gov’t pension
o Canadians who increase their income in response to inflation (via increased wages/changes to
their investment strategy) are less effected
 Reduces real value of investments (i.e., fixed-rate loans – loans must be paid back in dollars that buy
less)
o Borrower whose income rises w/ inflation will not be affected
o Lenders demand a higher int rate on money they lend during inflationary times
 Distorts price signals sent to market participants
o Prices set by supply and demand
o Inflation high = difficult to determine whether price increase is inflationary or a relative price
that reflects a change in supply/demand
 Accelerating inflation brings rising int rates and a recession
o High inflation economies experience more sever expansion and contractions than low inflation
economies
Initiatives by gov’t to lower inflation = higher int rates & higher unemployment

The Causes of Inflation

Balance btwn supply & demand conditions of economy = important determinant of inflation
Demand for all goods & service higher than what economy can product = prices increase as consumers compete
for too few goods

 Occur as we move from expansion towards peak phase of business cycle

 Businesses have trouble meeting higher demand – prices rise
o Higher and continued consumer demand pushes inflation higher

Demand-pull inflation: type of inflation that develops when continued consumer demands pushes prices
higher

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Deflation and Disinflation
Falling rate of inflation can have negative impact on the economy
Disinflation: decline in rate at which prices rise, i.e., decrease in the rate of inflation

 Prices are still rising, but at a slower rate

Deflation: sustained fall in prices where annual change in CPI is negative year after year

 Opposite of inflation
 Goods and services become cheaper  income has more buying power than it used to
 Can have negative consequences

Costs of Deflation and Disinflation:

Inverse relationship btwn inflation & unemployment
Unemployment low = inflation high
Unemployment high = inflation low
Phillips curve: graph showing relationship btwn inflation & unemployment

 Unemployment can be reduced in short run by increasing price level (inflation) at a faster rate
 Inflation can be lowered at the cost of possibly increased unemployment and slower economic growth
 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
Impact of sustained falling prices leads to decline in corporate profits

 Prices continue to fall – businesses sell their products at lower prices

o Cut back on product costs & wage rates, lay off workers

Unemployment rises – economic growth slows, consumers go from spending to saving

Declining company profits negatively impact stock prices

4.7 International Finance and Trade

International finance  trade, investment, capital flows and exchange rates

 Exchange rates: price at which one currency exchanges for another

Canada dependent on trade; exports of goods and services = 1/3 of our GDP
Economies of trading partners expanding = Canada’s economy benefits

 Trading partners increase their spending on goods  Canadian companies export more goods abroad
Canadian exports fall when economic growth in our trading partners declines

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The Balance of Payments
Balance of payments: Canada’s interactions w/ the rest of the world which are captured here in the current
account and capital account

 Detailed statement of country’s economic transactions w/ rest of the world over a given period
(quarter/year)
Two main components
1. Current account: acc that reflects all payments btwn Canadians and foreigners for goods, services,
interest and dividends
a. Also net transfers such as foreign aid
b. Aka trade acc in the financial press
c. Outflows might be used to buy foreign goods or pay int on debt held by foreigners = creating
demand for foreign currency to make those payments
i. Canadian dollars are offered in exchange for this foreign currency
d. What we spend on things and the capital and financial account as what we use to finance this
spending
i. Buy more goods and services from abroad than it sells  run current account deficit for
the year
ii. Need to sell more assets to finance this spending = running a capital and finance account
surplus – go into debt
2. Capital and financial account: acc which reflects the transactions occurring btwn Canada and
foreign countries w/ respect to the acquisitions of assets, such as land or currency
a. Records financial flows btwn Canadians and foreigners – related to investments by foreigners in
Canada and investments by Canadians abroad
Incur supply or demand of foreign currency and a corresponding supply or demand of Canadian currency
Spend more than you earn – make up the difference by either borrowing money or selling something of value
and using proceeds to pay off debt

The Exchange Rate

Buying foreign goods/investment in foreign country  use another currency to complete transactions
Foreign buyers purchase Canadian goods/invest in Canadian assets  need Canadian dollars
Foreign exchange market include all places in which one nation’s currency is exchanged for another at a
specific exchange rate

 Current price of one currency in terms of another

The Exchange Rate and The Canadian Dollar:

Value of Canadian dollar relative to other currencies influences economy

 Higher Canadian dollar compared to trading partners makes Canadian exports more expensive in
foreign markets and imports cheaper in Canada
Canadian dollar rises in value relative to foreign currency  dollar have appreciated in value against that
currency

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Canadian dollar falls in value relative to foreign currency  dollar depreciated in value against that currency

Determinants of Exchange Rates:

Pay close attention to currency exchange rate to predict its direction
Some countries fix value of their currency so that it is constant in comparison to their major trading partner
Canada allow its currency to float freely
Bank of Canada doesn’t intervene to support the Canadian dollar – might choose to intervene to slow down and
stabilize rate of change of the exchange rate
Factors that influences the exchange rate:

 Commodities  strongest influences on Canadian exchange rate is price level of commodities

o Canada heavily dependent on export of natural resources to other countries (i.e., lumber, base
metals, crude oil, and wheat)
o Countries around the world that buy Canadian products need Canadian dollars to finance their
purchases
o Demand for commodities increase, demand for Canadian dollars also rises
 Inflation  currencies of countries w/ consistently lower inflation rate rises over time
o Reflecting their increase purchasing power relative to other currencies
 Interest rates  central banks influence value of exchange rate by raising and lowering short term
nominal interest rats
o Higher domestic int rates increase return to lenders relative to other countries
 Attracts capital and lifts exchange rate b/c foreign investor must buy Canadian dollars to
invest
o Lower int rates have opposite effect
o Impact of higher int rates is reduced if domestic inflation is much higher/if other factors are
driving the currency down
 Trade  export goods & services  other countries must buy Canadian dollars to pay for the goods
o Increase demand for and value of Canadian dollars
o Importing goods we must sell Canadian dollars and buy the currency of the country we are
importing from
o Increases supply of Canadian dollars  causes downward pressure on value of currency
 Economic performance  country w/ strong growing economy  more attractive to foreign investors
b/c it improves investment returns and attracts investment capital
 Public debts & deficits  countries w/ large public sector debts and deficits are less attractive to foreign
investors
 Political stability  investors don’t invest in countries w/ unstable or disreputable gov’ts or those at risk
of disintegrating politically
o Political turmoil in a country can cause loss of confidence in its currency aka flight of quality –
rush to exchange country’s currency to that of more politically stable countries

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