CSC 101

CH 4:THE
ECONOMY
AMINA AZIZ
Learning Objectives
1. Define economics and describe the process for achieving market
equilibrium.
2. Describe the process for measuring gross domestic product and
productivity gains in the economy.
3. Differentiate between business cycle phases and economic indicators
used to analyze current and long-term economic growth.
4. Compare and contrast labour market indicators and the types of
unemployment.
5. Describe how interest rates affect the performance of the economy.
6. Describe inflation and the impact it has on the economy.
7. Analyze how trade between nations takes place through the balance of
payments and via the exchange rate.
2
Economics is a branch of social science that deals
with production, distribution and consumption of
goods and services within an economy.
It is the study of how limited resources are used to
maximize satisfaction.
The available resources in an economy are
considered limited in relation to unlimited human
wants. This results in an economic problem faced by
all societies called scarcity. Therefore, the decision
facing every economy is how to allocate limited
resources across unlimited wants.
How does it fit into our securities course?
Economics in General
The performance of the securities markets is strongly tied to the overall
performance of the economy.
■ A growing and stable economy over time has a positive impact on the
equity markets.
■ Bond market activity is strongly tied to the level and uncertainty of
inflation and interest rates.
■ The economy has an impact on how many people work, how much they
spend, how much product companies sell, and how high inflation and
interest rates will be.
■ These are the factors that determine investment returns.

4
Defining Economics
Microeconomics:
■ The market behaviour of individual consumers and firms.
■ How the price levels creates or leads to market equilibrium.
■ The impact of minimum wage laws on the supply of labour and company profit
margins.
■ Taxes on imports and the impact on industry profitability.
Macroeconomics:
■ The performance of the overall economy – the ‘big picture’.
■ Measuring output through GDP and GNP.
■ How changes in unemployment or inflation impact economic performance.
■ How a nation’s standard of living has changed over the last business cycle

6
GDP VS GNP

■ Gross Domestic Product (GDP) is used to calculate the total value of the goods and
services produced within a country’s borders
■ Gross National Product (GNP) is used to calculate the total value of the goods and
services produced by the residents of a country, no matter their location.
The 3 Decision Makers

■ Consumers set out to maximize their satisfaction and well-being within the limits of
their available resources, which might include income from employment, investments,
or other sources.
■ Businesses set out to maximize profits by selling their goods or services to consumers,
governments, or other firms.
■ Governments spend money on education, health care, employment training and the
military. They oversee regulatory agencies, and they take part in public works projects,
including highways, hydro-electric plants, and airports.

8
Demand & Supply
The interaction between demand and supply leads to market equilibrium in
the economy.
Market Demand= consumers, all purchasers of goods and services
Market Supply= suppliers of goods and services
Law of Demand= as the price of a product rises, quantity demand falls and
as the price of a product falls, quantity demand rises
Law of Supply= as the price of a product rises, quantity supplied rises and
as the price of a product falls, quantity supplied falls

9
Measuring Economic Growth
■ Gross Domestic Product (GDP): Value of all goods and services produced within
Canada’s borders
■ Two Methods to Measure GDP
1. Income approach This approach starts from the idea that total spending on goods
and services should equal the total income generated by producing all of those
goods and services. GDP using the income approach adds up all of the income
generated by this economic activity.
2. Expenditure approach The more common way of calculating GDP is to add up
everything that consumers, businesses, and governments spend money on during a
certain period. Included in the calculation are business investments and all of the
exports and imports that flow through the economy.

10
Measuring Economic Growth
Components of the Expenditure approach:
■ Consumption (C)
■ Investment (I)
■ Government Spending (G)
■ Net Exports (X-M)
GDP = C + I + G + (X – M)
Causes of GDP Growth:
• Population growth
• Rising productivity
• Technological innovation

11
Real GDP versus Nominal GDP
■Nominal GDP :
Is based on current prices, or the prices that prevailed in the same year. It
reflects the change in the size of GDP and the impact of price changes
■Real GDP :
Accounts for the effects of inflation a better measure of the overall
performance. A purer measure of changes in the amount of output produced
during the year. Isolates the change in output attributed to price changes (or
inflation).

12
A Typical Business Cycle
GDP

Rising Trend in GDP

Expansion

Peak Contraction Recovery

Expansion
Trough

Time

13
Stage 1: Recovery/Expansion
■ This is the first stage in the business cycle.
■ The recovery stage is also commonly referred to as a period of expansion.
■ Output and employment expand towards full employment and full
capacity.
■ Key macroeconomic indicators, such as employment, national income,
aggregate demand and economic growth tend to increase.
■ The amount of money and investment in the economy also increase as the
economy expands.

14
Stage 2: The Peak
■ The peak is the second stage in the business cycle.
■ During an economic peak, output is increasing or remains steady as the
economy reaches its full productive capacity.
■ The economy does not experience further growth and it is at maximum
capacity.
■ Employment is increasing or steady as it moves towards a steady state of
full employment.
■ During the peak stage, prices tend to rise.

15
Stage 3: Recession/contraction
■ Recession follows a peak and is the third stage in the business cycle.
■ Statistics Canada normally defines a recession as two consecutive
quarters (six months) of negative growth, or declining GDP.
■ In this stage, there is a clear and steady decline in key
macroeconomic indicators such as output, employment and income.
■ Business (economic) activity continues to contract.
■ Prices continue to fall.
■ After a prolonged recessionary period, would then likely be classified
as a depression.
Stage 4: Trough
■ A trough is the lowest point of a recession and the fourth stage in the
business cycle.
■ The trough that follows a recession, and less frequently a depression
■ In a trough output and employment reach their lowest point.
■ Economic growth is negative.
■ National income rapidly declines, unemployment rises and the
economy reaches its lowest level.
■ There is no specific duration for a trough.
Economic Indicators
Leading Indicator: Peak and trough before the overall economy –
anticipate emerging trends
Examples: Housing starts, manufacturers’ nee orders,
commodity prices, stock prices, money supply

Coincident Indicator: Change at same time and in same direction as the

economy – info on the current position of the economy
Example: GDP, retail sales, industrial production, personal
income
Lagging Indicator: Change after the economy changes – used to confirm a
business cycle pattern
Example: Unemployment rate, inflation, labour costs,
business loans
18
EXAMPLE

Robert Hans is the senior economist at ADB Bank. He was recently asked to deliver a
presentation on the state of the economy over the last two quarters. To prepare for
the presentation, John analyzed data for key variables, including the stock market,
manufacturing, housing, business start-up and expansion, GDP and consumer
confidence.
Based on his analysis, Robert confirmed that there has been an increase in these
variables for the past two quarters. This may signal the direction of the economy.
He is contemplating whether he should make a prediction. He knows he must be
careful, because these leading indicators may sound a false alarm.
Labour Markets
Economic performance directly affects the labour market.
■ Labour Force: Sum of the working age population who are employed or unemployed.
■ Participation rate: The % of the working age population in the labour force. Or:
Labour Force/Working Age Population x 100
■ Unemployment rate: The % of the labour force unemployed but looking. Or:
Not Working but Actively Looking for Work/Labour Force x 100
■ 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.
■ Discouraged : Workers people who are available to work but have given up their search
because they cannot find jobs.

20
Types of Unemployment
■ Cyclical unemployment: Is tied directly to fluctuations in the 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 unemployment: Some industries operate only during part of the
year
■ Frictional unemployment : Consists of the normal labour turnover that
occurs when people enter and leave the work force, and during ongoing
creation and destruction of jobs.
■ Structural unemployment : Reflects a mismatch between jobs and
potential workers. 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.
■ Note: 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

21
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.
■ What is the total labour force?
■ Using these figures to calculate the country’s participation rate?
■ The unemployment rate?
LABOUR MARKET INDICATORS

There are two key indicators that describe activity in the labour market:
1. The Participation 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 work force and take jobs.
2. The Unemployment Rate.
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).
Calculation: Participation and
Unemployment Rates
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
Interest is:

For business owners it is a component in the cost of capital for production

For consumers it is the “price” of credit for consumption

■ 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.

25
Determinants of Interest Rates
• Demand and Supply of Capital
A large government deficit or a boom in business investment raises the demand for capital and
forces interest rates to rise
Higher interest rates may encourage government, companies, and households to save more. An
increase in savings may reduce demand for borrowing, which in turn may reduce interest rates
• Default Risk
The greater the risk of default, the higher the interest rate demanded by lenders
• Central Bank Activities/Credibility
Central banks of different countries (including the Bank of Canada) exercise their influence on
the economy by raising and lowering short-term interest rates.
• Foreign Developments – Interest Rates/Exchange Rate
• 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.

26
Inflation
A generalized, sustained trend of rising prices.
Usually an indication of growth in the
1. Money supply
2. Economic expansion
3. Increase in demand without corresponding change in supply
Can lead to:
4. Investors demand a rate of return that protects them from
the erosion of their purchasing power
5. Pressure on wages and other variables

27
Inflation & the Consumer Price Index
Using the CPI to measure inflation:
• Tracks the retail price of a basket of goods to reflect typical consumer
spending
• Measures the ‘average’ price level for a consumption bundle
• Compares the CPI in the current period relative to a base year to
arrive at the inflation rate for the year

• Inflation Rate = x 100

28
Inflation
Costs of Inflation
• Erodes standard of living for those on a fixed income
• Erodes purchasing power or forces investors to demand higher
returns
• Higher interest rates slows growth
• Increases the cost of debt servicing to individuals, corporations
and governments

29
Inflation
The Output Gap
• The difference between real GDP and potential GDP
• Potential GDP
• What the economy is capable of producing when its existing inputs of labour, capital, and
technology are fully employed at their normal levels of use.
(the BoC does estimate potential output levels)

Negative Output Gap:

• When actual output is below potential output - spare or excess capacity.
• Increased demand does not result in inflation.
Positive Output Gap:
• Economy is operating above its potential:
- actual output (GDP) > potential output
• Strong consumer demand for goods and services.
• When companies continue to operate above capacity, they can raise prices in response to this
demand and leads to demand-pull inflation.
• A scarcity of resources can lead to cost-push inflation.

30
Disinflation vs. Deflation
Disinflation
 A decline in the rate at which
prices rise – is a decrease in the
rate of inflation.
 Prices are still rising, but at a
slower rate.
 Captured through the Phillips
Curve and the sacrifice ratio.
Deflation
 A sustained fall in prices - the
annual change in the CPI is
negative year after year.
 Deflation is just the opposite of
inflation.
 Problem: sustained falling
prices could lead to a decline
in corporate profits.
31
International Finance & Trade
■Exports account for significant part of Canada’s GDP.
Canada exports a majority of its goods to the U.S. and also imports a
significant amount from the U.S.
■What this means: the performance of the Canadian economy is strongly
tied to the performance of the U.S. economy.
■The balance of payments is used to track the economic transactions with
the rest of the world over a given time period.

32
Current Account & Capital Account
• Current Account
Records the exchanges of goods and services between Canadians and foreigners, the earnings from
investment income, interest, and dividends and net transfers such as for foreign aid.
• Deficit implies Canadians are spending more on foreign goods than they are selling – imports are
higher than exports.
• Surplus implies Canadians are selling more to foreigners than
buying abroad – exports are higher than imports.
• Capital Account
Records the financial flows between Canadians and foreigners related to investments by foreigners
in Canada and investments by Canadians abroad. When a country runs a current account deficit,
the shortfall financed from foreign sources by:
• Selling assets
• Borrowing funds
Both of these activities are captured through the capital account.
33
The Exchange Rate
Why it’s important:
■ The external value of a nation’s
currency impacts the volume of trade.
■ As the C$ rises in value against a
trading partner the volume of exports
falls and the volume of imports rises.
■ As the C$ falls in value against a
trading partner, the volume of exports
rises and the volume of imports falls.
Determinants of the Exchange Rate:
• Inflation differentials
• Interest rate differentials
• Current account
• Economic performance
• Public debt and deficits
• Political stability
• Commodities
34
Exchange Rates:
■ https://www.bankofcanada.ca/2020/0
8/understanding-exchange-rates/
■ https://www.bankofcanada.ca/core-fu
nctions/
■ EXAMPLE
Larry imports chestnuts from China for resale
in his organic food store. One case of
chestnuts costs 120 Chinese yuan.
The Chinese manufacturer told Larry he has
to pay 24 Canadian dollars per case.
This means that for every Canadian dollar he
spends, Lewis receives five yuan worth of
Chinese goods.
In this example, the Canadian/Chinese
exchange rate is $1/¥5.
The Labour Market

Statistics Canada defines the working age population as people 15 years of age and
older.
It further divides this population into three groups:
1. Those who are unable to work ( People institutionalized in Psychiatric hospitals &
Correctional facilities )
2. Those who are not working by choice (• Full-time students • Homemakers • Retirees •
Discouraged workers)
3. The labour force (• People who are working • People who are not working but are
actively looking for work)