Chapter 4- Overview of Economics
Defining Economics
- Economics: Study of how Users of capital make financial choices to
meet their needs
- Market economy: An economic system where decisions regarding
investment, production, & distribution of goods & services are guided
by the prices in the market
- Microeconomics & Macroeconomics
1) Microeconomics
Applies to individual markets of G&S’s (Businesses choices on
production, individuals choices on consumption)
2) Macroeconomics
Applies to factors regarding the overall health of the economy
(employment levels, interest rates, inflation)
Also deals with economic interactions between countries
- Decision Makers
1) Consumers
Want to get the most they can within their limits
2) Businesses
Want to get the most profit from selling their G&S’s
3) Governments
Spend money on education, health care, employment training, the
military
- Demand, Supply, & Market Equilibrium
Interaction with buyers & sellers determines the equilibrium price for
a product
1) Demand
Amount consumers are willing to buy at a given price
2) Supply
Amount producers are willing to sell at a given price
Measuring Economic Growth
- Occurs when an economy produces more output over time
- Gross Domestic Product (GDP)
Total market value of all the final goods produced in a country over a
given period
Final Good: Something purchased by the end user
Intermediatory Good: Something used to make the final good
Monthly/Quarterly GDP= Good indicator of short-term activity
Yearly GDP= Good indicator of growth & changes in production
- 3 Methods to Measure GDP
1) Expenditure Approach
Adds up everything the Decision Makers spend money on during a
given period
2) Income Approach
Based off the idea that the total spending on G&S’s should equal the
total income generated by producing those goods & services (Adds up
all the income generated by this economic activity)
3) Production Approach
Calculates an industry’s output & subtracts the value of all G&S’s
used to produce the outputs (Repeats this for each industry in a nation)
Real & Nominal GDP
- Nominal GDP
The value of all G&S’s produced in a given year with prices in that
same year
Can be misleading because the increase can be a result of prices
only (inflation)
- Real GDP
The true measure of a nation’s productivity in a given year as it
removes the effect of price increases
- Productivity
Output (GDP) per unit of input (labor & capital used to produce
output)
Factors:
1) Technological advances
2) Population growth
3) Improvements in skills (training & education)
The Business Cycle
- Different phases in the economy
1) Expansion
An increase of economic activity (Real GDP increases)
Inflation & Unemployment is stable, Corporate profits increase &
invest more, Start-ups outnumber bankruptcies, Markets are strong,
Job creation increases
2) Peak
Inflation & Interest rates rise, Bond prices fall, Corporate profits
decrease & invest less, Market begins to decline
3) Contraction
A decline in economic activity (Real GDP decreases)
Recession: Contraction of real GDP in 2 consecutive quarters
Unemployment increases, Consumers saving more, Corporate profit
decrease & invest less, Bankruptcies outnumber start-ups, Stock market
declines
4) Trough
Inflation & Interest rates fall which trigger a bond rally, Consumers
are encouraged to spend, Stock prices rally
5) Recovery
Real GDP returns to previous levels
Businesses increase production to meet new demand,
Unemployment remains high, wage pressures are restrained, inflation
declines further
- Economic Indicators:
Help indicate the phase of the economic cycle
1) Leading (Foreshadow)
Housing starts, Manufacturers’ new orders, Commodity prices,
Average hours worked per week, Stock prices, Money supply
2) Coincident (Current)
Personal income, GDP, Industrial production, Retail sales
3) Lagging (Late)
Unemployment rate, Inflation rate, Labor costs, Private sector
spending, Business loans
The Labor Market
- 3 groups:
1) Can’t work People in hospitals & jail
2) Don’t want to work Full-time students, Retirees, Discouraged
workers
3) Labor Force Actively working & Actively looking
- Labor Force Indicators
1) Participation Rate
The share of people actively working in the Labor Force
Participation Rate= (Labor Force / Working age population) x 100
2) Unemployment Rate
The share of people actively looking for work in the Labor Force
Unemployment Rate= (Actively looking / Labor force) x 100
- 4 Types of Unemployment:
1) Cyclical
Directly tied to the economic cycle phase (expansion & contraction)
2) Seasonal
Directly tied to jobs dependent on seasons (Farmers)
3) Frictional
The normal turnover that occurs of people entering & leaving the
workforce
4) Structural
Mismatch between jobs & potential workers due to lack of needed
skills, scarcity of jobs in the area, & poor compensation
- Natural Unemployment Rate: Most optimal level of unemployment
(excludes frictional & structural)
Role of Interest Rates
- Determinants of Interest rates:
1) Supply & Demand of Capital (Money Supply)
Increase in demand for capital= Interest Rates increase
Increase Saving= Interest rates decrease
2) Default risk
Higher the default risk= Higher the interest rate
3) Foreign Interest Rates & the Exchange Rate
Interest rates in Canada are affected by fluctuations in interest
rates abroad
4) Central Bank credibility
5) Inflation
Increase in inflation= Interest rates increase
- How Interest Rates affect the economy
Higher rates stunt growth, Lower rates promote growth
Higher Rates:
1) Decrease spending & borrowing, Increase saving
2) Reduce business investment
- Nominal Interest Rate: Rate charged by a bank that doesn’t account for
inflation
- Real Interest Rate: Rate charged by a bank that accounts for inflation
(Nominal rate – expected inflation rate)
- Negative Interest Rates
Occurs when interest rates are near zero but more economic activity
is needed
Banks may charge clients to keep deposits in accounts & pay them
to take a loan
Impact of Inflation
- Inflation: Sustained rising prices of G&S’s across the economy over a
period of time
- Measuring Inflation
Consumer Price Index (CPI): Measures the average price of a basket
of G&S’s for a given period
(Inflation Rate= (Current period CPI – Previous period CPI / Previous
period CPI) x 100)
- Costs of Inflation
Erodes the standard of living of Canadians whose incomes don’t
adjust
Reduces the real value of investments as it costs more dollars to buy
less
Distorts price signals sent to market participants as the price
increase can be a result of inflation & not value
Brings about rising interest rates & a recession
- Causes of Inflation
Demand-pull inflation: Consumer demands increase during the
expansion phase & businesses may not be able to supply this,
increasing the prices of G&S’s
Cost-push inflation: When businesses increase product prices due to
production cost increases
- Deflation & Disinflation
Disinflation: Decrease in the rate of inflation
Deflation: Sustained fall in prices where CPI is negative Y/Y
- Cost of Deflation & Disinflation
There’s an inverse relationship between inflation & unemployment
that is described by the Phillips curve
1) Lower unemployment is achieved in the short run by increasing
inflation at a faster rate
2) Lower inflation is achieved at the cost of possible increased
unemployment & slower economic growth (Businesses sell products
for less & earn less profit)
- Other Inflationary environments
Stagflation: High inflation rate & slowing rate of economic growth
Hyperinflation: Extremely high inflation rate (greater than 50% m/m)
International Finance & Trade
- Canada’s interaction with the rest of the world via trade, investment,
capital flows, exchange rates is directly correlated to that of their
trading partners
- Balance of Payments
A detailed statement of a country’s economic transactions with the
rest of the world over a given period
1) Current account
The import & export of G&S’s with Canada & foreigners (What we
spend on things)
2) Capital & Financial account
The financial flows between Canada & foreigners through
investments (What we use to finance our spending)
- Exchange Rate
The current price of one currency in terms of another (x USD / 1
CAD)
Export= Foreign country must get domestic currency to buy the
product
Import= Domestic country gets foreign country’s currency to
purchase the product
- Exchange Rate Determinants
Factors:
1) Commodities Increase in demand for domestic commodities=
Domestic currency appreciates
2) Inflation Lower inflation rate= Domestic currency appreciates
3) Interest Rates Higher interest rates= Domestic currency
appreciates
4) Trade Increase in exports= Domestic currency appreciates
Increase in imports= Domestic currency depreciates
5) Economic Performance Better performance= Domestic
currency appreciates
6) Public debts & deficits Larger debt= Domestic currency
depreciates (scares investors)
7) Political Stability Instable country= Domestic currency
depreciates (scares investors)
~ Key Focus ~
1) Define economics & describe the process for achieving market
equilibrium
2) Describe the process for measuring GDP & productivity gains in the
economy
3) Differentiate between business cycle phases & economic indicators
used to analyze current & long-term economic growth
4) Compare & contrast labor market indicators & the types of
unemployment
5) Describe interest rates & the impact it has on the economy
6) Describe inflation & the impact it has on the economy
7) Analyze how trade between nations takes place through the balance
of payments & via the exchange rates