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The performance of the securities markets is strongly tied to the overall performance ofthe economy. For example, a growing and stable economy over time has a positiveimpact on the equity markets. Similarly, bond market activity is strongly tied to the leveland uncertainty of inflation and interest rates over time. The economy determines how manypeople work, how much they spend, how much companies sell, how much they earn, and howhigh inflation and interest rates will be. These are the factors that determine investment returns.

A. OVERVIEW OF ECONOMICSEconomics is fundamentally about understanding the choices individuals make and how thesum of those choices determines what happens in our market economy. A market economydescribes all of the activities related to producing and consuming goods and services and wherethe decisions made by individuals, firms and governments determine the proper allocation ofresources.

Most of us would like to have more of what we have, or at least be able to buy or consume asmuch as we can. In reality, this is not possible because our spending habits are restrained by theamount of income we earn and by the fact that there is a limit to what an economy can produceduring a given period. Because scarcity prevents us from having as much as we would like of cer-tain goods, the performance of the economy hinges on the collective decisions made by millionsof individuals. Ultimately, the interaction between these market participants determines what wepay for a good or service, or a stock or mutual fund for example.

1. The Decision Makers

There are three main groups that interact in the economy: consumers, firms and governments.

Consumers set out to maximize their satisfaction or well-being within the limitations oftheir available resources income from employment, investments or other sources.

Firms set out to maximize profits by selling their goods or services to consumers, govern-ments or other firms.

Governments spend money on education, healthcare, employment training, and the mili-tary. They oversee regulatory agencies, and they take part in public works projects, includinghighways, hydro-electric plants, and airports.

The resources that these decision makers use to produce goods and services are called factors ofproduction and include labour, natural resources, capital and entrepreneurship. Labour refers tothe time and effort individuals dedicate to producing goods and services. Natural resourcesinclude land, minerals, water, energy, or the so-called gifts of nature used in the manufacturingprocess. Capital includes the tools, machinery, and instruments used to produce goods and serv-ices. Finally, entrepreneurship is a key ingredient as these individuals come up with the newideas that help to propel the economy forwards.

Chapter 2

The Canadian Economy

CSI Global Education Inc. (2005)

PRE-TEST

2. The Market

The activity between consumers, firms, and governments takes place in the various mar-kets that have developed to make trade possible. A market is any arrangement that allowsbuyers and sellers to conduct business with one another. For example, the market forwheat in Canada is a network of producers, suppliers, wholesalers, and brokers who buyand sell wheat. These decision makers do not meet physically, but are connected andmake their deals by telephone, computer, fax and other delivery methods. Ultimately,this organized marketplace transforms wheat into a product that consumers buy.

Within any market, there is a circular flow of goods and services and factors of produc-tion between consumers and firms. Consumers decide how much of their labour, entre-preneurship, natural resources, and capital to sell to firms in what are called factor mar-kets. In return for this, consumers receive incomes in the form of wages, rent, interestand profit. With this income, consumers then decide how to spend it on the goods andservices produced by firms in what are called goods markets. In their role, firms mustdecide on the quantity of the factors of production to buy, how to use them, and whatgoods and services to produce and in what quantity.

3. Microeconomics

Economics is divided into two main topic areas: microeconomics and macroeconomics.

Microeconomics analyzes the market behaviour of individual consumers and firms, howprices are determined, and how prices determine the production, distribution, and useof goods and services. For example, consumers decide how much of various goods topurchase, workers decide what jobs to take, and firms decide how many workers to hireand how much output to produce.

Microeconomics looks to answer such questions as:

How do minimum wage laws affect the supply of labour and company profit mar-gins?

How would a tax on softwood lumber imports affect the growth prospects in theforestry industry?

If government placed a tax on the purchase of mutual funds will consumers stopbuying them?

a) Demand and Supply

The price paid for a good or service is determined by the interaction between demandand supply. Consumers decide how much of a good or service to buy, while suppliersdecide 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 willingto buy at a particular price during a given time period. For example, if at a price of$2,000 consumers are willing to buy 200 laptop computers, then 200 is the quantitydemanded of laptops at that price. If the price of laptops rises to $2,500 and consumersare willing to buy 150 laptops, then the quantity demanded of this good has fallen to150 units at this price. The relationship between the quantity demanded of a good andits price is the demand for that good, other factors held constant. These other factorsinclude the prices of related goods, consumer income levels, consumer tastes and prefer-ences, and the population. According to the Law of Demand, the higher the price of agood or service the lower its demand, while the lower the price the higher its demand,other factors held constant.


2-2 CSI Global Education Inc. (2005)

The quantity supplied of a good or service is the total amount that producers are willingto supply at a particular price during a given time period. For example, if a companythat manufactures laptops is willing to supply 100 laptops to the market at a price of$1,500, then 100 is the quantity supplied of laptops at that price. The relationshipbetween the quantity supplied of a good and its price is the supply for that good, otherfactors held constant. These other factors include the prices of inputs used in the pro-duction process (labour, natural resources, capital, etc.), the prices of related goods,technology, and the number of suppliers in the market. According to the Law ofSupply, the higher the price of a good, the greater the quantity supplied.

b) Market Equilibrium

Market equilibrium occurs when the buying decisions of consumers and the sellingdecisions of producers balance themselves out. In other words, equilibrium occurs whenthe price consumers are willing to pay for a good matches the price at which producersare willing to supply it. For example, we can find the market equilibrium of our ficti-tious laptop market using the information from Table 2.1.

TABLE 2.1

Market for Laptops

Price Quantity QuantityDemanded Supplied

(units) (units)

$1,000 500 0

$1,500 350 100

$2,000 200 200

$2,500 150 300

$3,000 10 450

Figure 2.1 shows the market for laptops.

FIGURE 2.1

Market Equilibrium - Laptops

$1,000

$2,000

$3,000

2000Quantity Supplied

Pric

e

500

Equilibrium Point

Demand

Supplyy

x

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Table 2.1 lists the quantities demanded and the quantities supplied at each price level.At each price above $2,000, there is an excess supply or surplus of laptops in the marketbecause consumers are willing to buy less than producers are willing to sell at pricesabove $2,000. At each price below $2,000 there is an excess demand or shortage of lap-tops in the market as producers are unwilling to supply the market with adequate prod-uct at prices below $2,000. The one price that ensures a balance between the quantitydemanded and the quantity supplied is $2,000. This intersection yields an equilibriumprice of $2,000 and an equilibrium supply of 200 units.

Prices plays an important role in regulating the quantity demanded and the quantitysupplied of a any good or service. When the price of a good is too high, consumers willspend less on it so that the quantity demanded falls below the quantity supplied. Whenthere is too much supply in the market, this places downward pressure on the price ofthat particular good. Conversely, when the price of a good is too low, the demand forthat good will rise so that the quantity demanded exceeds the quantity supplied. Heavydemand not matched by an increase in supply places upward pressure on the price ofthat good. As Figure 2.1 shows, there is only one price at which the quantity demandedequals the quantity supplied, and this is our market equilibrium.

4. Macroeconomics

Macroeconomics focuses on the performance of the economy as a whole. It looks at thebroader picture and to the challenges facing society as a result of the limited amounts ofnatural resources, human effort and skills, and technology. Whereas microeconomicslooks at how the individual is impacted by changes in prices or income levels, macro-economics focuses on such important issues as unemployment, inflation, recessions,government spending and taxation, poverty and inequality, budget deficits and nationaldebts.

Macroeconomics looks to answer such questions as:

Why did total output shrink last quarter?

Why have the number of jobs fallen in the last year?

Will a decrease in interest rates stimulate economic growth?

How can a nation improve its standard of living?

Macroeconomics is our focus for the remainder of this chapter.

B. MEASURING ECONOMIC GROWTHThis section looks at the different ways of valuing a nations total production of goodsand services i.e., its output. Economic growth is an economys ability to producegreater levels of output over time and is expressed as the percentage change in a nationsgross domestic product (GDP) over a given period. By measuring growth, we can bet-ter gauge the performance and overall health of the entire economy.

1. Gross Domestic Product (GDP)

Gross domestic product or GDP is the market value of all final goods and services pro-duced within a country in a given time period, usually a year or a quarter. GDP esti-mates in Canada are prepared on a quarterly and annual basis by Statistics Canada. Thequarterly reports are used to keep track of the short-term activity within the market,while the annual reports are used to examine trends and changes in production and thestandard of living.


a) Final Goods and Services

Goods and services go through many stages of production before they end up in thehands of their final users. The calculation of GDP looks at the total amount of finalgoods produced over the period. A final good is a finished product, one that is pur-chased by the ultimate end user. For example, a Dell computer is a final good, but theIntel Pentium chip inside it is not since the Pentium chip was used to manufacture thecomputer. If the market value of all the Pentium chips were added together with themarket value of all the Dell computers GDP would be overstated. Only the marketvalue of the Dell computer, a final good, is included in GDP.

b) Measuring GDP

There are two ways of measuring GDP: the expenditure approach, which looks at totalspending on final goods and services produced in the economy, or by the incomeapproach, which looks at the total income earned producing those goods and services.

The expenditure approach measures GDP as the sum of four components: personalconsumption (C), investment (I), government spending on goods and services (G), andnet exports of goods and services (X M).

Personal consumption measures the spending by households on goods and servicesproduced in Canada and the rest of the world. It is the largest component of GDPand represented 56% of the total in 2004.

Investment measures spending by businesses on capital goods, such as plant andequipment, or by consumers on the purchases of new homes. It also measures thechange in business inventories during the year.

Government on goods and services records the purchases by all levels of governmentson such items as national defence, highway construction, and public health, amongothers.

Net exports of goods and services records the market value of exports, whatCanadian firms sell to the rest of the world, minus the market value of imports,what Canadians buy from the rest of the world.

The expenditure approach measures GDP as:

The income approach measures GDP by summing the incomes that firms pay house-holds for the factors of production they hire wages for labour, rent for land, interestfor capital goods, and profits for entrepreneurs. Since spending on goods and servicesare a source of income for someone else, the income approach looks at how the outputproduced in the economy during a period generates income.

These two measures of GDP show that all production results in income earned byworkers, firms or investors, and all production is eventually consumed (or stored asinventory). Thus, GDP is obtained by adding up either all income earned in the econo-my, or all spending in the economy. In theory, GDP measured by the income approachand by the expenditure approach should be the same.

Table 2.2 illustrates the relationship between the income and expenditure approachesand distinguishes between nominal GDP and the growth or percentage change in GDPon an annual basis.

GDP = C I G (X M)+ + +

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c) Gross National Product

Up until the late 1980s, Canada used gross national product (GNP) as its preferredmeasure of economic growth. GNP is the total market value of all goods and servicesproduced by only Canadian nationals, whether those goods and services were producedin Canada or in another country. Where GDP is a measure of the output producedwithin the borders of Canada, GNP measures the output produced by Canadians any-where in the world.

GNP is measured as:

Profits and interest on Profits and interest paidGNP = GDP + Canadian investments to foreign holders of

in other countries Canadian investments.

For example, NFR Inc. is a Canadian company that operates factories in Canada andmany other foreign countries. Lets assume that the market value of products manufac-tured by NFR in Canada over the last year was $50 billion while the market value ofproducts manufactured at one of its production facilities in France was $5 billion.Canadas GDP for the year would include the $50 billion worth of products manufac-tured by NFR here in Canada but would exclude the $5 billion worth of products man-ufactured in France. The $5 billion worth of the products manufactured in Francewould instead be included as part of Canadas GNP for the year.


TABLE 2.2

Gross Domestic Product at Market Prices

$ Millions % Change2004 2003 year-over-year

INCOME-BASED,Nominal GDP

Labour income 638,868 613,718

Corporation profits before taxes 178,014 151,210

Government enterprise profits 11,857 11,643

Interest & investment income 56,845 51,508

Accrued net farm income 1,700 694

Unincorporated business income 81,013 77,382

Inventory valuation adjustment (657) 4,876

Indirect taxes less subsidies 150,909 142,653

Capital consumption allowances 174,216 164,403

Statistical discrepancy 524 685

Gross Domestic Product 1,293,289 1,218,772 6.11%

EXPENDITURE-BASED,Nominal GDP

Personal Expenditures 722,631 688,707

Government Expenditures 282,494 269,227

Investment Expenditures 231,573 213,537

Net Exports of goods and services 494,519 461,596

Deduct: imports of goods and services (437,404) (413,611)

Statistical discrepancy (524) (684)


EXPENDITURE-BASED, Real GDP*

Personal Expenditures 641,863 620,444

Government Expenditures 243,030 237,189

Investment Expenditures 219,342 206,111

Exports of goods and services 461,291 439,798

Deduct: imports of goods and services (439,172) (405,977)

Statistical discrepancy (460) (616)


Source: Statistics Canada website

*Real GDP is measured by Statistics Canada using 1997 prices.

d) Real and Nominal GDP

Producing more goods and services represents an improvement in a nations standard ofliving. However, if the increase in GDP was simply the result of higher prices, then thecost of buying those goods and services has increased, which reflects an increase in ourcost of living but not an improvement in living standards.

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Nominal GDP is the dollar value of all goods and services produced in a given year atprices that prevailed in that same year, and is typically the amount reported in thefinancial press. Changes in nominal GDP from year-to-year reflect both changes in theprices of goods and services and changes in the amount of output produced in a year.

Table 2.2 shows that nominal GDP was $1.293 trillion in 2004 and $1.219 trillion in2003. Since GDP was higher in 2004 than it was in 2003, one or both of the followingthings happened during the year:

1. The economy expanded and produced more goods and services in 2004 than in2003;

2. Prices rose and consumers had to pay more for goods and services in 2004 com-pared with 2003.

Statistics Canada calculates a measure of GDP that isolates the change in productionfrom changes in prices that prevailed during the year. Real GDP, or constant dollarGDP, is the dollar value of all goods and services produced in a given year valued atprices that prevailed in some base year. Holding prices constant to this base year estab-lishes a better measure of the change in GDP that is the result of changes in the amountof output produced during the year. A doubling of GDP during the year tells us noth-ing about what is happening to the rate of real production unless we also know howprices or inflation also changed over the year. Therefore, differences between real andnominal GDP are entirely the result of changes in prices. Real GDP tells us what wouldhave happened to spending on goods and services if quantities had changed but priceshad not changed.

For example, Table 2.2 shows that nominal GDP increased by 6.11% between 2003and 2004, while the growth rate in real GDP was somewhat lower at 2.64%. The differ-ence between the nominal and real GDP of 3.47% is due to price changes, or inflation.Real GDP is therefore the amount of output adjusted for the effects of inflation becauseit eliminates the impact of changes in the prices of goods and services on the amount ofoutput produced during the year.

2. Growth and Productivity

Since the industrial revolution, the GDP of industrialized economies has tended to growover time. For example, Canadas real GDP is six times higher than it was 50 years ago.

Growth in GDP results from a variety of factors, among the more important are:

Increases in population over time. Even if the output of every worker remained con-stant, GDP would rise due to the growing work force.

Increases in the capital stock. As more workers are provided with additional equip-ment and as their skills have been improved with better training and education,individual productivity rises.

Improvements in technology. Technological innovation helps firms and workers torecombine existing resources of land, capital and labour in new and increasinglyproductive ways. Generally, this has involved the substitution of capital (i.e.,improved machinery) for labour in the production of goods and services. A recentexample is the continuing replacement of bank tellers by ATM machines.

Canadian labour productivity, or output per hour worked, has more than doubled since1961. Gains in individual prosperity are ultimately related to increases in productivity.If productivity growth exceeds increases in the unit costs of production, firms are able tolower the prices of the goods and services they sell.

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C. THE ECONOMY IN THE SHORT RUNReal GDP in Canada has grown on average by about 3.5% since the 1960s. Figure 2.2shows that this growth has not been uniform throughout the period. In fact, growth wasthe most rapid in the 1960s and slowest during the 1980s. Economic fluctuations pres-ent a recurring problem for policy makers as downturns in economic growth are directlyrelated to rising unemployment. Such fluctuations in output and employment are calledthe business cycle, and directly affect the value of investments over time.

FIGURE 2.2

Growth Rate in Real GDP (%)

Source: Statistics Canada

1. Phases of the Business Cycle

Growth in the economy is measured by the increase in real GDP. Figure 2.3 illustratesthe various phases of a hypothetical business cycle. Even though the term cycle suggeststhat the business cycle is regular and predictable, this is not really the case. In reality,fluctuations in real output are both irregular and unpredictable and this makes eachbusiness cycle unique. Nonetheless, the following sequence of events is relatively typicalover the course of a business cycle.

a) Expansion

In times of normal growth, the economy is steadily expanding. Inflation is stable, busi-nesses have adjusted inventories to meet higher demand and are investing in new capac-ity to meet increased demand and to avoid shortages. Corporate profits are rising, newbusiness start-ups outnumber bankruptcies, and stock market activity is strong. Job cre-ation is steady and the unemployment rate is steady or falling. Overall, the growth rateof real GDP is rising during an expansion.

b) Peak

In the final stages of the expansion, demand begins to outstrip the capacity of the econ-omy to supply it. Labour and product shortages cause wage increases and inflation to

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rise. As a result, interest rates rise and bond prices fall. This begins to dampen businessinvestment and reduce sales of houses and big-ticket consumer goods. Business salesdecline, resulting in accumulation of unwanted inventory and reduced profits. Stockprices fall and stock market activity declines.

c) Recession

The economy is in recession when the level of economic activity actually begins todecline i.e. real GDP decreases. Firms faced with unwanted inventories and decliningprofits reduce production, postpone investment, curtail hiring and may lay off employ-ees. Business failures outnumber start-ups. Falling employment erodes householdincome and confidence. Consumers react by spending less and saving more, which fur-ther cuts into sales, fuelling the recession.

As business conditions worsen, economic activity slows in most sectors. If other coun-tries are also experiencing a recession especially the United States the magnitude andduration of the recession in Canada is significantly increased by the reduction in the saleof goods to those outside Canada; in short, by the reduction in our exports. In turn, therate of default and the probability of default by corporate borrowers increases, and isreflected in a higher default premium on corporate borrowings.

d) Trough

As the recession continues, falling demand and excess capacity curtail the ability of firmsto raise prices and of workers to demand higher salaries, and inflation falls. Interest ratesfollow, triggering a bond rally. The trough is reached when consumers who postponedpurchases during the recession are spurred by lower interest rates to begin satisfyingsome of their pent-up demand. Stock prices rally.

e) Recovery

During the recovery, GDP returns to its previous peak. The recovery typically beginswith renewed buying of interest rate-sensitive items like houses and cars. Firms thatreduced inventories during the recession must increase production to meet the newdemand. They are typically still too cautious to hire back significant numbers of work-ers, but the period of widespread layoffs is over. Capacity utilization, or the degree towhich businesses are making use of their production power, remains low, so firms arenot yet ready to make significant new investment. Since unemployment remains high,wage pressures are restrained and inflation may decline further. When the economy risesabove its previous peak, at point A in Figure 2.3, another expansion has begun.

FIGURE 2.3

The Business Cycle

2. Identifying Recessions

A popular definition of a recession is at least two consecutive quarters of declininggrowth in real GDP. However, Statistics Canada and the U.S. National Bureau ofEconomic Research describe a recession differently.

Statistics Canada judges a recession by the depth, duration and diffusion of the declinein business activity. The decline must be of substantial depth, since marginal declines inoutput may be merely statistical error. The duration must be more than a couple ofmonths, since bad weather alone can cause a temporary decline in output. The declinemust be a feature of the whole economy. While a strike in a major industry can causeGDP to decline, that does not constitute a recession. The behaviour of employment andper capita income may also be taken into account.

The recession that began in April 1990 (see Table 2.3) posed particular dating prob-lems. After four quarters of unambiguous decline and one quarter of unambiguousgrowth, the economy neither grew nor shrank meaningfully for six quarters, althoughemployment continued to fall. We have dated the end of that recession to the secondquarter of 1992, when employment reached its trough. The latest recession in Canadabegan in April 2001. However, this episode was viewed by many as a mini-recession asthe economy never actually produced two successive quarters of negative growth.

In recent years, the term soft landing has been used to describe a business cycle phasewhen economic growth slows sharply but does not turn negative, while inflation falls orremains low. Soft landings are considered the Holy Grail of policy makers, who wantsustained growth without the cost of recurring recessions.

GDP

Time

Expansion

Trough

Contraction

Expansion

Peak

Recovery

Peak

Rising Trend in GDP

A

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TABLE 2.3

Post-War Periods of Economic Slowdownand Recession in Canada

Highest Peak-to-TroughUnemployment Decline in:

Dates Duration Rate GDP

* June 51 Dec. 51 7 months 3.6% 0.7%

* June 53 June 54 13 months 5.2 3.1%

* Feb. 57 Jan. 58 12 months 6.5 0.5%

* Apr. 60 Jan. 61 10 months 7.7 1.7%

Feb. 70 Sept. 70 8 months 6.7 0.5%

* June 74 Mar. 75 10 months 7.2 0.6%

* Nov. 79 June 80 8 months 7.8 1.9%

* July 81 Dec. 82 18 months 12.7 6.5%

Apr. 90 Mar. 92 23 months 11.5 3.6%

** Apr. 01 Sept. 01 5 months 7.9 4.3%

*Recession as determined by Statistics Canada

**Technically a growth slowdown or downturn and not a recession

Some economists feel that the February September, 1970 period should be regarded as a recession, breaking the

expansion period from January, 1961 to June, 1974 into two segments.

3. Using Economic Indicators to Match the Business Cycle

Economic indicators are statistics or data series that are used to analyze business condi-tions and current economic activity. They can help to show whether the economy isexpanding or contracting. For example, if certain key indicators suggest that the econo-my is going to do better in the future than had previously been expected, investors maydecide to change their investment strategy.

Economic indicators are classified as leading, coincident, or lagging.

a) Leading indicators

Leading indicators tend to peak and trough before the overall economy, i.e., they aredesigned to anticipate emerging trends in economic activity. They are the most usefuland widely used of the economic indicators since they anticipate change by indicatingwhat businesses and consumers have actually begun to produce and spend.

Among the most important leading data series are housing starts (which precede con-struction) and manufacturers new orders, especially for durables (which indicate expec-tations of higher levels of consumer purchases of such items as automobiles and appli-ances). Others include spot commodity prices (which reflect rising or falling demand forraw materials), average hours worked per week (which rise or fall depending on the levelof output and therefore anticipate changes in employment), stock prices (which suggestchanging levels of profits) and the money supply (which indicates available liquidity andthus has an impact on interest rates).

Statistics Canada combines 10 leading indicators into a single index of leading indica-tors, called the Composite Leading Indicator. Its components are listed in Table 2.4. Inaddition to Statistics Canada, most financial institutions prepare studies based on simi-lar data to identify changing business cycle trends.

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TABLE 2.4

Statistics Canadas Composite Leading Indicator

S&P/TSX Composite Index

Real Money Supply (M1)

United States Composite Leading Index

(which attempts to anticipate American demand for Canadian exports)

New Orders for Durable Goods

Shipments to Inventory Ratio Finished Goods

Average Work Week

Employment in Business and Services

Furniture and Appliance Sales

Sales of Other Retail Durable Goods

House Spending Index

(includes housing starts and house sales)

There are problems implicit in relying on composite leading indicators to predictchanges in the business cycle. On occasion, a trend in published statistics is observableonly after the economy has already moved into the stage of cycle the trend predicts.Sometimes a false signal is given. In any case, the magnitude of the anticipated newtrend is not signaled (i.e., it may be a pause, an economic slowdown or a recession).However, if all indices are signaling the same trend for a similar period of time, theprobability of accuracy is higher.

b) Coincident indicators

Coincident indicators are those which change at approximately the same time and inthe same direction as the whole economy, thereby providing information about the cur-rent state of the economy.

Personal income is a good example because if it is rising, economic growth will typicallyfollow. Other coincident indicators include GDP, industrial production, and retail sales.A coincident index may be used to identify, after the fact, the dates of peaks andtroughs in the business cycle.

c) Lagging indicators

Lagging indicators are those which change after the economy as a whole changes. Theseindicators are important because they can confirm that a business cycle pattern is occurring.

Unemployment is one of the more popular lagging indicators because a rising unem-ployment rate is an indication that the economy is doing poorly or that companies areanticipating a downturn in the economy. Other examples of lagging indicators includeprivate sector plant and equipment spending, business loans and interest on such bor-rowing, labour costs, the level of inventories, and the inflation rate.

To predict stock market price movements, investment strategists use leading indicators thatprecede changes in the business cycle by a longer time period than the stock market does.

D. THE ECONOMY IN THE LONG RUNReal economic growth in a country improves the overall standard of living and generatesa variety of opportunities for those living in that country. A growing economy attractsmore capital, which in turn supports further expansion and diversification.

This section describes economic growth in industrialized countries such as Canada andalso looks at the determinants of this growth.

1. Growth in the Industrialized World

Table 2.5 reports actual and per capita real GDP growth rates for several OECD(Organisation for Economic Co-operation and Development) countries. The tableshows that real GDP per capita growth was fairly uneven for these countries over thelast 30 years. The United States was the exception, however, as it reversed the slowdownin growth performance observed during the 1970s and 1980s, while most other coun-tries had stable or even falling actual and per capita growth rates in the 1990s.

TABLE 2.5

GDP Growth Performance Selected Countries, 1970-2004Average annual rates of change

Real GDP Growth Actual Growth of Real GDPper capita

1970-86 86-95 96-04 2004 1970-86 86-95 96-04 2004

Canada 4.5 2.3 3.4 2.6 2.7 1.0 2.4 2.0

France 3.2 2.1 2.3 2.6 2.5 1.6 1.8 2.2

Germany 2.6 2.7 1.4 2.0 2.8 2.0 1.3 2.0

Italy 3.1 2.1 1.5 1.4 3.2 1.9 1.5 1.2

Japan 4.6 3.1 1.6 4.4 3.4 2.8 1.4 4.3

U.K. 1.8 2.5 2.8 3.4 1.6 2.2 2.4 2.9

U.S.A. 3.4 2.9 3.4 4.3 2.3 1.7 2.3 3.3

Source: International Monetary Fund, World Economic Outlook, 2004

The OECD attributes the outperformance of the United States in GDP per capitagrowth to significant improvements in labour productivity. The 1990s saw improve-ments in employment rates in the United States, while countries like Germany, France,Italy and Canada saw declines. Measuring growth on a per capita basis is useful forstudying changes in living standards. GDP per capita is obtained by dividing the valueof GDP by the population of a nation. By doing so, we have a measure of how muchGDP there is on average for each person in the economy. Productivity growth has majorimplications for the overall wealth of an economy, as there is a direct relationshipbetween the amount of output generated per worker and the standard of living of a typ-ical family.

Sustained growth compounds remarkably over time. A policy measure that increasesannual growth from 2% to 3% doubles a nations standard of living over a 30 to 40 yearperiod. Apart from the growth slowdown experienced by countries in Table 2.5 in the1990s, most have shown strong growth in GDP and labour productivity over the pastthirty year period. Consequently, the standard of living, as measured by output per indi-vidual, has improved dramatically in all these countries.



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In a separate study, the OECD reported that countries considered to be behind in 1960have virtually caught up with the U.S. Such convergence to the standard set by the cur-rent leader is a feature of the improving economies in many of the 30 OECD membercountries. Most of the countries that had a per capita income much lower than the U.S.in 1950 are now converging towards the U.S. standard. This trend is evident in Figure2.4, which shows real GDP per capita in Canada and in other countries between 1960and 2001. The figure shows that Canada had the second highest real GDP per capita in2001 next to the United States. Note that although real GDP per capita in Canadaapproached U.S. levels in the 1980s it slipped back in the 1990s. Also notice that Japanrecorded the most spectacular growth during the 1960s.

FIGURE 2.4

Economic Growth Around the World

Source: World Economic Outlook, International Monetary Fund, 2004.

The same OECD study found that several South American countries in this categoryare exceptions, and most African countries do not exhibit any tendency towards conver-gence to the U.S. standard. The analysis of long-term trends in GDP growth rates isimportant, as it allows for the identification of countries with higher expected growthrates. If the analysis is correct, investment in these countries can lead to superior invest-ment returns.

2. The Determinants of Economic Growth

Increases in output per worker must originate from either an increase in capital perworker or improvements in the technology that combine labour and capital to produceoutput. The liquidity to support investment i.e., additions to the capital stock isgenerated from savings. In Canada, the ratio of savings to GDP over the last 45 yearshas averaged approximately 22% compared with 25% in Germany and 34% in Japan.Concern has been expressed that the comparatively low savings rate is one of the factorsfor the slowdown in productivity growth rates in Canada during the 1990s. However,current research on the determinants of economic growth (which are reflected in higherinvestment values) suggests the following conclusions:

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Capital accumulation alone cannot sustain growth. Eventually, increased capitalleads to smaller and smaller gains in output. So a higher savings rate is not responsi-ble for a sustained higher growth rate over long periods of time. Nonetheless, ahigher savings rate can ultimately support a higher level of output per individual.

Sustained growth requires technological progress which is associated with a complexpattern of basic research, applied research and product development situated in asupportive entrepreneurial context.

Growth accounting is a technique that was developed to differentiate between real GDPgrowth per worker due to capital, versus real GDP growth per worker due to technolog-ical progress. According to this approach, the period of high growth in the industrializedeconomies from 1950 to 1973 was largely due to rapid technological growth. Between1973 and 1996, a slowdown in productivity growth occurred as technological progressand the rate of capital growth slowed over the period. Although productivity growthimproved a great deal during the period 1996 to 2002, largely due to gains in technolo-gy, the rate of growth was slower than what was experienced in the 1960s and 1970s.

E. INTEREST RATESInterest rates are an important link between current and future economic activity. Forconsumers, interest rates represent the gain from deferring consumption from today totomorrow via saving. For businesses, interest rates represent one component of the costof capital i.e., the cost of borrowing money. Thus, the rate of growth of the capitalstock, which determines future output, is related to the current level of interest rates.

Interest rates are one of the most important financial variables affecting securities mar-kets. Since they are essentially the price of credit, changes in interest rates reflect, andaffect, the demand and supply for credit and debt, and this has direct implications forthe bond and money markets. Changes in interest rates made by the Bank of Canadaalso signal changes in the direction of monetary policy and this has broader implicationsfor the entire economy.

1. How Interest Rates Affect the Economy

Higher interest rates affect the economy in the following ways:

They may raise the cost of capital for business investments. An investment shouldearn a greater return than the cost of the funds used to make the investment.Higher interest rates reduce the possibility of profitable investments. In turn, thisreduces business investment.

By increasing the cost of borrowing, higher interest rates discourage consumersfrom spending, especially to buy houses and major durable goods like cars and fur-niture on credit. This encourages consumers to save more.

By increasing the portion of household income needed to service debt, such asmortgage payments, they reduce the income available to be spent on other items.This effect may be offset somewhat by the higher interest income earned by savers.

Thus, higher interest rates have a negative effect on growth prospects. The effect oflower interest rates is the opposite in each case and can provide a positive environmentfor economic growth.



2. Determinants of Interest Rates

A broad range of factors influence interest rates:

Demand and supply of capital: A large government deficit or a boom in businessinvestment raises the demand for capital and forces up the price of credit (interestrates), unless there is an equivalent increase in the supply of capital. In turn, thehigher interest rate may encourage people to save more. An increase in the savingsof government, companies or households may reduce their demand for borrowing.This, in turn, may reduce interest rates.

Default risk: The greater the risk that borrowers may default, the higher the interestrate demanded by lenders. If the central government is at risk of defaulting on itsdebt, interest rates rise for everybody. This additional interest rate is referred to as adefault premium.

Central bank operations: The Bank of Canada exercises its influence on the economyby raising and lowering short-term interest rates. However, it has much less impacton longer-term rates, especially bond yields. Its influence on bond yields resultsmore from the credibility of its long-term commitment to low inflation rather thanany direct influence over long-term bond yields.

Foreign interest rates and the exchange rate: Since Canada has an open economy andinvestors are free to move their money between Canada and other countries, foreigninterest rates and financial conditions influence Canadian interest rates.

For example, a rise in interest rates in the U.S. increases investors returns on moneyinvested there. Investors holding Canadian dollars and who would like to invest in theU.S. will need to sell their Canadian dollars to purchase U.S. dollar-denominated secu-rities. This increases the supply of Canadian dollars on the foreign exchange market andplaces downward pressure on the value of the Canadian dollar. If the Bank of Canadawould like to slow or reduce the fall in the value of the Canadian dollar, they can inter-vene and raise short-term interest rates, even if underlying conditions in Canada areunchanged. This will encourage investors to continue holding Canadian investmentsrather than switch to U.S. dollar-denominated securities.

Central bank credibility: One of the main responsibilities of a central bank is to keepinflation low and stable. The more credible and long-established a commitment tolow inflation has been, the lower interest rates will be to compensate for the risk ofrising inflation.

Inflation: The higher the expected inflation rate, the higher the interest rate thatmust be charged by lenders to compensate for the erosion of the purchasing powerof money over the duration of the loan.

3. Expectations and Interest Rates

Investment decisions are forward-looking. Any decision to purchase a security is basedon an expectation about the future return from the security. Increased optimism in themarket can generate a rise in stock prices. Consumer pessimism can stall economicgrowth, and decrease share prices. Moreover, government economic policies may workonly through their impact on peoples expectations. For example, the Bank of Canadamakes considerable effort to maintain the credibility of its commitment to low inflation.

The role of inflation expectations is particularly important in determining the level ofnominal interest rates. The nominal interest rate is one where the effects of inflationhave not been removed for example, the rate charged by a bank on a loan, or thequoted rate on an investment such as a Guaranteed Investment Certificate or Treasurybill. Other things equal, the higher the rate of inflation, the higher nominal interest

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rates will be. In contrast, the real interest rate is the nominal interest rate minus theexpected inflation rate over the term of the loan. Since it is difficult to measureinvestors inflation expectations, the realized inflation rate is often used as a proxy forthe expected inflation rate.

Figure 2.5 shows nominal and historical (or ex post) real rates in Canada over the last25 years. Notice that nominal interest rates are considerably lower than they were in theearly 1980s. Real rates have fluctuated between 5% and 7% until recently when theydropped below 1%.

FIGURE 2.5

Nominal and Real (ex post) T-Bill RatesCanada 1980 2004

Source: Bank of Canada

If the progress of future inflation is uncertain, then so are expectations of future nominalinterest rates. Bond prices reflect both a change in expectations and any uncertaintiesassociated with such expectations. In an environment with consistently low inflation, thepricing of financial instruments such as government bonds is more straightforward.

F. MONEY AND INFLATIONMoney makes the market go around. It is used to purchase goods and services, realassets like land and capital goods, and financial assets such as bonds, stocks and otherinvestments. Money is the essential ingredient that makes the economy function. As wediscuss below, changes in the amount of money in circulation impacts the economy indifferent ways.

Inflation occurs when prices are rising. This is problematic because as prices rise moneybegins to lose its value that is, more and more money is needed to buy the sameamount of goods and services, and this has a negative effect on living standards.Inflation is an important economic indicator for securities markets because it is the rateat which the real value of an investment is eroded.

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1. The Nature of Money

Money can be any object that is accepted as payment for goods and services, and thatcan be used to settle debts. Its function as a medium of exchange is essential. Withoutmoney, goods and services would need to be exchanged with other goods and services insome form of barter system. Money also acts as a unit of account so that we know exact-ly the price of a good or service. Finally, money represents a store of value since it doesnot have an expiration date if a consumer decides to save it for a later use. The morestable the value of money, the better it can act as a store of value.

The amount of money in circulation can be measured in a variety of ways. Some ofthese different measures, known as monetary aggregates, are described in Table 2.6. Asone way of monitoring economic activity, the Bank of Canada looks primarily atchanges in the growth rate of M1 and M2+ when conducting monetary policy becausethese aggregates provide information about changes that are occurring in the economy.M1 gives information on the future level of production in the economy, while thebroader aggregates, M2 and M2+, provide a useful leading indicator of the rate of infla-tion. By monitoring these aggregates, the Bank strives to keep the rate of money growthconsistent with low inflation and long-term growth.

TABLE 2.6

Bank of Canada Monetary Aggregates

M1

Currency (Bank of Canada notes and coin) held outside banks

Personal chequing accounts

Demand deposits at chartered banks held by individuals and businesses

M2 = M1 plus the following:

Personal savings deposits at chartered banks

Non-personal notice deposits at chartered banks

M2+ = M2 plus the following:

Deposits at trust and mortgage and loan companies

Deposits at credit unions and caisses populaires

Life insurance company individual annuities

Money market mutual funds

M2++ = M2+ plus the following:

Canada Savings Bonds (CSBs)

Non-money market mutual funds

M3 = M2 plus the following:

Non-personal term deposits at chartered banks

Foreign currency deposits at chartered banks

2. Inflation and The Consumer Price Index (CPI)

Inflation in an economy-wide sense is defined as a generalized, sustained trend of risingprices. A one-time jump in prices caused by an increase in the price of oil or the intro-duction of a new sales tax is not true inflation, unless it feeds into wages and other costsand initiates a wage-price spiral. Likewise, a rise in the price of one product is not initself inflation, but may just be a relative price change reflecting the increased scarcity ofthat product. Inflation is ultimately about money growth. It is a reflection of too muchmoney chasing too few products.



The Canadian Consumer Price Index (CPI) is one of the most widely used indicatorsof inflation and is considered a measure of the cost of living in Canada. StatisticsCanada tracks the retail price of a shopping basket comprised of 600 different goodsand services, each weighted to reflect typical consumer spending. In this way, the CPIrepresents a measure of the average of the prices paid for this basket of goods and servic-es. Statistics Canada has a difficult task creating a basket of goods and services that isrepresentative of the typical Canadian household. They try to make the relative impor-tance of the items included in the CPI basket the same as that of an average Canadianhousehold. However, it is almost impossible to construct a basket of goods that wouldbe representative of all consumers. For example, the spending patterns of a family withyoung children would not be the same as the spending patterns of a retired couple.

When calculating CPI prices are measured against a base year, which at the moment is1992, and this base year is given a value of 100. In December 2004, the CPI was 125.4.This indicates that the basket of goods costs 25.4% more than it did in 1992. The CPIis an important economic indicator because it is used in the calculation of the inflationrate, which is the percentage change in the price level from one year to the next. Theinflation rate is calculated by comparing the current period CPI with a previous period:

The CPI was 125.4 in December 2004 and 122.8 in December 2003. The inflation rateover the year was 2.12%:

Inflation has not been much of a problem over the last decade, however for most of the1970s inflation was a serious problem in Canada. Over the past 40 years, Canadas infla-tion rate reached 12.2% in 1981 and fell as low as 0.2% in 1994. The inflation ratedeclined dramatically in both the early 1980s and 1990s based on monetary policyactions taken by the Bank of Canada. Figure 2.6 shows the inflation rate in Canada overthe last 40 years.

Inflation Rate 122.8 120.4

120.40.01993 100 .99%=

= = 1

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CPICurrent Period Previous Period=

PPrevious Period100

FIGURE 2.6

The Inflation Rate in Canada 1965-2004

Source: Bank of Canada.

3. The Costs of Inflation

Inflation imposes many costs on the economy:

It erodes the standard of living of those on a fixed income or those who lack wagebargaining power. It rewards those able to increase their income either throughincreased wages or changes to their investment strategy, in response to inflation.Thus, inflation aggravates social inequities.

Inflation reduces the real value of investments such as fixed-rate loans, since theloans are paid back in dollars that buy less. This can be good for the borrower if hisor her income rises with inflation. But, more likely, inflation results in lendersdemanding a higher interest rate on the money they lend.

Inflation distorts the signals prices send to participants in market economies, whereprices are critical for balancing supply with demand. Rising prices draw resourcesinto areas of scarcity, and falling prices move funds away from glutted areas. Wheninflation is high, it is difficult to determine if a price increase is simply inflationary,or a genuine relative price change.

Accelerating inflation usually brings about rising interest rates and a recession.Thus, high inflation economies usually experience more severe booms and buststhan low-inflation economies.

In recent years, central banks throughout the world have become more acutely con-cerned with these costs and have increased their commitment to price stability.

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4. The Causes of Inflation

The relationships among the growth rate of money, inflation and the rate of unemploy-ment are a subject of considerable controversy. Areas of agreement on the causes ofinflation include:

In the long run, money is neutral; that is, changes in money growth are reflectedfully in changes in inflation. The extra money in the economy is a monetary phe-nomenon that serves only to bid up prices.

Higher money growth may lower interest rates in the short-run and lead toincreased economic activity through increased investment and lower unemploy-ment. In the long-run, nominal interest rates adjust to the new level of moneygrowth and there is no impact on real economic variables such as output and unem-ployment. Only the inflation rate changes.

Some evidence supports a short-run inverse relationship between inflation and thelevel of unemployment. This relationship is called the Phillips curve.

An important determinant of inflation is the balance between supply and demandconditions in the economy. Economists use an indicator called the output gap tomeasure inflation pressures in the economy by looking at the difference betweenreal GDP, what the economy actually produces, and potential GDP, what the econ-omy is capable of producing when its existing inputs of labour, capital, and technol-ogy are fully employed at their normal levels of use. Think of potential output asthe maximum level of real GDP that the economy can maintain without inflationincreasing.

A negative output gap occurs when actual output is below potential output. In thiscase, economists would say there is spare or excess capacity in the economy theeconomy can produce more output because its resources are not being used to theirfull capacity. Unemployed workers and unused plant and equipment resources canbe called into service without impacting wages or prices. Thus, inflation will fall orremain steady.

A positive output gap occurs when actual output is above potential output. In thiscase, economists would say the economy is operating above capacity the economyis trying to produce more than it can with existing resources. Scarce labour fuelswage increases and other strains on productive resources place upward pressure oninflation. In general, a positive output gap occurs as the economy moves through anexpansion towards the peak. Output continues to expand, consumer income is ris-ing and this leads to strong consumer demand for goods and services. However, thiscreates a situation whereby if companies can continue to operate well above normalcapacity, they can raise prices in response to this strong demand. In this way, higherand continued consumer demand pushes inflation higher. This state of affairs iscalled a situation of demand-pull inflation.

Inflation can also rise or fall due to shocks from the supply side of the economy when the cost of producing output changes. For example, the rise of world energyprices in the 1970s caused inflation to rise. At a given price level, when faced withhigher costs of production from higher wages or increases in the price of raw mate-rials, firms respond by raising prices and producing a smaller amount of their prod-uct. In this way, the higher costs push inflation higher. This is an example of cost-push inflation.

Since determining the output gap and its impact on inflation is so difficult, a number ofindicators are monitored for signs of changes in inflation. Commodity and wholesaleprices often react to shortages or gluts before consumer prices. Wage settlements may

give a signal on wage inflation and inflation expectations. Bank credit reflects house-holds demand for major purchases. Movements in the exchange rate often affect infla-tion through their impact on the price of imports.

5. The Costs of Disinflation

Just as there are costs associated with rising inflation, a falling rate of inflation can alsohave a negative impact on the economy. Disinflation is a decline in the rate at whichprices rise i.e., a decrease in the rate of inflation. Prices are still rising, but at a slowerrate.

The potential cost of disinflation is captured by the Phillips curve, which says thatwhen unemployment is low, inflation tends to be high, and when unemployment ishigh, inflation tends to be low. According to this theory:

Lower unemployment is achieved in the short-run by increasing inflation at a fasterrate.

Lower inflation is achieved at the cost of possibly increased unemployment andslower economic growth.

To gauge the cost of disinflation, the sacrifice ratio is used to describe the extent towhich GDP must be reduced with increased unemployment to achieve a 1% decrease inthe inflation rate. Recent studies by the Bank of Canada suggest that the sacrifice ratiois as high as 5; that is, 5% of output must be sacrificed to bring down inflation 1%. Sothere may be a considerable cost in lost output in pursuing the goal of lower inflation.This cost could involve a significant period of relatively high unemployment.

The costs of disinflation were evident in Canada most recently in the early 1990s. In1988, the inflation rate in Canada was 4% and the unemployment rate was 7.8%. Sixyears later in 1994, the inflation rate had dropped dramatically to 0.2% while theunemployment rate had risen to 10.4%. As Table 2.7 shows, real GDP also droppedconsiderably during this period before it began to recover in 1992.

TABLE 2.7

The Costs of Disinflation in Canada

Year Bank Unemployment Inflation Real Rate % % % GDP %

1988 9.69 7.8 4.0 5.0

1989 12.29 7.5 5.0 2.6

1990 13.05 8.1 4.8 0.2

1991 9.03 10.3 5.6 -2.1

1992 6.78 11.2 1.5 0.9

1993 5.09 11.4 1.8 2.3

1994 5.77 10.4 0.2 4.8

6. The Costs of Deflation

Deflation is a sustained fall in prices where the annual change in the CPI is negativeyear after year. In fact, deflation is just the opposite of inflation. Falling prices are gener-ally preferred over rising prices. Goods and services become cheaper, and our incomeseems to go a little farther than it used to. Although true in the short-term, there arenegative consequences of deflation.

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One view holds that the impact of sustained falling prices eventually leads to a declinein corporate profits. As prices continue to fall businesses must sell their products atlower and lower prices. Businesses cut back on productions costs, wage rates, and, ifconditions worsen, lay off workers. For the economy as a whole unemployment rises,economic growth slows and consumers shift their focus from spending to saving.Ultimately, declining company profits will negatively impact stock prices.

As the economy slows and enters a recession, the central bank can use lower short-terminterest rates to stimulate consumer and business spending. However, there is a limit tohow low interest rates can fall rates cannot fall to a negative level or below zero. Theeconomy of Japan in the 1990s provides a good example of the impact of deflation. Atthe time, the Bank of Japan and the government tried to eliminate deflation by reduc-ing interest rates. However, despite having rates near zero for a sustained period theireconomy is still in the process of recovery.

G. LABOUR MARKETSFor most Canadians, the performance of the economy affects them most personally inthe labour market. When the economy is strong, so is the demand for labour.Employment rises, the unemployment rate falls, and workers win bigger wage raisesand/or non-wage benefits. Conversely, when the economy weakens, so does the demandfor labour, and wage demands are restrained.

1. The Canadian Labour Market

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. StatisticsCanada also defines the labour force as the sum of the working-age population who areeither employed or unemployed.

Since 1945, the Labour Force Survey has been the main source of information concern-ing the Canadian labour market. Currently, a panel of some 50,000 households acrossCanada is surveyed monthly. The panel is chosen to represent the countrys differentdemographic groups, and each household stays in the survey for 6 months.

Table 2.8 shows Canadian population statistics for 2004. Of the 25.6 million Canadiansincluded as part of the working-age population, 17.3 million were part of the labourforce. The remaining 8.3 million likely consisted of full-time students and those retiredfrom working. Within the labour force, 16.1 million were employed in either full-timeor part-time work and 1.2 million were unemployed and did not have jobs.

TABLE 2.8

The Labour Market in CanadaAs at December 2004

Population Working-Age Labour Employed UnemployedPopulation Force

32,078,819 25,613,947 17,263,800 16,057,400 1,206,400


There are two key indicators that describe the labour market: the participation rate andthe unemployment rate.

The participation rate represents the share of the working-age population that is inthe labour force. Using numbers from Table 2.8, at the end of 2004, the labour

force participation rate in Canada was 67.4% (17,263,800 divided by 25,613,947).The participation rate is an important indicator because it shows the willingness ofpeople to enter the workforce and take jobs.

The unemployment rate represents the share of the labour force that is unemployedand actively looking for work. The unemployment rate may rise either because thenumber of employed fell or the number of people entering the work force lookingfor work rose, or both. At the end of 2004, the number of people unemployed inCanada was 1.2 million and the unemployment rate was 7% (1,206,400 divided by17,263,800). Incidentally, the average unemployment rate in Canada over the past40 years has been 7.7%.

The participation rate in Canada has followed a mostly upward trend over the last 40years, rising from 54% in the early 1960s to its current level of 67.4% in 2004. In fact,the participation rate remained relatively stable in Canada over the last several yearsaveraging around 65%.

Figure 2.7 shows the patterns in the Canadian unemployment rate since the 1960s. Ingeneral, the upward trend with large fluctuations corresponds to the trend and stages ofthe business cycle. Significant post-war peaks in unemployment were recorded duringthe last two major recessions in Canada. The peak at 11.9% corresponds to the reces-sion of 1980-1983, while the peak of 11.4% corresponds to the recession of 1991.Typically, the impact of economic downturns varies across workers with young andunskilled workers the most vulnerable. The recession of 1990-91 was somewhat differ-ent as the unemployment rate among prime-age workers jumped higher than usual.

FIGURE 2.7

Unemployment Rate in Canada (%)


Some people are unemployed for a short time, while others are unemployed for longerperiods. The average duration of unemployment varies over the business cycle and istypically shorter during an expansion and longer during a recession. At times, jobprospects are so poor that some of the unemployed simply drop out of the labour forceand become discouraged workers. Discouraged workers are those individuals that areavailable and willing to work but cannot find jobs and have not made specific efforts to

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find a job within the previous month, and so are not included as part of the labourforce. The disappearance of these discouraged unemployed workers can produce anartificially low unemployment rate.

2. Types of Unemployment

There are three general types of unemployment: cyclical, frictional and structural.

Cyclical unemployment is tied directly to fluctuations in the business cycle. It riseswhen the economy weakens and firms lay off workers in response to lower sales. Itdrops when the economy strengthens again.

Frictional unemployment is the result of normal labour turnover, from people enteringand leaving the workforce and from the ongoing creation and destruction of jobs. Evenin the best of economic times, people are looking for work because they have finishedschool, quit, been laid off or fired from their most recent job. This is a normal part of ahealthy economy.

Structural unemployment occurs when workers are unable to find work or fill availablejobs because they lack the necessary skills, do not live where jobs are available, or decidenot to work at the wage rate offered by the market. This type of unemployment is close-ly tied to changes in technology, international competition and government policy.Structural unemployment typically lasts longer than frictional unemployment becauseworkers must retrain or possibly relocate to find a job.

The distinction between frictional and structural unemployment is sometimes difficultto determine. There are always job openings and potential workers to fill those jobs.With frictional unemployment, unemployed workers have the required skill levels to filla job vacancy. With structural unemployment, however, unemployed workers lookingfor work do not possess the needed skills to find a job.

A pressing problem in Canadas economy is the apparent rising trend in unemployment,both frictional and structural, since the mid-1960s as shown in Figure 2.8. Some expla-nations advanced for this increase:

Labour market regulations may discourage hiring. Minimum wages may be set toohigh, thereby reducing the incentive for businesses to hire low-skilled workers andoffer on-the-job training.

Labour market rigidities, such as the strength of unions to maintain wages in theface of economic downturns, may prompt firms to reduce costs by laying off work-ers. Payroll taxes and other indirect labour costs also make it more expensive to cre-ate jobs.

Welfare and employment insurance benefits can make it more attractive for workersto remain unemployed or at least encourage longer periods of searching for workinstead of taking low-paying jobs. Although the generosity of these programs inCanada has decreased significantly over the past 20 years, they have contributed tothe rising trend in the unemployment rate.

The severity of recent recessions means workers spend more time unemployed. As aresult, their skills may become rusty or even obsolete, especially in a context wheretechnological change is rapidly altering what employers demand of workers. Theseworkers may become unemployable even in strong economic times due to their lackof marketable skills.

The existence of frictional and structural factors in the economy prevents unemploy-ment from falling to zero. This means that even in times of healthy economic growththere is a level below which unemployment will not drop without causing other nega-



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tive economic effects. This minimal level of unemployment is called the natural unem-ployment rate, the full employment unemployment rate, or the non-accelerating infla-tion rate of unemployment (NAIRU). At this level of unemployment, the economy isthought to be operating at close to its full potential or capacity such that all resources,including labour, are fully employed. Further employment growth is achieved eitherthrough increased wages to attract people into the labour force which fuels inflation, orby more fundamental changes to the labour market that removes impediments to jobcreation.

The Bank of Canada and the Department of Finance estimate Canadas natural unem-ployment rate at somewhere between 6% and 7%. The Bank of Canada pays closeattention to the actual unemployment rate and the natural unemployment rate as thegap between the two has an important influence on wage inflation. When the actualunemployment rate is above the natural rate an excess supply of workers in the marketweakens labour bargaining power, which discourages wage gains and helps to keep infla-tion in check. When the actual unemployment rate is below the natural rate, a shortageof workers contributes to an increase in wage gains and higher inflation. Thus, the natu-ral unemployment rate is often viewed as the level of unemployment that is consistentwith stable inflation, which is why it is an important number with respect to monetaryand fiscal policy decisions.

Over time, workers wages are determined by their productivity. If the value of whateach worker in a firm produces rises by 5% in a year, each workers wage can also rise5% without reducing profits. Occasionally, when unemployment is low, wage increasesmay outstrip productivity growth. Firms try to recover the increased cost by raisingprices, which may contribute to a wage-price spiral. Thus, wage settlements by bothunionized and non-unionized workers are considered an important indicator of infla-tion, firm profitability and international competitiveness.

H. THE EXTERNAL SECTORThe external sector deals with the interactions Canada has with the rest of the world trade, investments and capital flows, and the exchange rate. Since the end of the SecondWorld War, the dependence of industrial economies on trade has risen significantly.This is especially so for Canada. In 2004, exports of goods and services equalled 44% ofGDP, compared to 19% in 1964. As a result, the economic performance of our tradingpartners is an important determinant of Canadian economic growth.

1. The Balance of Payments

The balance of payments is a detailed statement of a countrys economic transactionswith the rest of the world for a given period of time typically over a quarter or a year.The two components of the balance of payments are the current account and the capitalaccount.

The current account records the exchanges of goods and services betweenCanadians and foreigners, the earnings from investment income, and net transferssuch as for foreign aid.

The capital account records financial flows between Canadians and foreigners relat-ed to investments by foreigners in Canada and investments by Canadians abroad.

Balance of payments transactions can be thought of as incurring either a demand orsupply of foreign currency and a corresponding supply or demand of Canadian curren-cy. Current account outflows, such as to buy foreign goods or pay interest on debt heldby foreigners, create a demand for foreign currency to make those payments. Canadian

dollars are offered in exchange for this foreign currency unless there is a correspondingdemand for Canadian dollars.

Table 2.9 shows Canadas balance of payments in 2004. Items in the current accountand the capital account that have a plus sign represent a flow of foreign currency intoCanada, while items with a negative sign represent an outflow of foreign currency fromCanada.

TABLE 2.9

Canadas Balance of International Payments, 2004($Millions)

CURRENT ACCOUNT

Merchandise Exports + 430,279

Merchandise Imports - 362,952

Merchandise Trade Balance + 67,327

Non-Merchandise Exports Services + 62,238

Non-Merchandise Imports Services - 73,529

Net Investment Income - 22,438

Net Transfer Payments + 125

Current Account Balance + 33,723

CAPITAL ACCOUNT

Foreign Direct Investments in Canada + 8,548

Foreign Portfolio Investments in Canada + 53,208

Other Foreign Investments in Canada - 8,942

Total Canadian Liabilities + 52,814

Canadian Direct Investments Abroad - 57,453

Canadian Portfolio Investments Abroad - 16,174

Other Canadian Investments Abroad - 8,049

Total Canadian Assets - 81,676

Net Canadian Claims (Assets Liabilities) - 28,862

Net Capital Account + 4,415

Capital Account Balance - 24,447

STATISTICAL DISCREPANCY(between Current and Capital Account) + 9,276


In theory, the current account balance should equal the capital account balance. Thinkof the current account as what we spend on things and the capital account as what weuse to finance this spending.

During a given year, if Canada buys more goods and services from abroad than it sells itwill run a current account deficit for the year. It will need to sell more assets to financethe spending, which means running a capital account surplus, or go into debt. As ananalogy, when an individual spends more than he/she earns, the difference is made upby either borrowing money or selling something of value and using the proceeds to payoff the debt. In this way, a country experiencing a current account surplus is savingmore than it is spending and can lend out this surplus amount to foreigners.



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a) Trade and the Current Account

The most important component of the current account is merchandise trade. Table 2.9shows that Canada exported $493 billion of goods and services (the total of merchan-dise exports and non-merchandise exports services) abroad and imported $437 billionworth of goods and services (the total of merchandise imports and non-merchandiseimports services) in 2004. The vast majority of this trade involved the U.S. Canadaexported 84% of its goods to U.S. markets and imported 72% of its goods from theU.S. Overall, Canada recorded a current account surplus of $34 billion in 2004.

A number of factors influence the performance of Canadas trade. The most importantis the relative pace of demand in foreign and Canadian economies. Strong growth inU.S. demand for automobiles, raw materials and other products made in Canada boostsexports. Likewise, strong demand in Canada for foreign products boosts imports.

The competitive position of Canadian firms in foreign markets and foreign firms inCanada also influences trade. A falling Canadian dollar, for example, lowers the price ofCanadian exports in foreign markets and raises the price of imports in Canada. Thisboosts exports and depresses imports. Those benefits are lost, however, if the price ofCanadas goods rise in response to the lower dollar. A rising Canadian dollar has theopposite effect.

Since many companies in Canada are closely integrated with affiliates and suppliers inother countries, imports are closely linked to exports. Automobile components may beimported and the subsequently assembled autos exported. That is one reason Canadasexports and imports tend to move in the same direction.

Although trade is the largest component of the current account, others are also impor-tant:

Investment Income: Canadians pay interest on debt borrowed from foreigners anddividends to owners or investors in Canadian companies. Likewise, foreigners payinterest and dividends to Canadian investors. These payments are investmentincome. Because Canada has a large net foreign debt, it makes large payments toforeigners in the form of interest on that debt. This substantial deficit on invest-ment income represents the largest contributor to the total current account deficit.

Services: Canada usually runs a deficit on services trade, reflecting, among otherthings, the large contingent of Canadians living part of the year in the southernU.S. Examples of items that fall into the services category are:

Some services trade is directly linked to merchandise trade, such as freightcharges;

Canadian companies such as engineering and accounting firms may sell theirservices in foreign markets; and

Tourism and travel represent an important part of services trade.

Transfers: This category refers to unilateral transfers of money between Canadaand foreign countries. Canadas official development assistance to poor coun-tries is the most important transfer outward. Immigrants bringing their savingsto Canada is the most important transfer inward.

b) The Capital Account

Table 2.9 shows that Canada ran a capital account deficit of $24.447 billion in 2004.This means that more capital flowed out of Canada in the form of loans or investmentsthan Canada received from foreigners in the form of direct investment in Canada.

The key difference between current and capital account transactions is that the latterresult in an acquisition of an asset and the right to any income it earns. Thus, the pur-chase of a computer made in Canada is a current account transaction, whereas the pur-chase of the company that made the computer is a capital account transaction.

Over time, a succession of current account deficits result in growing foreign claims on acountry, and thus a large foreign debt. Likewise, a country with successive currentaccount surpluses eventually becomes a large creditor nation.

The borrowing and lending of these amounts are recorded in the capital account. Themajor capital account components are:

Direct Investment: Since Confederation, foreign investors have put money intoCanada for the purpose of starting new businesses, acquiring existing ones, or buy-ing land and other income-producing assets. More recently, Canadians have becomeactive investors in corporate assets abroad, especially in the U.S. If the foreigninvestor owns 10% or more of a Canadian company, the investment is classified asdirect; anything less is categorized as portfolio investment.

Portfolio Investment: The two main types of portfolio investment are debt and equi-ty. This type of investment involves issuing bonds and treasury bills to foreigninvestors. This takes place usually through foreign purchases of a newly issued oroutstanding bond or Treasury bill, or purchases of equity for investment rather thancontrol.

International Reserve Transactions: The Bank of Canada, on behalf of the federal gov-ernment, buys or sells Canadian dollars in currency markets in exchange for foreigncurrency to smooth its movements. The acquisition or sale of these reserves isrecorded as a capital account transaction.

2. The Exchange Rate and its Impact on the Economy

Buying foreign goods or investing in a foreign country requires the use of another cur-rency to complete the transactions. Conversely, when foreigners buy Canadian goods orinvest in Canadian assets, they need Canadian dollars. The foreign exchange marketincludes all the places in which one nations currency is exchanged for another at a spe-cific exchange rate the price of one currency in terms of another. For example, aCanadian dollar exchange rate of US$0.80 means that it costs 80 U.S. cents to buy oneCanadian dollar.

a) The Exchange Rate and the Canadian Dollar

Although the United States dollar (US$) exchange rate is the most important rate forCanada because so much of our business is carried on with the U.S., an officialexchange rate exists between the Canadian dollar and every other convertible currencyin the world. For example, the impact of a rise in the Canadian dollar against the US$might be offset by a fall against the Euro.

In an economy as dependent on trade and open to international capital flows asCanadas, the behaviour of the exchange rate is vitally important. The value of theCanadian dollar relative to other currencies influences the economy in a number of ways.The most important influence is through trade. A higher dollar makes Canadian exportsmore expensive in foreign markets and imports cheaper in Canada. When the Canadiandollar rises in value relative to a foreign currency the dollar is said to have appreciated invalue against that currency; conversely when the Canadian dollar falls in value relative toa foreign currency the dollar has depreciated in value against that currency.

Suppose a machine made in Canada sells for $1,000. With the Canadian dollar atUS$0.65, it sells for US$650 in the U.S. If a similar product sells for $700 in the U.S.



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the Canadian manufacturer benefits at this exchange rate as the machine will sell for alower price in the U.S. market. If the exchange rate appreciates in value to US$0.80, themachine would now sell for US$800, making its manufacturer less competitive in theU.S. market and decreasing sales and probably corporate profitability. Likewise, a U.S.company that sold a similar machine for US$650 in the U.S. would sell it for $1,000 inCanada with the exchange rate at US$0.65, but only $812.50 with the exchange rate atUS$0.80, taking sales away from the Canadian company.

Since many Canadian exporters price their products in U.S. dollars, they will often electto keep its US$ price unchanged as the dollar appreciates in value even though thatresults in less revenue in Canadian dollars. Such a decision would force the exportereither to accept lower profits, or find a way to reduce the costs of making the product.A lower exchange rate would have the opposite effects, making Canadas exports cheaperand imports more expensive. An exporter that kept its US$ price unchanged wouldpocket higher profits, or allow costs to rise.

Figure 2.8 shows the exchange rate between Canada and the U.S. between 1975 and2004. The figure shows that the Canadian dollar depreciated steadily against the U.S.dollar for most of this period, other than for a brief rise in the currency in the late1908s. This downward trend reversed beginning in early 2003, as the currency rosesteadily against the U.S. dollar during 2003 and 2004.

FIGURE 2.8

The Exchange Rate 1975 - 2004U.S dollar per Canadian Dollar

Source: Bank of Canada

Other factors come into play when determining the impact of a change in the exchangerate on trade. For example, if Canada has a lower inflation rate than the U.S., then theimpact of a higher exchange rate is offset by Canadas lower costs. Thus, it is importantto distinguish between the nominal exchange rate, which is most widely followed in mar-kets and the media, and the real exchange rate, which economists use to adjust for the

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impacts of different inflation rates. Suppose the Canadian dollar rises from US$0.70 toUS$0.735. The nominal exchange rate has risen 5%. However, suppose in the same peri-od, the U.S. inflation rate is 5% and Canadas is 2%, so prices rose about 3% more inthe U.S. than in Canada. In that case, the real exchange rate has risen only 2%, and theimpact on the economy is less than the change suggested by the nominal exchange rate.

b) Fixed Exchange Rates

A number of different exchange rate systems or regimes exist in the world. The mostcommon are fixed and floating. Under a fixed exchange rate, a countrys central bankmaintains the domestic currency at a fixed level against another currency or a compositeof other currencies.

This is achieved in one of two ways.

The first way is for the government to impose controls on purchases of foreignexchange, compelling everyone to buy and sell the domestic currency only through itsown banks, at its price. In such cases, a black market rate almost always emerges thatbetter reflects supply and demand for the domestic currency. Because capital controlsimpose a high regulatory and distortionary burden on an economy with a sophisticated,internationally integrated financial system, such systems are used almost exclusively bypoor, developing countries.

Many advanced economies fix their exchange rates without capital controls. They allowthe currency to trade freely but instruct their central banks to keep the domestic curren-cy in a prescribed range by buying and selling it on the open market and adjustinginterest rates if necessary. Occasionally investors or speculators will attack such a peggedcurrency if they think it is overvalued, and the central bank lacks the ability or will tomaintain the peg. Such attacks often result in market turmoil and devaluation. Thedevaluation of the Mexican peso in December 1994 and the ensuing financial crisis is adramatic example of the risks of fixed exchange rates. Such risks are reduced when thepeg is strongly backed by ample foreign exchange reserves, a sound economy and ahighly credible monetary authority.

c) Floating Exchange Rates

Most advanced countries, including Canada and the U.S., have a floating exchangerate. In such a system, the central bank allows market forces to determine the value ofthe currency. The central bank may intervene if it thinks movements in the exchangerate are excessive or disorderly. The Bank of Canada has occasionally used interest ratesto halt free-falls in the Canadian dollar because of the threat such a fall poses either toorderly markets or inflation. For example, if interest rates in Canada rise relative to ratesin the U.S., Canadian dollar-denominated assets may become more attractive toinvestors. If this is the case, the demand for Canadian dollars increases and the exchangerate appreciates in value. Similarly, if interest rates in Canada fall relative to U.S. rates,investors transfer out of Canadian investments and into U.S. dollar-denominated invest-ments. This has the effect of increasing the supply of Canadian dollars and leads to adepreciation in the currency.

Virtually all countries, including Canada, maintain a reserve of foreign assets that can beused to buy and sell the domestic currency to influence its level in currency markets. InCanada, the Exchange Fund Account is made up of foreign currencies (mostly U.S. dol-lars), gold, and reserves in the International Monetary Fund (IMF). The accountbelongs to the federal gove

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