CHAPTER 4:

ECONOMIC PRINCIPLES
Topic One: Foundations of Economics

1. Microeconomics and Macroeconomics.

A. Microeconomics is the study of how individual consumer and corporate behaviour affects
the prices of goods and services.
(1) For instance, the way the change in the price of a good influences a family's
purchasing decisions is a microeconomic issue.

B. Macroeconomics is the study of the economy as a whole.

(1) For instance, how a change in interest rates influences national savings
is a macroeconomic issue.

2. The Decision Makers.

A. There are three groups that interact economically.
(1) Consumers—whose income from such sources as salaries and
investments is used to purchase products.
(2) Companies—that manufacture and sell goods and services to
consumers, governments, and other companies.
(3) Governments—that spend on various public services such as health
care and fund large-scale capital projects such as hydro-electric dams.

B. These groups rely on four factors of production to produce goods and services.
(1) Labour contributed by individuals.
(2) Natural resources.
(3) Capital.
(4) Entrepreneurship in the form of new ideas.

C. Factor markets are where consumers exchange their factors of production in

return for income.
(1) For instance, labour is exchanged for wages; capital is exchanged for
shares that increase in value and pay dividends.

D. Goods markets are where consumer income is exchanged for goods and
services.
(1) For instance, a portion of wages is exchanged for a new refrigerator.
3. Supply and Demand.
A. The relationship between supply and demand determines the cost of goods and
services.
(1) Supply is the amount of a good or service available in the market at a
specific price and time.
(2) Demand is the amount of a good or service bought by consumers at a
specific price and time.

B. When a buying price matches a selling price, market equilibrium, or balance, is

reached. This equilibrium is challenged when either supply or demand changes:
(1) When a product becomes too expensive, fewer consumers will buy it,
and supply can exceed demand.
(2) When competition increases (e.g., by several companies offering similar
products), pressure is put on companies to reduce prices. However,
when the price consumers are willing to pay is too low, supply ceases.
(3) When enough product cannot be made to meet heavy demand, the
price of that good or service will rise.
Topic Two: Economic Growth

1. Gross Domestic Product (GDP).

A. GDP is a measure of economic growth.
(1) This is the value of all final goods and services produced in the country in a year.
(a) Final goods are the last stage in the production process and represent a
finished product. For instance, a cell phone is a final good, and its sale
will contribute to the GDP; the chip in the cell phone is not a final good.
(2) There are two measurements of GDP. GDP will be the same no matter which
measurement is used.
(a) The expenditure-approach formula is:

GDP = C + I + G + (X – M)

i. C is personal consumption: the amount spent by

Canadian households on Canadian- and foreign-
produced goods and services.
ii. I is investment: the amount spent by businesses on
capital goods and the amount spent by consumers on
new homes.
iii. G is the amount spent by government at all levels on
goods and services.
iv. X is the market value of Canadian exports, from which
is subtracted M, the value of Canadian imports.

(b) The income-approach formula is: total value of income from

production, minus wages, rent, interest on capital goods,
and entrepreneurial profits.

(3) GDP is directly related to levels of employment, since economic growth

is associated with rising employment and economic contraction with
unemployment.

B. GDP is reported as either nominal GDP or real GDP.

(1) Nominal GDP (also called current-dollar GDP or chained-dollar GDP)
calculates economic activity for a given year in dollars of that year.
(a) Nominal GDP makes comparisons between time periods
difficult, due to the effects of inflation.
 (2) Real GDP (also called constant-dollar GDP) calculates economic
activity for a given year in dollars of a base year.
(a) Real GDP allows for easy comparisons between time periods,
since inflation is factored out.

C. Productivity and determinants of economic growth.

(1) Increasing GDP can be the result of:
(a) Population growth and the growth of the work force.
(b) Increasing worker productivity.
(c) Increasing business productivity due to technological
innovations.
(2) The impact of productivity is considerable: yearly GDP increases of 2%
to 3% can double a country’s standard of living over 30 to 40 years.
(3) Countries with higher growth rates represent opportunities for higher
investment returns.

D. Economic growth results from greater worker output as a result of greater capital
expenditures or improved technology.
(1) Capital expenditures are based on a country’s capital stock, which in
turn is a result of capital accumulation, i.e., savings.
(a) Canada’s relatively low savings rate underlies its relatively low
growth rate.
(b) Growth cannot be sustained by capital accumulation alone. A
higher savings rate can, however, help support higher levels of
output per individual.
(2) Technological progress is needed for sustained growth.
Topic Three: The Business Cycle

1. Changes in the Economy as Seen in the Business Cycle.

A. The business cycle has five phases.
(1) Expansion occurs when GDP grows. It is characterized by:
(a) Stable inflation.
(b) Business inventories and investments adjusted to meet higher
demand.
(c) A rise in corporate profits, and start-ups outnumbering
bankruptcies.
(d) A strong stock market.
(e) Unemployment either steady or falling.

(2) The peak occurs when GDP growth has been maximized. It is
characterized by:
(a) Supply unable to keep up with demand.
(b) Wages and inflation increasing due to labour and product
shortages.
(c) Interest rates rising and bond prices falling.
(d) Business investment and house sales beginning to slacken.
(e) Company sales beginning to decline, resulting in excess inventory
and reduced profits.
(f) Stock prices falling and stock-market activity declining.

(3) A contraction occurs when GDP decreases. It is seen when:

(a) Companies battle excess inventories and declining profits.
(b) Business failures outnumber start-ups.
(c) Unemployment increases; therefore, household spending and
savings decrease.
(d) Exports decline.
(e) The rate and probability of default is reflected in an increased
default premium paid by corporate borrowers.
 (4) A trough occurs when GDP decline has maximized. It is characterized
by:
(a) Falling inflation as demand continues to decrease.
(b) Declining interest rates, bond prices rally.
i. When interest rates bottom out, consumers begin to buy.
ii. Stock prices rally.

(5) A recovery has occurred when GDP returns to its previous peak. It is
characterized by:
(a) Purchases of interest-rate-sensitive products, such as houses
and cars, beginning to pick up.
(b) Companies beginning to increase production to meet the new
demand.
(c) Unemployment remaining high, so wage increases are
constrained and inflation may decline even further.
(d) When the economy has passed its previous peak, another
expansion is considered to have begun.

B. A soft landing has occurred when a contraction or trough cycle does not lead to
a subsequent recession.

2. Economic Indicators.
A. There are three economic indicators that show whether the economy is
expanding or contracting.
(1) Leading indicators show the direction the economy is moving; they peak
and trough before the GDP. They indicate change and include: housing
starts, house spending index, "spot" commodity prices, stock prices,
manufacturers’ new orders, employment levels, average hours worked
per week, and money flows.
(a) The Composite Leading Indicator produced by StatsCan
combines 10 indicators into a single index that is closely
monitored for indications of growth or recession.
 (2) Coincident indicators show where the economy is; they measure
changes in the economy as they are taking place and give a picture of
its current state. Examples are: GDP, industrial production, personal
income, and retail sales.
(3) Lagging indicators show where the economy has been; they change
after the overall economy has changed. Examples are: plant and
equipment purchases, business loans, interest rates, the unemployment
rate, inventory levels, and inflation.
(a) Lagging indicators are used to identify phases of the business
cycle.
3. Recession.
A. Statistics Canada (StatsCan) identifies a recession by:
(1) Depth — is the decline of output substantial enough to exclude the
possibility of statistical error?
(2) Duration — has the decline lasted more than a couple of months?
(3) Diffusion — is the decline diffused throughout the economy, rather than
in a single sector?

Topic Four: The Canadian Labour Market

1. Labour Force.
A. The labour force is the working age population and includes both those who
work and those who do not.

2. Labour Market Indicators.

A. There are two rates, called indicators, that are used to describe the labour force.
(1) The participation rate is the percentage of the working-age population
(age 15 and older) in the labour force. These people are willing to work.
(2) The unemployment rate is the percentage of the labour force that is
unemployed and actively looking for work.
(a) Discouraged workers are unemployed individuals who are able
to work but have not made an effort to find work over the
previous 30 days. They are not considered part of the labour
force.
3. Unemployment.
A. There are three types of unemployment.
(1) Cyclical unemployment moves in tandem with the business cycle.
(a) A strong economy = demand for labour; wages increase.
(b) A weak economy = reduced demand for labour; wages fall.
(2) Frictional unemployment is a result of normal employment conditions;
old jobs are eliminated, people leave the workforce.
(3) Structural unemployment occurs when people do not have the required
skills for jobs available, do not live close enough to available jobs, or do
not wish to work for the offered wage.

B. The unemployment rate can never be zero. The lowest it can be is estimated at
6.5% to 7%. This is called the natural unemployment rate, the full- employment
unemployment rate, or the non-accelerating inflation rate of unemployment
(NAIRU).
(1) At this level of employment, the economy is operating near its full
potential.
(2) A higher rate of unemployment means too many workers chasing too
few jobs, in which case wages (and inflation) fall.
(3) A lower level of unemployment means too few workers for jobs
available, and thus wages (and inflation) rise.

C. Factors that impede employment in Canada are:

(1) Labour regulations that discourage hiring (e.g., minimum wages that are
too high for some low-skilled jobs).
(2) Unions that maintain their wage levels during recessions, causing
workers to be laid off and firms to be reluctant to hire in the future.
(3) Costs of hiring (e.g., payroll taxes) that hinder job creation.
(4) Generous benefits from welfare and Employment Insurance that
discourage some people from seeking low-paying jobs.
(5) Workers’ skills that have become obsolete due to technological
changes, making them unemployable, even in economic upturns.
4. Interest rates.
A. Interest rates affect both the cost of borrowing and the return on lending.
(1) The returns for the bond and money markets (debt securities) are based
on interest rates.

B. Interest rates are determined by six factors.

(1) Supply and demand of capital: when capital is short, interest rates rise
and demand falls.
(2) Risk of default: higher default risk is compensated for by higher interest
rates.
(3) Central bank operations: the Bank of Canada increases and decreases
short-term interest rates in an effort to curb inflation.
(4) Foreign conditions and the exchange rate: foreign investors expect
higher rates (or an equivalent exchange-rate advantage) to offset better
foreign (e.g., US) opportunities.
(5) Central bank credibility: the commitment shown by the central bank to
keep inflation low will be reflected by low interest rates.
(6) Inflation: investors expect higher interest rates to offset lost purchasing
power due to inflation.

C. Higher interest rates increase the cost of borrowing.

(1) Business investment is reduced, because the cost of borrowing may
exceed the return on investment.
(2) Consumers refrain from borrowing money or from using savings (which
are earning high interest rates) to make a purchase.
(3) The portion of household income allocated to debt (e.g., mortgages)
increases, and thereby decreases the amount of disposable income
available for other purchases.

D. Investment returns, as evidenced in interest rates, must exceed the rate of

inflation.
(1) Higher inflation rates = higher interest rates, and vice versa.
(a) The inflation rate is the percentage change in the price level of the
Consumer Price Index from one year to the next.
(2) The nominal interest rate = the posted annual interest rate (e.g., 3%
two-year GIC.
(3) The real interest rate = the nominal rate, minus the expected inflation
rate.
Topic Five: Money and Inflation

1. Money.
A. Inflation results when the demand for products (and the money to pay for them)
increases beyond the supply (i.e., too much money chasing too few products).

B. Increasing inflation means more money is required to buy the same goods and
services.

C. Inflation erodes the value of investments. If an investor has a nominal 6%

interest rate on a savings account, and inflation is 3%, the real rate of return is
3%.

D. Monetary aggregates measure the amount of money in circulation. Inflation

pushes demand for money, so measures of the money supply are important
indicators of inflation.

2. Inflation.
A. Economy-wide inflation refers to a sustained trend of rising prices. Inflation is not
created by an increase in the price of one product, unless that product has a
ripple-through effect.

B. The Consumer Price Index (CPI) measures the Canadian cost of living by
estimating the costs of specific goods and services representative of the needs
of the Canadian family. CPI is tracked and measured against a base year (given
a value of 100).
(1) The CPI is used in the calculation of the inflation rate. A CPI of 130.7
means that the basket costs 30.7% more than during the base year.

C. The inflation rate is calculated as:

CPI current period – CPI previous period x 100
CPI previous period

D. Inflation has a negative economic impact.

(1) Erodes the standard of living of people with low or fixed incomes.
(2) Reduces the real value of investments, because the return has less
purchasing power.
 (3) Distorts the signs of price increases, because one cannot determine if
price increases are real or inflationary.
(4) Causes interest rates to rise, followed eventually by a recession. Thus,
a country with a higher rate of inflation is a more volatile investment.

E. The growth of the money supply is considered to be a good leading indicator of

inflation.
F. Supply and demand has a role in determining inflation.
(1) The output gap is a measure of inflation; it is the difference between the
potential and actual level of output in the economy.
(a) When actual output is less than potential output, a negative
output gap occurs. Inflation will fall (or remain constant).
(b) When actual output is greater than potential output, a positive
output gap occurs. Inflation increases.
i. Demand-pull inflation results when the demand for products
causes increased supply and increased prices. For
instance, as consumer income increases, there is more
demand for housing and this will increase the price of house
that will cause inflation to rise.
ii. Cost-push inflation results when supply declines and
prices increase. For instance, OPEC limits in oil production
have led to increased price-per-barrel of oil. This could
produce cost-push inflation.

G. Inflation indicators include:

(1) Commodity and wholesale prices.
(2) Wage settlements.
(3) Availability of credit.
(4) The exchange rate.

H. A decrease in the inflation rate signals disinflation.

(1) The Phillips curve illustrates that increasing inflation leads to less
unemployment, and vice versa.
(2) To decrease inflation by increasing unemployment is called the sacrifice
ratio. For example, a ratio of 5 to 1 means that, to lower inflation by 1%,
there must be 5% lower output.
 I. Deflation is the opposite of inflation. It occurs when the CPI declines year after
year.
(1) Prices fall with deflation, and corporate profits correspondingly decline.
As a result:
(a) Unemployment increases.
(b) Economic growth slows.
(c) Sales of goods and services decrease.
(d) Stock prices decline.
(2) If prices continue to decline, businesses have to find ways to reduce
their costs of production.

Topic Six: International Economics.

1. The Balance of Payments.

A. The balance of payments is a statement reflecting economic activity between
Canada and its trading partners. It is comprised of the current account and the
capital account.

B. The current account should equal the capital account, however, a surplus or
deficit can arise in one or the other. If, for instance, more goods and services are
bought than sold, a current account deficit will arise. This can be compensated
for by a capital account surplus, or by assuming debt.

2. The Current Account.

A. The current account can be summarized as what Canadians spend.
 B. There are four components of the current account.
(1) Trade.
(a) Trade is the largest component of the current account.
(b) US demand for Canadian products boosts exports, and demand
in Canada for foreign products boosts imports.
(2) Investment income.
(a) Canada’s large national debt requires significant interest
payments. This is the greatest contributor to the current account
deficit.
(3) Services.
(a) Canadians spend considerably on services rendered outside
Canada.
(b) This category also includes income generated by Canadian
companies that sell their services abroad.
(4) Transfers.
(a) Transfers are made by foreign-aid payments and immigrants
bringing their savings to Canada.

3. The Capital Account.

A. The capital account finances current account spending.

B. There are two forms of transaction recorded in the capital account.

(1) The flow of money between Canada and foreigners who invest in
Canada and Canadians who invest abroad.
(2) An acquisition of an asset (e.g., a printing plant), and income produced
by that asset.

C. There are three components of the capital account.

(1) Direct investment.
(a) When foreigners invest in Canada by purchasing assets directly
(e.g., buy a business); a direct investment is made when a
foreign investor buys 10% or more of a Canadian company or
when a Canadian invests abroad.
 (2) Portfolio investment.
(a) A portfolio investment consists of a debt that involves issuing
IOUs in the form of bonds or T-bills to foreign investors or in
equity investment.
(3) International reserve transactions.
(a) When the Bank of Canada buys or sells Canadian dollars for
foreign currency.

4. The Exchange Rate.

A. The exchange rate is the value of a domestic currency expressed in a foreign
currency (e.g., $1 Canadian = $1.20 US).

B. The exchange rate influences the economy through trade. Canadian exports
become more expensive when the Canadian dollar appreciates in value. Exports
then decline, and Canada’s trade balance is lowered. The opposite is true when
the dollar depreciates in value.

C. Just as there is a real and nominal interest rate, so too is there a real and
nominal exchange rate. The real exchange rate takes inflation into account.

D. Every economic activity of a country has a corresponding effect on the

exchange rate, as indicated in this table:

Exchange Rate Reactions

Action Exchange Action Exchange

Rate Rate
Reaction Reaction
Low inflation  High inflation 
rate rate
High interest  Low interest 
rate rate
Current  Current 
account account
surplus deficit
Strong  Weak 
economic economic
performance performance
Small or no  Large public 
public debt debt
Increasing  Decreasing 
exports exports
Political  Political 
stability instability
E. The relationship between export and import prices is represented as a ratio
called the terms of trade.
(a) Greater demand for exports and increased revenues from exports show
a rising terms of trade.

F. The most common types of exchange rates are fixed and floating.
(1) A fixed exchange rate sets the ―home‖ currency at a fixed level against
one or more foreign currencies. It is maintained by:
(a) Controlling the purchase of foreign exchange (usually
implemented by poorer countries) by requiring all buying and
selling of the currency to be done through the ―home‖ banks at a
fixed rate.
(b) Allowing currency to trade freely within a certain range by the
central bank buying or selling in the open markets or by
adjusting interest rates.

(2) Most advanced countries have a floating exchange rate (e.g., Canada
and the US) in which market forces determine the value of the currency.
(a) Control is exercised by the central bank buying or selling
domestic or foreign currency or increasing or decreasing
interest rates.