Exploring Macroeconomics. Exploring the Business Cycle Some Key Terms. The Business Cycle

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1 Some Key Terms Exploring Macroeconomics Macroeconomics: the area of economic study which examines the overall economy, as opposed to specific markets or firms. (The sum value of all economic activity within a defined region. Ex. world, country, province) Economic Indicators: statistical figures which indicate the general state of a particular aspect of the economy. Related to net domestic output: Gross omestic Product (GP) unemployment rate Related to the value of a dollar : inflation rate exchange rate interest rate The Business Cycle Exploring the Business Cycle Gross omestic Product (GP): The total value of goods produced and services provided in a country during one year. peak decline trough recovery The business cycle (aka economic cycle) is characterized by differing amounts of net domestic production, with Gross omestic Product (GP) growth during peaks and decline of GP during troughs. As this happens, various economic indicators such as employment, inflation, and interest rates tend to slowly set up counter forces that oppose any particular trend, thus stopping us from continuing in any one direction indefinitely, and bringing about a change in the direction of GP. Ray alio attributes the economic cycle almost entirely to cycles of debt and repayment. Let s take a look at his theory. alio suggests that the business cycle modulates through two basic patterns: short-term debt cycles, and long-term debt cycles. Short-term debt cycles (each cycle last about 7 to 10 years): Up-cycles are caused by low-interest rates and the associated high levels of borrowing. This causes high levels of spending, production, employment, and, eventually, inflation. Once inflation starts to rise, interest rates must rise, and this causes the borrowing and spending to slow down. For every dollar that was borrowed and spent in the up-cycle, a dollar (plus interest) must be repaid later on, causing a subsequent downcycle. Long-term debt cycles (each cycle last about 70 to 100 years): Characterized by subtle elevation of each short-term debt cycle. Eventually, debt levels rise so high that the economy becomes overleveraged and incapable of actually paying back massive debt. ebt must be reduced through defaults, restructuring, austerity, and printing of money. 1

2 Following the video, students will break into groups of three to four students in order to examine the following issues related to Ray alio's theory of the "Economic Machine. 1. According to Ray alio, what is the difference between a short-term down-cycle and a long-term deleveraging? 2. According to Ray alio, how much of spending in the economy is related to cash, and how much is related to credit? 3. According to Ray alio, what is the big difference between spending with cash as opposed to spending with credit? 4. According to Ray alio, what tends to cause the "long-term" debt cycle? 5. Are there any claims that Ray alio makes that you might question? alio doesn t differentiate between credit and the various measures of the money supply. The money base is the actual hard currency (i.e. bills and coins). We call this M0. SIEBAR However, there s a difference between the cash we have in our wallets and the money we have in the bank. id you think all the money we have in our accounts exists somewhere as cash? You d be wrong. This is the money supply including deposits This is the money base. (In purple.) SIEBAR It s here that we find a slight difference between alio s depiction of the economic machine and the actual economy. Not all non-cash transactions are credit transactions. If we buy items by cheque (the major method utilized by business) or debit card, then no actual cash is involved, yet they are technically considered cash transactions because they don t involve credit. SIEBAR Therefore, such transactions are (as alio would say) settled immediately: they do not require a payment in the future, and therefore they will not require the lack of spending in the future (to pay off debt) that typically (according to alio) causes a down-cycle. SIEBAR Such transactions (not involving cash, but not involving credit either) are facilitated by money in the bank, and this money in the bank is another measure of the money supply, usually referred to as M1, M2, and M3. (M0 refers to the money base, or in other words, hard cash.) Yes, banks create money SIEBAR The typical banking activities of i) taking in deposits, and ii) loaning out money, (and then taking in more deposits, and then loaning out more money, etc. etc.) do pump up the money supply. However, the money supply itself is not credit per se. alio is invariably suggesting that the other measures of the money supply beyond the money base are created through bank loans. While it may be an exaggeration to suggest that any money besides M0 is credit, an argument could be made that any money other than M0 is created from prior borrowing. These other measures of the money supply (i.e. M1, M2, M3) are money, but they don t exist as physical cash as does the money base. 2

3 SIEBAR Exploring Exchange Rates Weird things to note: Almost half of our money base is comprised of $ bills. Thousand dollar bills account for almost nine times the value of our loonies! Back Key efinitions Goods & Services What comprises the demand for Canadian ollars? Exchange Rate: The price of a foreign currency in terms of a nation's own currency. For example, if the cost of one American dollar is $1.50 Canadian, then the exchange rate is $1.50. Foreign Exchange (FOREX) Market: The market in which the currency of one country is exchanged for the currency of another. Not an autonomous physical entity, but rather a network of thousands of importers, exporters, banks, and foreign exchange brokers. + Investment = + Speculation emand for Canadian ollar Peso / Euro e 1 e 2 S 1 S 2 Q 1 Q 2 of Euros Foreign Exchange Market Graph This graph plots the supply of a given country s currency against the demand for that same country s currency. This supply and demand exists within the foreign exchange market. Calculating the Exchange Rate The exchange rate is calculated by: currency measured against currency measured For example, if it costs 0.32 Euros to buy 1 Peso: Peso Euro = = Pesos In this model, the price on the y-axis is actually in terms of some other country s currency (labeled as currency measured against / currency measured ) For example: Peso / Euro. This is, in fact, the formula for calculating the exchange rate. [See next slide.] The X-axis is labeled with the currency measured (ex. of Euros)]. Mnemonic: Common enominator (The denominator of the y-axis is the same as the currency on the x-axis.) Thus, the value of the Euro in terms of Pesos is Pesos. Alternatively, if we wanted to express the value of the Peso in Euros, we would calculate: Euro Peso = = 0.32 Euros Thus, the value of the Peso in terms of Euros is 0.32 Euros. 3

4 The key to understanding the foreign exchange market is to realize that foreign parties who wish to: i) purchase a country s goods or services, ii) invest in a country s stock market, or iii) enjoy higher interest rates offered within a country will FIRST have to purchase that country s currency! Naturally, this will shift the demand for that currency up. Conversely, if current holders of a country s currency wish to buy other currencies, then the market supply of that country currency will increase as holders of that currency go about trading that currency for other currencies. Naturally, an increase in supply reduces the currency s value. The Exchange Rate The exchange rate plays a particularly important role in the Canadian economy because, compared to other countries, imports and exports represent a relatively large part of Canada s economic activity. World of CN ollar emand for $CN comes from holders of other currencies seeking to buy $CN. Supply and emand for Canadian ollar Foreign Exchange S of CN ollars Supply comes from holders of $CN seeking to buy other currencies. Canada S Analyzing the Exchange Rate Increasing the supply of the Canadian dollar Analyzing the Exchange Rate ecreasing the supply of the Canadian dollar Yen/$CN. Supply and emand for Canadian ollar S 1 S 2 More holders of Canadian dollars (usually Canadians) buying other currencies on the FOREX market will increase the supply of Canadian dollar and decrease the value of the dollar. Yen/$CN. Supply and emand for Canadian ollar S 2 S 1 Fewer holders of Canadian dollars (usually Canadians) buying other currencies on the FOREX market will decrease the supply of Canadian dollar and increase the value of the dollar. P 1 P 2 P 2 P Q 1 Q 2 of $CN Q 2 Q 1 of $CN Analyzing the Exchange Rate Increasing the demand for the Canadian dollar Analyzing the Exchange Rate ecreasing the demand for the Canadian dollar Yen/$CN. Supply and emand for Canadian ollar S 1 More holders of other currencies (usually foreign entities) buying Canadian dollars on the FOREX market will increase the demand for the Canadian dollar and increase the value of the dollar. Yen/$CN. Supply and emand for Canadian ollar S 1 Fewer holders of other currencies (usually foreign entities) buying Canadian dollars on the FOREX market will decrease the demand for the Canadian dollar and decrease the value of the dollar. P 2 P 1 P 1 P Q 1 Q 2 of $CN Q 2 Q 1 of $CN 4

5 Exploring Interest Rates Examining the Effects of an Increase in Money Supply on Interest Rates and GP Transmission mechanisms in economics are just like a row of dominos! increases which increases Buying which lowers money borrowing, bonds interest supply spending, and rates GP! 1 step 2 step 3 step Here s another one where we apply ceteris paribus Here s one where we ON T apply ceteris paribus Exchange rate decreases increases exports / decreases imports which increases A Which increases GP! Exchange rate decreases Hmmn I guess this is because we re in recession which means A is going down Which means GP must be decreasing! 1 step 2 step 3 step 1 step 2 step 3 step The Bank Rate: The rate of interest paid by chartered banks on money borrowed from the Bank of Canada; determined by setting an operating band for the overnight lending rate. Increase Interest Rates à reduce incentive to borrow à reduce consumer / investment spending à lowers both inflation and GP The Target for the Overnight Loans Rate The Target for the Overnight Rate is the main tool used by the Bank of Canada to conduct monetary policy. It tells major financial institutions the average interest rate that the Bank of Canada wants to see in the marketplace where these institutions lend each other money for one day or "overnight." When the central bank changes the Target for the Overnight Rate, this change usually affects other interest rates, including mortgage rates and prime rates charged by commercial banks. So then, how is this operating band established? 5

6 Canada's major financial institutions routinely borrow and lend money among themselves overnight in order to cover their transactions during the day. Through the Large Value Transfer System (LVTS), these institutions conduct large transactions with each other electronically. Think of the LVTS as EBay for money! lvts At the end of the day, the financial institutions need to settle with each other. One bank may have funds left over at the end of this process, while another bank may need money. The trading in funds that allows all the institutions to cover their transactions is called the overnight market. The interest rate charged on those loans is called the overnight rate. Large Value Transfer System Simulation Let s see how the Bank of Canada sets interest rates within a free market system. Game Play All students acts as chartered banks. lvts Some banks have a cash shortage they need to fill by borrowing on the LVTS for the lowest possible interest rate. Some banks have a cash surplus they would like to loan out on the LVTS for the highest possible interest rate. There are two potential winners: i) the bank that loans out all their surplus for the highest average interest rate, and ii) the bank that borrows all their shortage for the lowest average interest rate. Large Value Transfer System Simulation lvts Let s see how the Bank of Canada sets interest rates within a free market system. Today s Operating Band Game Play Oh yeah and one more thing. The teacher is the Bank of Canada (i.e. central bank) The central bank also participates in the market by: i) offering loans at a set interest rate, and ii) offering interest on deposits at ½ % below the rate at which they loan out money. 0.50% Bank rate! Operating Band 4.75% 4.25% The central bank will loan the chartered banks money at this rate. The central bank will pay the chartered banks this rate on deposits. The Bank of Canada operates a system to make sure trading in the overnight market stays within its "operating band." This band, which is one-half of a percentage point (50 basis points) wide, always has the Target for the Overnight Rate at its centre. For example, if the Target for the Overnight Rate = 4.50%, then the operating band would range from 4.25 to 4.75 per cent. 0.50% Bank rate! Operating Band 4.50% 4.75% 4.25% The central bank will loan the chartered banks money at this rate. The central bank will pay the chartered banks this rate on deposits. Since the chartered banks know that the Bank of Canada will lend them money at the top of the band, and pay interest on deposits at the bottom, there is no reason for the chartered banks to trade funds at rates outside the band. The Bank can also intervene in the overnight market (borrow or loan money) at the Target rate if the market rate is straying too far from the Target. When the Bank changes the Target for the Overnight Rate, this sends a clear signal about the direction in which it wants short-term interest rates to go. These changes usually lead to moves in the prime rate (the rate that chartered banks will offer their best customers) at commercial banks, which serves as a benchmark for other types of loans. These changes can also indirectly affect mortgage rates, as well as the interest paid to consumers on bank accounts, GICs, and other savings. NOTES: The Bank of Canada announces changes in the Target for the Overnight Rate eight times a year (approx. every six weeks). About 15 chartered banks participate in the LVTS. Collateral is required of banks operating in the LVTS. Assets eligible as collateral are usually both liquid and secure, such as government bonds and T-Bills. 6

7 The Consumer Index (CPI) Exploring Inflation ecember 2014 The Consumer Index (CPI) rose 1.5% in the 12 months to ecember, following a 2.0% increase in November. The slower year-over-year rise in the CPI was mostly attributable to gasoline prices, which dropped 16.6% in the 12 months to ecember, after falling 5.9% in November. Excluding gasoline, the CPI increased 2.3% on a year-over-year basis in ecember, matching the rise in November. The Consumer Index (CPI) The CPI is NOT inflation! The CPI provides a broad measure of the cost of living (i.e. inflation) in Canada. Rather, the CPI is used to calculate inflation. Statistics Canada tracks the retail price of a representative shopping basket of about 600 goods and services from an average household's expenditure. These include: Essentially, inflation is the percentage change in CPI. food, shelter, household operations, transportation, furniture, clothing, recreation, and tobacco & alcohol. The percentage of the total basket that any item occupies is termed the weight and reflects typical consumer spending patterns. Food, naturally, has a greater impact on the index than footwear. The Base Year Following the base year The base year is the initial year when we collect the prices of the CPI basket of goods, and translate that number to 100 by: i) dividing that number by itself, and ii) multiplying it by 100 Example: If our base year basket totals $17,984.72, then: 2010 is the base year. 17, X 100 = , , X 100 = , In all cases, we are simply subtracting the present year from the previous year, and then taking the difference as a percentage of the previous year. 2013: CPI = : CPI = For the years following, we would perform this calculation using the same common denominator as the base year is the next year. Following the base year, the number that we re comparing to is not a nice neat 100, so we must be more cognizant of the calculation we are performing. In this example, it s plain to see that prices increased by 3%. Thus, inflation is 3% ifference = = 2.3 Rate of change = 2.3 / = 0.02 or 2% While the CPI and inflation are not the same thing, it s safe to say that the CPI is the tool used to calculate inflation. 7

8 As of January, 2015 the base year was still Categories of Inflation The base year is revised every so often because the base year is associated with a cost of a given basket of goods. However, as the base year gets older it tends to present a less accurate base comparison of present spending patterns. (For example, what did an iphone cost ten years ago?) Source: Note: I keep saying they ll change the base year any year now, and I ve been wrong for the last few years. Let s see what happens next year! creeping <10% galloping % hyperinflation 1000% > stagflation with recession Not a huge problem, but it threatens to become a problem. A real threat to the economy. Although some countries deal with it. Horrible. Like dropping a bomb on the economy. Very difficult. We depend on low inflation to bring us out of recession. Causes / Types of Inflation 1. emand Pull Inflation This occurs when A increases at a faster rate than AS. emand pull inflation will typically occur when the economy is growing faster than the long run trend rate of growth. If demand exceeds supply, firms will respond by pushing up prices. 2. Cost Push Inflation Exploring Unemployment This occurs when there is an increase in the cost of production for firms causing aggregate supply to shift to the left. Cost push inflation could be caused by rising energy and commodity prices. 3. Structural Inflation Inflation not caused merely by the excess of demand over supply but built into an economy due to the government's monetary policy. (Ex. Post WWI Germany, printing money, Canada, 2000s, lowering interest rates and doubling the price of houses.) Calculating Unemployment Unemployed: All people who are actively seeking employment, but have not yet obtained employment. Unemployment Rate: The percentage of the labour force that is unemployed. Labour Force: The total number of people who are able to work and are actively seeking work, or already have jobs, or are self-employed. Participation Rate: The percentage of the total population which is in the labour force. These are natural. These are always occurring regardless of economic conditions. (i.e. GP) This is related to GP! Types of Unemployment Frictional Unemployment: Arises from normal labour turnover. (i.e. people leaving and entering the workforce) Generally seen as a healthy form of unemployment. [Mnemonic: between jobs Think of the job ads in any paper on any day.] Structural Unemployment: Arises from technological changes or management decisions (i.e. to purchase products or hire labour overseas) that result in long-term unemployment within a given country. [Mnemonic: downsizing Think of a blacksmith still looking for work.] Seasonal Unemployment: Arises from a decrease in jobs owing to a change in season. Typically, there are less jobs in the winter because of the slowdown in construction, farming, and summer tourism jobs. Cyclical Unemployment: Arises from a decrease in jobs owing to a downturn in the overall economic conditions. In other words, when the economy heads into a slow period in its economic cycle. [Mnemonic: recession ] 8

9 Precarious Employment Precarious Work: Non-standard employment that is poorly paid, insecure, unprotected, and cannot support a household. The Precariat: A social class comprised of people suffering from a lack of full-time, predictable, secure employment. This affects material and psychological welfare, as well as the ability to form independent family units (i.e. get married and have children). Casualization of Labour: The altering of working practices so that regular workers are re-employed on a casual or short-term basis. Contract Work: Workers who serve firms as an independent contractor instead of as an employee. Such workers do not have income taxes deducted, and thus must submit their own income tax to the government. Firms generally do not pay into employment insurance or the Canada Pension Plan for contract workers. Such workers do not participate in health insurance plans or pension plans. A Snapshot of Precarious Work in Canada (CAW Canada) This is Contract Faculty Time (Tenured faculty from York University standing up for contract faculty.) Calculating Gross omestic Product GP is often defined as: the total spending on all final-user goods and services produced domestically during a period. Three key issues highlighted in this definition are: 1. spending (only marketed goods & services count 2. produced during the fiscal year, and 3. final-user goods and services (avoid double-counting the same thing) Example: car parts plus the final car. What s counted? What s not? One misleading issue present in this definition is: exported products do not need to be final-user. Exports of raw lumber, crude oil, and wheat are all counted in GP. (Canada depends a lot on this!) A product is only counted in GP once in its life! Current transactions involving assets produced in previous periods are not counted in the current GP, as this is just transfer of ownership not the creation of new value. Other things not included in the GP are: government social security and welfare payments, current exchanges in stock and bonds, and changes in the values of financial assets. Since GP measures the market values of goods and services, economic activities that do not pass through the regular market channels are excluded in the computation of GP. For example, a mother caring for her child at home does not count towards GP, but the same service provided in a paid daycare facility would count. Black market sales will not be counted. (This is particularly significant in developing or less stable countries.) There are two approaches to measuring GP: i) the income approach, and ii) Total income must equal total expenditures! the expenditures approach. A Simple Example Imagine an island where just one product is bought or sold coconuts! If $ of coconuts trade hands within a year, then we should expect to find the following figures: Total money spent: $ Total money earned: $

10 We will focus on the expenditure approach Y = C + I + G + (X-M) Consumption (sometimes thought of as Consumer Spending): spending by households on goods and services, with the exception of purchases of new housing. Investment: spending on capital equipment, inventories, and structures, including household purchases of new housing. Government purchases: spending on goods and services by local, provincial, and federal governments Net exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports) 10