PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 1 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES
FIRST EDITION
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MAIN CONTRIBUTORS
François Dupuis Vice-President and Chief Economist 514-281-2336 [email protected]
Hendrix Vachon Francis Généreux Economist; author of this guide Senior Economist 514-281-7192 514-281-7125 [email protected] [email protected]
Benoit P. Durocher Martin Lefebvre Senior Economist Senior Economist 514-281-2307 514-281-2317 [email protected] [email protected]
OTHER CONTRIBUTORS
Geneviève Denault François Bilodeau Desktop Publishing Technician Linguistic Consultation
IMPORTANT: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. Any reproduction in part or in whole of this document is forbidden without the written permission of the Desjardins Economic Studies department. This publication is based on the most accurate information available as of August 24, 2007. A French version is also available.
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International Co-operative Banking Association Legal Deposit: Bibliothèque nationale du Québec National Library of Canada Copyright © 2007, Desjardins Group. All rights reserved. 2007 2 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES FOREWORD
very day, many people deal with economic concepts, whether directly or indirectly, such as personal financial advisors, financial planners, fund Emanagers and other investors. At a basic level, economics is the study of interactions among the economic agents who produce, exchange and consume goods and services. In fact, however, it is a discipline with many branches which flood the literature with a range of concepts. Published by Desjardins Group’s Economic Studies, this third guide sets out to provide succinct, practical explanations for many current concepts and theories.
The guide contains six broad sections; these sections are broken down into subsections which group together 230 headings on about 500 concepts in economics, organized in a logical order. It covers microeconomics, macroeconomics, the economy and international finance, public economy, market finance and a number of statistical concepts that permeate economic analysis. From the law of supply and demand to gross domestic product, labour productivity, portfolio theory and so on, these concepts are frequently applied to the Canadian and North American context.
Part of the inspiration in developing the guide came from existing works such as theory textbooks, encyclopedias, specialized dictionaries, a variety of articles and Internet links. However, the raw material comes, in large part, from the knowledge and experience of Desjardins’ team of economists.
The choice of concepts and the way in which they are introduced make the guide accessible to a broad audience: neophytes can become acquainted with the fundamentals, while economy watchers can mine additional information from it and specialists will find it a valuable reference. In other words, it is a very complete, user-friendly guide.
Enjoy!
François Dupuis
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 3 4 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES CONTENTS
FOREWORD
MICROECONOMICS Consumer ...... 11 Opportunity Cost; Marginal Analysis; Law of Diminishing Marginal Utility; Paradox of Value; Concept of Elasticity and Inelasticity; Income Effect; Substitution Effect; Wealth Effect; Engel’s Law; Moral Hazard; Consumer Surplus; Pareto Optimality Producer ...... 16 Perfect Competition; Monopolistic Competition; Oligopoly; Monopoly; Market Power; Theory of Contestable Markets; Vertical and Horizontal Integration; Law of Diminishing Returns; Economies of Scale; Economies of Scope; Theory of External Economies; Externalities; Free Rider; Producer Surplus; Game Theory
MACROECONOMICS Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy ...... 27 Law of Supply and Demand; Gross Domestic Product; Value Added; Potential GDP; Output Gap; Consumptiom; Investment; Public Expenditure; Net Exports Labour Market ...... 38 Labour Market; Employment; Unemployment; Okun’s Law; Labour Productivity; Human Capital Theory; Capital-Labour Substitution; Division of Labour; Labour Mobility; Wage Rigidity; Reservation Wage; Minimum Wage; Poverty Threshold; Lorenz Curve and Gini Coefficient Growth and Economic Cycles ...... 47 Business Cycles; Real Business Cycle; Golden Rule of Capital Stock; Savings; Acceleration Principle; Productivity Cycle; Creative Destruction; Mobility of Capital; Technical Progress; Multifactor Productivity; Economic Indicators; Carry-Over Effect; Base Effect; Sustainable Development Inflation ...... 57 Inflation; Disinflation and Deflation; Inflation Target; Stagflation; Phillips Curve; Expectations; Disinflation and the Coefficient of Sacrifice; Price Rigidity Money ...... 63 Role of Money; Money Supply; Monetary Base; Money Creation Process; Demand for Money; Money Market; Gresham’s Law; Quantity Theory of Money; Neutrality of Money; Money Illusion; Real Balance Effect; Seigniorage
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 5 Monetary Policy ...... 71 Central Bank; Key Rate; Monetary Policy; Liquidity Trap; Sensitivity of Investment Demand; Goodhart’s Law; Monetary Conditions; Taylor Rule; Neutral Interest Rate Fiscal Policy ...... 78 Fiscal Policy; Multiplier; Crowding Out Effect; International Crowding Out Effect Supply Side Economics ...... 81 Supply Shock; Supply Side Policies; Say’s Law; Kaldor-Verdoorn’s Law
INTERNATIONAL ECONOMICS AND FINANCE Balance of Payments ...... 89 Balance of Payments; Link Between Savings and the Current Account; Domestic Absorption; Capital Flow; Official International Reserves International Monetary System ...... 94 International Monetary Fund; World Bank; Exchange Rate Systems; Exchange Rate Movements; Nominal and Real Exchange Rate; Effective Exchange Rate; Interest Rate Parity Condition; Currency Arbitrage; Purchasing-Power Parity; Exchange Rate Overshooting; Theory of the International Fisher Effect; Dollarization; Sterilization; Mundell’s Triangle of Incompatibility International Trade ...... 105 Theory of Comparative Advantage; Heckscher-Ohlin Theorem; New Trade Theory; Degree of Openness of an Economy; Terms of Trade; Prebisch-Singer Thesis; Marshall-Lerner Criterion; J-Curve; Dutch Disease; Commercial Policy; Dumping; Balassa-Samuelson Effect; Fair Trade Economic Integration, Globalization, International Development ...... 113 Economic Integration; Optimal Currency Area; Globalization; Alterglobalization; Economy in Transition; Emerging Economy; World Trade Organization; Tobin Tax; Factor-Price Equalization
PUBLIC ECONOMICS Government and Economy ...... 123 Economic Role of State; Public Choice Theory; Adam Smith’s Invisible Hand; Size of Government; Centralization Ratio; Wagner’s Law; Parable of the Broken Window; Public Goods and Private Goods; Cost-Benefit Analysis Budget and Government Indebtedness ...... 129 Government Budget; Transfer Payments; Equalization; Tax Base; Value-Added Tax; Direct and Indirect Tax; Public Debt; Deficit; Foreign Debt; Twin Deficits; Debt Service; Ricardian Equivalence
6 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Economy and Taxation ...... 136 Fiscal Neutrality; Laffer Curve; Fiscal Drag; Efficiency vs. Equity of Taxation; Tax Credit; Deductions; Marginal Tax Rate; Progressive and Regressive Tax; Flat Tax; Green Tax; Pigouvian Tax; Excess Burden; Fiscal Competition; Fiscal Imbalance
MARKET FINANCE Portfolio Management ...... 149 Return; Yield Curve; Nominal and Real Interest Rate; Risk; Risk Aversion; Value at Risk; Portfolio Theory; Buying on Margin/Short Selling; Hedging; Short Position/Long Position; Interest Rate Position; Leverage Effect; Venture Capital; Hedge Fund Financial Markets ...... 158 Financial Markets; Market Efficiency Theory; Stock Market Indexes; Tobin’s Q; Price/Earnings Ratio; Technical and Fundamental Analyses; Calendar Effect; Announcement Effect; Overshooting; Speculative Bubble; Panurge’s Law; Real Estate Bubble; Link Between Bond Value and Bond Market Interest Rate; Eurodollars; Disintermediation; Chaos Theory; Internal Rate of Return
STATISTICAL CONCEPTS Descriptive Statistics ...... 173 Average; Variance and Standard Deviation; Trend; Seasonality; Absolute and Relative Variation; Annualizing; Nominal and Real Value; Present Value; Normal Distribution; L-Stable Distributions Econometrics ...... 181 Correlation; Linear Regression; Coefficient of Determination; Exogenous and Endogenous Variables; Dummy Variable; Auto-Correlation; Heteroscedasticity; Endogeneity; Multicollinearity; T-Stat; P-Value; Cointegration; Binary Choice Model
INDEX
BIBLIOGRAPHY
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 7 8 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES MICROECONOMICS
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 9 10 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Microeconomics / Consumer
CONSUMER
Opportunity Cost
Definition Opportunity cost is the cost of any decision that is imposed by scarcity. It represents the sacrifice we make when we make a decision. It may be resources, money, profit, return, etc. Alternative cost is synonymous with opportunity cost.
EXAMPLE 1 If a state-owned electrical power company can sell its electricity to the export market or to its domestic market, when it decides to sell to the domestic market, its opportunity cost corresponds to the revenues the utility foregoes by opting not to sell its power internationally.
EXAMPLE 2 When an investor opts to invest in a particular security, and his other option would have been to invest in a security with a return of 5%, the opportunity cost corresponds to the 5% return the investor gave up.
Marginal Analysis
Definition Marginal analysis is based on small changes in economic variables (marginal changes). In marginal analysis, the terms used most often are: marginal cost, marginal revenue and marginal utility.
A marginal cost is the cost of increasing an activity slightly. How much would it cost to produce one more litre of maple syrup?
Marginal revenue is the revenue generated by increasing an activity slightly. How much more revenue is earned by producing an additional litre of maple syrup?
Marginal utility is the utility derived from consuming an additional unit of the same good or service. What is the extra utility derived from consuming an additional litre of maple syrup?
Law of Diminishing Marginal Utility
Definition According to the law of diminishing marginal utility, as someone’s consumption of a good increases, the utility derived from consuming an additional unit of that good declines.
A few familiar examples can be used in support of the law. Putting a little ketchup on your fries may add flavour to a meal, but adding more ketchup may not improve the flavour as much. Using a single electric light bulb to light up a room may improve visibility substantially, but the effect of adding a second bulb will be smaller than that of the first bulb.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 11 Microeconomics / Consumer
Paradox of Value
Definition The paradox of value is also called the diamond-water paradox. This paradox describes the fact that water, which is useful to life, is worth almost nothing, while a diamond, which has little utility to those who consume it, is very expensive. The solution lies in the fact that price does not depend on total utility but rather on marginal utility, as water’s marginal utility is lower than that of a diamond.
Marginal utility is the utility derived from consuming an additional unit of a good or service. Marginal utility declines as consumption increases.1 As water is very abundant, a lot of it is consumed. The initial quantities of water that are used fill people’s vital needs (very high marginal utility). The final quantities consumed fill needs that are much smaller, for lower marginal utility. The large supply of water and low marginal utility of water mean that it is cheap. Conversely, diamonds are much less abundant, and only a small quantity of them is consumed. The marginal utility of diamonds is higher than it would be if they could be consumed in larger quantities. The limited supply of diamonds and high marginal utility make them expensive. ______1 See Law of Diminishing Marginal Utility at page 11.
Concept of Elasticity and Inelasticity
Definition Elasticity is the ratio between the percentage variation in one variable and the percentage variation in another variable. If variable Z fluctuates a lot following a change in variable X, we can say that Z is highly elastic. Conversely, Z is inelastic if it does not fluctuate much following a change in X.
A demand2 function can be used to illustrate the concepts of
elasticity and inelasticity. The price elasticity of demand ep is calculated as follows:
ΔQuantity / Quantity e p ΔPrice/Price
where Δ is the change for a given period.
Demand is inelastic (or not very elastic) when the quantity in demand following a price variation does not change much
(ep > -1). Demand is perfectly inelastic (vertical) if the quantity
demanded is the same regardless of price (ep = 0). On the contrary, demand is elastic when the quantity demanded
following a price variation changes a great deal (ep < -1). It is said to be perfectly elastic (horizontal) if price elasticity tends toward minus infinity (-∞).
The elasticity calculation can be applied to different economic variables. These include consumption in relation to income, exports in relation to prices and home prices in relation to interest rates. ______2 See Law of Supply and Demand at page 27.
12 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Microeconomics / Consumer
Income Effect
Definition The income effect is a change in demand for a good or service that originates from a change in the consumer’s income. A change in income can have a positive or negative impact on demand for a good or service. It is the nature of the good that determines which direction demand takes.
In general, we can say that there are two types of goods: inferior goods and normal goods. The income effect will be positive for demand for normal goods and negative for demand for inferior goods. For example, a drop in revenue can cause the consumption of macaroni and cheese to go up and consumption of pork loin to go down. In this example, macaroni and cheese is implicitly seen as an inferior good, while pork loin is considered a normal good. The same reasoning applies to services.
Substitution Effect
Definition In microeconomics, the substitution effect is a change in demand for a good subsequent to a change in the good’s price, or a change in the price of a good that can be substituted for it. When a good costs more, people tend to reduce consumption of it and increase consumption of replacement goods. The same reasoning applies to services.
For example, if beef and chicken are considered to be substitutes for each other, as the price of beef goes up, consumers will increasingly tend to replace the beef they eat with chicken, and vice versa.
The substitution effect concept can also be defined macroeconomically. In this context, the substitution effect instead refers to changes in aggregate demand following an overall change in national goods and services prices. Specifically, on a national basis, there are two types of substitution effects. First, a price increase will make people postpone the consumption of some goods and services. These people are said to be substituting future consumption for present consumption, causing present aggregate demand to decline. Second, an increase in national prices will make residents reduce consumption of locally produced goods and opt for substitute goods produced abroad; this curbs production and national revenue, and therefore aggregate demand.
Wealth Effect
Definition A wealth effect is the impact on consumption of an increase or decrease in wealth. Where all else is equal, when consumers believe they are richer, they tend to consume more, and vice versa.
The graph on page 14 is a good depiction of the relationship between wealth and household consumption in the United States. As you can see, on average, the quarterly change in household consumption moves in tandem with quarterly changes in securities. It can also be shown that consumption responds to real estate wealth.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 13 Microeconomics / Consumer
The wealth effect is sensitive to interest rates and is one of the Example: The wealth effect in the United States means by which monetary policy3 is transmitted. Among other things, a change in interest rates modifies the value of stock Quarterly variation in % Quarterly variation in % market equity and the growth of the real estate market, and hence 1.6 Annual moving averages 10 8 consumers’ wealth. An interest rate increase makes wealth and 1.4 6 consumption decline. Conversely, a rate cut makes wealth and 1.2 4 consumption go up. 1.0 2
______0.8 0 -2 3 0.6 See Monetary Policy at page 72. -4 0.4 -6
0.2 -8 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Household consumption (left) Wilshire-5000 stock index (right)
Sources: Datastream, Bureau of Economic Analysis and Desjardins, Economic Studies
Engel’s Law
Definition Engel’s Law states that food spending’s relative share of total consumption tends to fall as income increases.
Ernst Engel, a Russian statistician, observed this relationship in 1857 from statistics on consumer spending by European households. The explanation for the law is that food is an essential good that is purchased by rich and poor alike. An essential good is a good for which demand increases more slowly as a person’s income increases. People with higher incomes can consume more food or better quality food, but this fact does not usually offset the fact that they also like to consume other kinds of goods and services and, as a result, devote a smaller proportion of their income to food.
Moral Hazard
Definition There is a moral hazard when someone has an interest in acting in a way that will make someone else bear a cost. Here, the word “moral” must be understood in the same way as people can be understood to be “morally committed” to doing something or abiding by their word, even though there is no way to make them (this is where the “hazard” comes from).
A classic example for explaining moral hazard is people who take out car insurance: car insurance substantially reduces the costs that will have to be borne in the event of an accident, making insured drivers more careless. This means that insurance companies must endorse an additional risk that comes from their clients’ behavioural changes.
In finance, waiving some debts or the existence of a lender of last resort (a role that central banks may play) can cause agents who are in debt, for instance, financial institutions or countries, to take excessive risks that affect their solvency since, no matter what happens, these agents do not have to worry about the consequences of their actions.
14 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Microeconomics / Consumer
Consumer Surplus
Definition The consumer surplus is the gain a consumer achieves when he can buy a good or service for less than the maximum amount he is prepared to pay. Among other things, this concept is used in the framework of cost-benefit analyses4 and in examining the impact that taxes have on the economy5.
This illustration depicts the supply and demand for a given good. Consumer surplus Demand is the aggregate of the individual demands of all consumers. At the market price, consumers will opt to consume Price a specific quantity of the good available; the price that consumers Supply pay for the good is the same for everyone. What’s more, some consumers, who would have paid a higher price, benefit from Consumer surplus the fact that they are paying less to consume this good. Here, Price the consumer surplus is the aggregate surplus of all consumers paid who paid less for a good that they would have agreed to pay more for. Graphically, the consumer surplus is represented by the surface area of the shaded portion. A decrease in market Demand price would cause the consumer surplus to increase, while an increase in price would reduce the surplus. Quantity consumed Quantity ______Source: Desjardins, Economic Studies 4 See Cost-Benefit Analysis at page 128. 5 See Excess Burden at page 142.
Pareto Optimality
Definition Pareto optimality means it is impossible to increase one person’s well-being without making someone else worse off.
In theory, there are an infinite number of Pareto optimalities which can correspond to very divergent resource allocations among economic agents (companies, governments and households). It all depends on the initial resource allocation. Based on the initial allocations, exchanges occur among economic agents until it is no longer possible to make one person better off without making someone else worse off. This state is Pareto efficient. Under the theory, any equilibrium that is perfectly competitive is Pareto efficient. For some economists, the Pareto criterion can be used to assess the efficiency of an allocation of resources. An allocation is efficient if there is no other allocation that would be preferable to it according to the Pareto criterion.
SECOND BEST Given the existence of externalities6, public goods7, taxation systems that do not solely consider issues of efficiency but also consider issues of equity8 and various other factors, Pareto optimality, also called Pareto efficiency, is hard to achieve in practice. By definition, a second-best solution is a resource allocation that is the best possible allocation given the existence of various constraints that keep perfect competition prices from being compatible with Pareto’s optimal resource allocation. In other words, a second best refers to any situation that is not Pareto efficient but is still the best that can be done under the circumstances.
______6 See Externalities at page 21. 7 See Public Goods and Private Goods at page 126. 8 See Efficiency vs. Equity of Taxation at page 137.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 15 Microeconomics / Producer
PRODUCER
Perfect Competition
Definition Perfect competition is a theoretical concept to describe a market in which several companies produce the same good or provide the same service. It makes efficient resource allocation1 possible. However, perfect competition depends on several hypotheses, such that it is rarely seen in the real world.
An auction at which several sellers try to sell identical goods to several buyers is a situation that is most akin to a market characterized by perfect competition. Perfect competition is usually framed by four hypotheses. First, there is the hypothesis of atomicity, i.e., that there are many companies and consumers in the market for a given good or service. Second, there is homogeneity, i.e., all the companies in the market produce the same good or deliver the same service (what Company A produces is completely substitutable for what Company B produces). Third, information must be perfect and complete, i.e., consumers and companies all have the same information that is required for making their respective decisions. Last, there must be no barrier to entry: each company can enter or exit a market when it wants to at no additional cost.
A perfect competition market is in equilibrium when the marginal cost of production is equal to the price. If the price is Equilibrium in perfect competition less than the additional cost of producing one unit more, Price companies lose money by producing that unit. If the price is Supply = marginal cost higher than the marginal cost, companies can improve their balance sheets by producing more. Given that, at any price level,
companies will produce until their marginal cost is equal to the Average price, the marginal cost curve corresponds, barring a few details, total cost P Competition Average to the market’s supply. Breakeven variable cost point Shutdown point In fact, it is not always optimal for companies to produce at marginal cost. This graph shows the average total cost (ATC) Demand
Q and average variable cost (AVC) curves. The difference between Competition Quantity
the two curves is that the average total cost curve includes fixed Source: Desjardins, Economic Studies costs. At the outset, there is a large difference between the two curves. However, as fixed costs are amortized over the larger number of units produced, the curves tend to converge and move in tandem. The “U” shape stems from the hypothesis that variable costs tend to decline in the beginning, but then the time comes when it is increasingly expensive to increase output, translating into ascending cost curves. The marginal cost (MC) curve intersects with the ATC and AVC curves at their lowest point. If the price falls to a point where MC = AVC, this means that the company’s total revenues are exactly equal to its total variable costs. This is the shutdown point. With a price below this threshold, it is in the company’s best interests to stop producing. The company’s supply curve therefore starts at the point where MC = AVC. For information purposes, where MC = ATC, the company has reached the breakeven point. Below this point, its fixed costs are not offset by its revenues, but it still opts to produce as it is covering its variable costs and reducing the loss associated with its investment in fixed costs. In this graph, the market price is above the breakeven point. The market price is determined by supply and demand.2 ______1 See Pareto Optimality at page 15. 2 See Law of Supply and Demand at page 27.
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Monopolistic Competition
Definition Monopolistic competition is when several companies produce slightly different goods and services. Each company therefore has a monopoly on the sale of what it produces or delivers but, given that the goods and services can be substituted, there is still competition among the companies. Differentiation between the goods and services means that the companies can set prices that are slightly different from the prices for goods sold by the competition.
Take ketchup, for example. Several companies may make their own ketchup in different flavours and sell it in different formats with different nutritional qualities, etc. While, overall, all ketchups look alike (substitutability of ketchup brands), some consumers prefer a specific brand and will pay more for that brand than for a different ketchup.
Oligopoly
Definition An oligopoly is a market in which a small number of firms dominates the market. The dynamics of this kind of market are different from those of a market characterized by perfect competition or monopolistic competition: in an oligopoly, each company must consider how its rivals will respond to any action on its part. Oligopolies can be the scene of the most devastating price wars as well as, occasionally, highly profitable collusion.
The air transport industry and the tobacco, aluminium and automotive industries are all examples of oligopolies. Oligopolies behave in very different ways; there is no single model for analyzing them. Nonetheless, all companies in oligopoly situations are constantly torn between a desire to beat out their rivals and the opportunity for increasing the sector’s profits by coordinating among themselves to reduce production. If the companies in an oligopoly are able to limit production, where everything else is equal, prices in their market should go up, along with profits. This type of collusion is often unstable as, notwithstanding the benefits of colluding, it will be to the benefit of each company to take advantage of the artificially high prices to increase its production and thus its profits. In the final decades of the 20th century, the Organization of Petroleum Exporting Countries (OPEC) was an example of producers voluntarily limiting production.
Monopoly
Definition A monopoly is a market in which there is only one producer. When a single company provides a good or service, it is in control of how much is available on the market and, by implication, the market price.
A monopoly that maximizes its profits is not behaving like a company in a perfect competition situation. In perfect competition, a company keeps producing more until the cost of producing an additional unit is equal to the unit’s selling price. Now, as a monopoly controls the market price, it targets a price at which it can maximize its profit, which is determined by the difference between total revenues and total costs. It can be shown that its profit is maximized when marginal revenue3 equals marginal cost. As the graph on page 18 shows, the amount produced by a profit-maximizing monopoly is less than the amount that will be ______3 See Marginal Analysis at page 11.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 17 Microeconomics / Producer
produced in a competitive situation. Consumers will also have Maximization of the monopolist’s profit to pay a price that is higher than the perfect competition price. 4 Price This makes the consumer surplus smaller. In exchange, the 2) ... but the monopoly can limit 5 the total quantity produced to Supply = marginal cost producer surplus increases, but not by an amount equal to the maximize its profits. The price loss incurred by consumers. This is why theorists say that a consumers pay is higher.
monopoly is less efficient than competition. PMonopoly
1) In perfect competition, PCompetition equilibrium is located at the intersection between Sometimes a monopoly is more optimal than having numerous supply and demand, ... companies, given the existence of substantial economies of scale6. These are called natural monopolies. For example, in terms of water services, it is less expensive for one company to operate a single water supply system than it is for several Marginal revenue Demand Q companies to operate individual networks to serve a single pool Monopoly QCompetition Quantity of consumers. The same is true for operating an electrical Source: Desjardins, Economic Studies distribution network or public transit network. In such contexts, consumers are able to get a better price than they would in a competitive market. In practice, governments frequently regulate monopolies to control their influence on price and the quantity produced. ______4 See Consumer Surplus at page 15. 5 See Producer Surplus at page 22. 6 See Economies of Scale at page 20.
Market Power
Definition Market power is a measure of how easy it is for a company to influence the market price of a good or service it produces. In perfect competition, companies have no market power. A monopoly has a lot of market power.
Most markets are neither in perfect competition nor controlled by monopolies. Various indices have been created to assess companies’ power over these markets. One popular measurement of market power is a sector’s concentration ratio: we compare the share of the output (or shipments of goods produced or services delivered) of a sector’s biggest companies with the output for the sector as a whole. The ratio is 100% when the sector is dominated by a monopoly; it tends toward 0 in perfect competition. As a ratio approaches 100, the risk that some companies will have substantial market power increases.
Another measurement of market power is the Herfindahl-Hirschman index (HHI), which is calculated by adding the squares of the market shares of all market participants. In perfect competition, the HHI will tend toward 0; in a monopoly situation, it will tend toward 10,000. By giving them a greater weight, the HHI is better at considering the role of dominant companies.
Theory of Contestable Markets
Definition According to the theory of contestable markets, a market does not need to have many companies to have the price and quantity produced correspond to a perfect competition7 situation. It is enough to have potential competitors who can get into the market at any time.
______7 See Perfect Competition at page 16.
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It is the presence of potential competitors that characterizes contestable markets. These competitors can “contest” the market price and supplant companies that are already in the market. The basic assumptions are similar to those of pure, perfect competition. Specifically, the theory assumes that companies can enter and exit a market at any time, and that there are no set- up costs (e.g., purchase of land, buildings, equipment). According to this theory, even a monopoly8 has to apply a perfect competition price if it is contestable. In a contestable market situation, the state’s role is not to monitor or impose rules, but rather to make sure that the conditions are there to ensure that existing companies can be challenged.
Criticisms of the theory mainly focus on the assumption of costless entry and exit, and on the assumption that existing businesses remain passive in the face of the threat from potential competitors. In fact, industries that have no entry and exit costs are fairly rare, and the existing companies’ passivity is contradicted by recurrent price wars that damage new competitors. ______8 See Monopoly at page 17.
Vertical and Horizontal Integration
Definition Vertical integration exists when a company joins forces with companies that are upstream (suppliers) and downstream (customers) from it. In horizontal integration, companies at the same level of goods and services production join forces.
By joining together, companies can benefit from such things as decreased competition, cost reductions or a larger market share.
Oil companies, which own oil fields, tankers, pipelines, refineries and networks of retailers, are companies with a great deal of vertical integration.
In Québec, the merger between two major construction material dealers, Rona and Réno-Dépôt, is an example of horizontal integration.
Law of Diminishing Returns
Definition The law of diminishing returns deals with the general idea that the production process’ inefficiency increases as it grows. Specifically, this law states that we will get fewer and fewer additional products as we add additional amounts of one input, where the others are fixed.
For example, if a farmer employs more farmhands, the fields will be better cultivated and buildings and equipment will be better maintained. However, at one point, the additional labour will start to become less and less productive. A third rock- picking effort or fourth round of preventive equipment maintenance in a given day will not improve the farm’s production.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 19 Microeconomics / Producer
Economies of Scale
Definition A company benefits from economies of scale when it can produce more than several small firms with an equal number of inputs (machinery, workers, resources, etc.).
There are a number of reasons why a single company is able to produce more than several other companies with the same quantity of inputs. A bigger company has the advantage of specialized labour and equipment; it can also get discounts from suppliers given the larger purchasing volume.
Economies of Scope
Definition A company benefits from economies of scope if it can produce “n” different products for a cost that is lower than “n” firms, each of which specializes in making a single product.
Sometimes, some goods or services can be produced for less when they are produced by a single company. For instance, a railway that offers both passenger and freight transportation services may be more profitable than two companies that each offer one of the two services.
Theory of External Economies
Definition When economies of scale9 apply industry-wide rather than to individual firms, they are called external economies of scale. External economies occur when a group of companies reduce their costs by locating in a single area.
The author of the theory of external economies, economist Alfred Marshall, gave three reasons why a group of companies could reduce their costs by being located in the same area. First, it is easier for a group of small businesses to attract specialized suppliers than it is for a single small business. Second, a geographically concentrated industry can attract a larger pool of the specialized labour the industry needs. Last, an industry that is concentrated in a single location helps to develop spillover effects in terms of knowledge.
Some Canadian industries that feature substantial external economies are the Ontario automotive industry and the Québec aerospace industry. In the United States, there are, among others, the semi-conductor industry located in Silicon Valley, the banking industry located in New York and the entertainment industry located in Los Angeles. ______9 See Economies of Scale at page 20.
20 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Microeconomics / Producer
Externalities
Definition Also known as external effects, externalities are any situation in which the activities of one or more economic agents have consequences for the well-being of other agents, even though there are no exchanges or dealings with them. If the consequences are beneficial, the externalities are said to be positive. Otherwise, they are called negative externalities.
Pollution is one example of a negative externality. When a plant pollutes air and water, it causes people’s well-being to deteriorate even though they do not receive compensation for this loss in well-being. On the other hand, companies that spend a lot of money on research and development have positive side effects on the rest of society. For example, AT&T researchers invented the transistor and launched the electronic revolution. Yet the increase in profits for the company was miniscule in comparison to the global social benefits.
Externalities call on state intervention. These days, the state is primarily concerned with negative externalities. Among other things, the various environmental policies that have been implemented attest to public intervention. There is, however, a current of thought that privileges private solutions to the problem of externalities. The Coase theorem, set out by economist Ronald Coase, suggests that, rather than intervening directly, the state could, in many cases, simply assign clearly defined property rights to resources that are affected by externalities (water, intellectual property, etc.). These rights, which then become merchandise also, can be exchanged on a competitive market and enable efficient use of all of the resources, including the resources that are affected by the externalities. The creation of a market to govern CO2 emissions is an example of a private solution to the problem of externalities.
Free Rider
Definition This expression describes the behaviour of someone who gets the benefit of a good or service without having to pay for using it. This type of behaviour is more frequent when a public good10 is involved, i.e., a good that is consumed by several people at the same time whose consumption cannot be restricted, such as street lighting.
In a situation in which each individual is called upon to finance a public good (like street lighting), if each person acted as a free rider, the public good would not be produced even though the project’s costs are less than the benefits the public would receive. In other words, free riders want to be able to enjoy the good without having to pay for it. Once street lighting is installed, it is impossible to keep the people who did not help finance it from using it.
The free rider problem justifies some state action, such as charging taxes so that various public goods and services can be delivered to the public, like the army, police, street lighting and public parks. ______10 See Public Goods and Private Goods at page 126.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 21 Microeconomics / Producer
Producer Surplus
Definition The producer surplus is the gain a firm achieves when it can sell a good for more than it costs to make it. Like the consumer surplus11, the concept can be used in the framework of cost-benefit analyses12 and in examining the impact that taxes have on the economy13.
This illustration depicts the supply and demand for a good Producer surplus produced by a given company. At any point, the company’s supply curve corresponds to the marginal cost14 of producing Price
one additional unit, i.e., the minimum price at which the Supply company will agree to sell that unit.
At the market price, consumers will choose to consume a specific Selling 15 price quantity of the good available. In perfect competition , the price Producer that consumers pay corresponds to what it costs to produce the surplus final unit sold. Assuming that marginal costs increase (each additional unit costs more and more to produce), the company Demand thus derives a surplus from each unit sold that corresponds to the difference between the selling price and what it costs to Quantity produced Quantity produce each of the units. Graphically, the producer surplus is Source: Desjardins, Economic Studies represented by the surface area of the hatched portion. A decrease in the selling price would cause the producer surplus to decrease, while an increase in price would increase the surplus. ______11 See Consumer Surplus at page 15. 12 See Cost-Benefit Analysis at page 128. 13 See Excess Burden at page 142. 14 See Marginal Analysis at page 11. 15 See Perfect Competition at page 16.
Game Theory
Definition Game theory is the analysis of situations (and potential strategies) that involve two or more decision makers whose interests diverge at least in part. It can just as easily apply to the interaction of oligopolistic16 markets as to bargaining situations like strikes and to conflicts such as wars.
The prisoner’s dilemma is a famous game theory example. It is particular because it takes the individuals involved to a suboptimal equilibrium.
In the framework of this dilemma, the prosecutor interrogates Alex and Eric, two larcenous accomplices, separately. The prosecutor has enough evidence to put them both in jail for two years, even though both deny they are guilty. However, if one of the accomplices informs on the other one, the first will get a lighter one-year sentence while the second will have to serve ______16 See Oligopoly at page 17.
22 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Microeconomics / Producer
an exemplary six-year sentence. Also, if both accomplices rat on Prisoner’s dilemma each other, they will be in jail for five years. What will Alex do? If (Alex’s sentence, Eric’s sentence) he testifies against Eric, he could get a lighter sentence, but something else is pushing him to rat on him. Alex knows that, if Eric Eric testifies, he could serve a six-year sentence. In this situation, Says nothing Informs on Alex it is better to inform and get five years instead of six. This means that, regardless of what Eric opts to do, it is in Alex’s interest to Says (-2,-2) (-6,-1) nothing testify against Eric. Eric is facing the same dilemma and sees the Alex same benefit in ratting on Alex. In the end, the accomplices Informs inform on each other and both receive a longer sentence than on Eric (-1,-6) (-5,-5) they would have gotten if they had both remained silent.
The dilemma’s principle can easily be applied to various contemporary economic situations. For example, a competing Source: Desjardins, Economic Studies business that opts to lower its prices to gain market share and eventually increase its earnings may see its ambitious plans crumble if its main competitor also decides to drop prices. In the end, the companies could both see their earnings decline.
Note that the equilibrium reached in the prisoner’s dilemma is called a “Nash equilibrium”. By definition, in a Nash equilibrium, neither player regrets his decision after having found out what the other party decided. In effect, Alex does not regret his decision when he sees that Eric decided to inform on him, since, if Alex had made the opposite decision, it would have done him more harm. The same goes for Eric.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 23 Microeconomics
Additional references:
CONSUMER Oligopoly Opportunity Cost Bernard Guerrien. 2002, p. 393. Douglas Greenwald. 1984, p. 178-179. Joseph E. Stiglitz. 2004, p. 272-276. John Downes and Jordan Elliot Goodman. 2003, p. 646. Monopoly Marginal Analysis Graham Bannock et al. 1998, p. 283-284 and 294. Michael Parkin et al. 2000, p. 9. Hal R. Varian. 2000, p. 450-453. Graham Bannock et al. 1998, p. 257-258. Wikipedia. [http://en.wikipedia.org/wiki/Monopoly]. Jean Tirole. 1988, p. 63-92. Law of Diminishing Marginal Utility Carl Schweser and Andrew Temte. 2002, p.165-166 and 173. Market Power Paul A. Samuelson and William D. Nordhaus. 2005, p. 184-185. Paradox of Value Robert E. MacAuliffe. 1997, p. 36-37. Alain Beitoine et al. 2001, p. 318-319. Wikipedia. [http://en.wikipedia.org/wiki/Market_power]. Graham Bannock et al. 1998, p. 311-312. Theory of Contestable Markets Concept of Elasticity and Inelasticity Alain Bruno et al. 2005, p. 289. Yves Bernard and Jean-Claude Colli. 1996, p. 606. [http://psteger.free.fr/theories-economiques.htm]. Carl Schweser and Andrew Temte. 2002, p. 168-170. Graham Bannock et al. 1998, p. 76-77. Bernard Guerrien. 2002, p. 98-99. Income Effect Carl Schweser and Andrew Temte. 2002, p. 172-173. Vertical and Horizontal Integration Graham Bannock et al. 1998, p. 197-198. Jean Tirole. 1988, p. 33 and 185-188. Graham Bannock et al. 1998, p. 272 and 428-429. Substitution Effect Josette and Max Peyrard. 2001, p. 144. Carl Schweser and Andrew Temte. 2002, p. 172-173. Michael Parkin et al. 2000, p. 68, 157 and 196. Law of Diminishing Returns Paul A. Samuelson and William D. Nordhaus. 2005, p. 110-111. Wealth Effect Douglas Greenwald. 1984, p. 568-569. [www.economist.com/research/Economics/alphabetic.cfm]. Economies of Scale Engel’s Law Jean Tirole. 1988, p. 18-20. Alain Beitone et al. 2001, p. 269. Graham Bannock et al. 1998, p. 122-123. Hal R. Varian. 2000, p. 106-113. Bernard Guerrien. 2002, p. 441-442. [www.economist.com/research/Economics/alphabetic.cfm]. Economies of Scope Moral Hazard Jean Tirole. 1988, p. 18-20. Wikipedia. [http://en.wikipedia.org/wiki/Moral_hazard]. Wikipedia. [http://en.wikipedia.org/wiki/Economies_of_scope]. Harvey S. Rosen et al. 2003, p. 254-255. Bernard Guerrien. 2002, p. 462. Theory of External Economies Paul R. Krugman. 2001, p. 168-171. Consumer Surplus Graham Bannock et al. 1998, p. 74. Externalities Douglas Greenwald. 1984, p. 936-938. Paul A. Samuelson and William D. Nordhaus. 2005, p. 36-37 Wikipedia. [http://en.wikipedia.org/wiki/Consumer_and_ and 375-382. producer_surplus]. Bernard Guerrien. 2002, p. 70-72 and 212-214. Harvey S. Rosen et al. 2003, p. 73-74. Pareto Optimality Alain Beitone et al. 2001, p. 314. Free Rider Bernard Guerrien. 2002, p. 173-175, 393-394, 398-399 and 469-470. Bernard Guerrien. 2002, p. 399-400. Hal R. Varian. 2000, p. 552-558 and 603-615. Wikipedia. [http://en.wikipedia.org/wiki/Pareto_efficiency]. Producer Surplus Graham Bannock et al. 1998, p. 332-333. Wikipedia. [http://en.wikipedia.org/wiki/Consumer_and_ PRODUCER producer_surplus]. Perfect Competition Graham Bannock et al. 1998, p. 316-317. Game Theory Hal R. Varian. 2000, p. 389-393 and 406-413. Paul A. Samuelson and William D. Nordhaus. 2005, p. 213-220 Wikipedia. [http://en.wikipedia.org/wiki/Perfect_competition]. and 757. Bernard Guerrien. 2002, p. 162-164 and 367-371. Monopolistic Competition Bernard Guerrien. 2002, p. 86-89. Graham Bannock et al. 1998, p. 283.
24 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES MACROECONOMICS
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 25 26 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
SUPPLY, DEMAND, MACROECONOMICS EQUILIBRIUM AND MEASURES OF THE ECONOMY
Law of Supply and Demand
Definition The law of supply and demand is generally used to explain changes in price in a given market or in the economy as a whole. According to this law, price increases when demand exceeds supply and falls when demand is lower than supply.
To understand the essence of the law of supply and demand, we must first understand the concept of supply and demand and how equilibrium between these two components is achieved in a market.
DEMAND Demand refers to the relationship between the quantity Demand demanded of a good or service and its price. As the price of a Price good or service falls, the quantity demanded increases. Decrease in quantity Graphically, demand is illustrated by a downward sloping curve demanded where each point represents a quantity demanded at a given Increase price. in demand
Decrease Demand can change based on other variables such as income in demand and the price of a competing product or service. The effect of Increase in quantity these variables causes shifts (increase or decrease) in the demand demanded curve, for example, an increase in income may increase demand for a good or service (demand curve shifts to the right), whereas Quantity a decrease in the price of a competing product (e.g., coffee versus Source: Desjardins, Economic Studies tea) may cause demand to fall (demand curve shifts to the left).
Supply SUPPLY Supply refers to the relationship between the quantity offered Price Increase of a good or service and its price. The higher the price, the in quantity greater the number of companies interested in offering this good offered or service. Graphically, supply is an upward sloping curve where each point represents a quantity offered at a given price. Decrease in supply Increase in supply Supply can change based on other variables such as production costs and technological progress. These variables cause the Decrease in quantity supply curve to shift (increase or decrease). For example, the offered arrival of new, more efficient production processes lowers costs for businesses and increases supply (supply curve shifts to the Quantity right), whereas higher salaries and raw material prices increase Source: Desjardins, Economic Studies costs and reduce supply (supply curve shifts to the left).
EQUILIBRIUM OF SUPPLY AND DEMAND Equilibrium of supply and demand is achieved when the quantity demanded is equal to the quantity offered. For a given price, if the quantity demanded exceeds the quantity offered, there is a shortage of the product. Consumers who want to purchase this
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 27 Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
product will pay more. Faced with increased demand for their product, businesses will increase their production so long as consumers agree to pay more. Similarly, higher prices can discourage consumers, and the quantity demanded falls as price increases. In short, the price goes up, the quantity offered increases, and the quantity demanded falls. These adjustments stop when the quantity demanded is equal to the quantity offered for a given price. Graphically, equilibrium is achieved when the supply and demand curves intersect. At the other end of the spectrum, there could be a situation where at a given price, the quantity demanded is below the quantity offered. To achieve equilibrium, the price falls, the quantity offered falls and the quantity demanded increases.
Equilibrium of supply and demand shifts as supply and demand shift (increase and decrease). An increase in supply (technological progress) increases the equilibrium quantity and pushes the equilibrium price down. Conversely, a decrease in supply (higher raw material prices) reduces the equilibrium quantity and pushes prices up. Moreover, an upturn in demand (increase in income) increases quantity and the equilibrium price while a decrease in demand (lower income) reduces quantity and the equilibrium price.
Quantity demanded exceeds quantity offered Quantity demanded lower than quantity offered
Price Price
4) The quantity offered increases Supply Supply until it matches quantity demanded. 4) Quantity offered falls until it is equal Price goes up. to quantity demanded. Price falls.
p0
2) ... attracts d 1) Quantity qo demand q that is lower 1) Quantity qo offered offered at price p0... d 2) ... attracts a demand q than supply... at prices p0... that exceeds supply... p0
3) ... and causes a 3) … and causes a o d shortage equal to qd-qo. surplus equal to q -q . Demand Demand
qo qd Quantity qd qo Quantity
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
Various equilibrium scenarios are possible when supply and demand shift simultaneously.
Shift in demand and market equilibrium Shift in supply and market equilibrium
Price Price A decrease in supply reduces the equilibrium quantity and increases market price.
An increase in demand increases the equilibrium quantity and market price. Pmarket Pmarket
An increase in supply increases equilibrium quantity and A decrease decreases market price. in demand reduces the equilibrium quantity and market price.
Qat equilibrium Quantity Qat equilibrium Quantity
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
THE LAW OF SUPPLY AND DEMAND IN A MACROECONOMIC CONTEXT The law of supply and demand is generally applied within a microeconomic framework, i.e., to analyze the price of a product or service on a market (e.g., the price of homes in Canada). The aggregate prices of all the goods and services in an economy can also be analyzed based on movements in supply and demand. In this context, we speak of aggregate supply and demand. Aggregate supply refers to the entire output capacity of an economy while aggregate demand represents the quantity of output purchased by all economic agents at a given overall level of prices.
28 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
However, it is important to distinguish between the short and Aggregate supply and demand long term when analyzing the impact of supply and demand on and long-term macroeconomic equilibrium prices and output. In the long term, an economy is considered Price Long-term supply to be in equilibrium when all the resources are used efficiently, and supply is equal to full output capacity1. Long-term supply is 1) In the long term, an increase 2 in demand... inelastic in relation to general price levels: it does not depend P2 on price, only capital and labour availability and the technology 2) ... pushes the used are determining capacity. general level of prices up, ...
P1 As the above graph shows, any movement in demand causes Demand2 the equilibrium level of prices to rise or fall, while GDP remains 3) ... but leaves production unchanged. Demand at full potential. An increase in demand can be caused by an 1 Potential GDP increase in government spending, an increase in investments, Income, production growth in the money supply, etc. In the long term, the only way Source: Desjardins, Economic Studies to change supply is to increase the economy’s output capacity. Technological development plays a key role in increasing supply in the long term.
In the near term, given certain price rigidities3 (businesses announce their prices through advertising and in catalogues and want to hold them steady) and wage rigidities4 (collective agreements and labour contracts are set for anywhere from several months to several years), it is possible to achieve an equilibrium above or below long-term output capacity. In the short term, supply is influenced by the general level of prices. For example, a company that wants to set the salary of its employees for three years and that sees demand for its products increase may be interested in producing more, knowing that costs will remain relatively stable despite the increased production.
Graphically, the short-term supply curve is sometimes illustrated Aggregate supply and demand by a perfectly horizontal curve (perfect price rigidity) and and short-term macroeconomic equilibrium sometimes by an upward curving slope such as the one in the Price graph on the right. In the near term, equilibrium is achieved when short-term supply and demand curve intersect. An increase 3) ... and the impact on prices is limited. Short-term in demand increases the level of production and slightly 1) In the short term, an supply increase in demand... increases prices, whereas a decrease in demand pushes P production and prices down. 2
P1 Demand As prices and wages adjust, the pressure on business costs 2 intensifies and leads to successive decreases in short-term supply 2) ... pushes GDP above (short-term supply curve shifts to the left). These adjustments potential... Demand1 continue until such time as prices and wages adjust to the initial Potential GDP Income, production increase in demand. Short-term equilibrium therefore shifts to Source: Desjardins, Economic Studies long-term equilibrium as prices and salaries adjust.
Basically, in a macroeconomic context, when the economy produces more than its capacity, prices tend to rise (or increase more rapidly), and conversely, they tend to fall (or grow less rapidly) when the economy operates below potential. ______1 See Potential GDP at page 32. 2 See Concept of Elasticity and Inelasticity at page 12. 3 See Price Rigidity at page 62. 4 See Wage Rigidity at page 44.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 29 Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Gross Domestic Product – GDP
Definition GDP measures the value of an economy’s total output for a year. GDP can be calculated either by recording spending on final goods and services or by recording the income from the input factors that were used to produce them. A third approach can also be used; it is based directly on value added5.
Final goods and services are goods and services that will not be used to make other products. The value of a final good is the total of the value added at each step in producing the good. If we recorded the value of all of the goods, some would be counted twice, as a single value added would be added in more than once.
Two completely different but equivalent ways of obtaining a measurement of the value of all goods and services produced involves either adding up spending on final goods and services or adding up the income from producing them. The first measure can be called “aggregate expenditure”, while the second can be called “aggregate income”. For buyers of final goods and services, their value is the price they paid to acquire them. For producers, the value corresponds to what it cost to produce them. These two measures are equivalent, since all the revenues a company makes from selling its products are used to pay for production factors. Workers receive a salary, owners share the profits, creditors charge interest, etc.
CALCULATING GDP USING THE EXPENDITURE APPROACH To calculate GDP using the expenditure approach, we add up the following expenditure items:
• Personal consumption spending6 (C) • Investment spending7 (I) • Government spending on goods and services8 (G) • Net exports9 (NX), i.e., exports of goods and services (X) minus imports of goods and services (M).
Graph on the left at page 31 shows that consumption is the biggest component of aggregate expenditure.
CALCULATING GDP USING THE INCOME APPROACH To calculate GDP using the income approach, we add up the following revenues from production factors:
• Salary, wages and supplementary labour income • Net corporation profits before tax • Interest and miscellaneous investment income • Net income of farm operators • Net income of non-farm unincorporated businesses • Indirect taxes10 minus subsidies • Amortization.
In the graph on the right at page 31, to simplify presentation, corporate profits, net income of farm operators and net income of non-farm unincorporated businesses have been grouped under the heading “Net corporation profits before tax”. The biggest component of aggregate income is salaries and other compensation paid to workers. ______5 See Value Added at page 32. 6 See Consumption at page 34. 7 See Investment at page 35. 8 See Public Expenditure at page 36. 9 See Net Exports at page 36. 10 See Direct Tax and Indirect Tax at page 132.
30 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Canadian GDP using the expenditure method Canadian GDP using the income method
In billions of CAN$ In billions of CAN$ In billions of CAN$ In billions of CAN$ 1,400 1,400 1,400 1,400 1,300 Consumption 1,300 1,300 Wages and other labour income 1,300 1,200 Inv estment 1,200 1,200 Net corporate profits before tax 1,200 1,100 Government 1,100 1,100 Interest and investment income 1,100 1,000 Net exports 1,000 1,000 1,000 Indirect taxes minus subsidies 900 900 900 900 Amortization 800 800 800 800 700 700 700 700 600 600 600 600 500 500 500 500 400 400 400 400 300 300 300 300 200 200 200 200 100 100 100 100 0 0 0 0 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006
Sources: Statistics Canada and Desjardins, Economic Studies Sources: Statistics Canada and Desjardins, Economic Studies
We should add something further about the two calculation approaches mentioned. The economic literature frequently specifies that GDP is calculated either at market price or at factor cost; when we total expenditures on final goods and services, we get GDP at market prices, i.e., the price paid to acquire a good or service. GDP at factor cost is the sum of the costs of all factors that were used in making final goods, which is the same idea as the factor income approach. Because governments exist, there is an estimation difference between the two methods. At market price, consumers pay taxes, increasing the value of the goods in comparison to their value when estimated at factor cost. Conversely, subsidies to businesses help to decrease the market price in comparison with factor cost. To balance the GDP estimated by the factor income approach with the expenditure approach GDP, we have to add indirect taxes and remove subsidies. This gives us the factor income market price approach. We can also estimate GDP using the expenditure approach at factor cost by subtracting indirect taxes and at adding subsidies paid to businesses.
OTHER WAYS TO MEASURE THE VALUE OF AN ECONOMY’S OUTPUT As we have seen, GDP corresponds to aggregate expenditure (AE), which is equal to aggregate income (Y). This equality can be expressed algebraically:
GDP AE Y C I G X M
There are other ways to measure the value of an economy’s output. Here are some of them, along with a brief description:
• Net domestic product (NDP): GDP minus depreciation.
• Gross national product (GNP): GDP after adding net investment income from abroad, i.e., payments of interest and dividends from other countries. For example, when a company produces overseas, the profits it earns overseas are not included in GDP, but are included in GNP. As a result, when a foreign company earns a profit in a given country, the profits are included in that country’s GDP, but not included when calculating its GNP.11
• Gross national disposable income (GNDI): The gross national product after adding net unilateral transfers between countries. These transfers are international payments that are not for the purpose of acquiring any good, service or asset.11 For instance, Canadian donations overseas bring down the value of GNDI, but do not affect Canada’s total GDP or GNP.
______11 See Balance of Payments at page 89.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 31 Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Value Added
Definition The value added by a business corresponds to the difference between the value of its output, assessed at market price, and the value of the intermediate products it buys from other companies.
The above definition refers specifically to gross value added. The gross value added created by a miller is the value of the flour he produces minus the value of the wheat he bought. Similarly, the gross value added by a baker corresponds to the value of the bread minus the value of the flour he purchased. We get net value added by including depreciation of the capital (building, equipment, machinery) used in production. The total value added by an entire economy is an approximation of its gross domestic product12 (GDP). Also, in Canada, GDP data per industry are obtained using the total value produced by industry minus the value of the intermediate goods and services the industry buys, which is the same as calculating the total value added per industry.
The graph shows how Canada’s annual GDP per industry Canadian GDP using the value added method evolved between 1976 and 2003. To simplify presentation, the (GDP per industry)
value added by industries has been grouped into businesses that In billions of CAN$ In billions of CAN$ produce goods, businesses that produce services and non- 1,200 1,200 1,100 Business sector, goods 1,100 Business sector, services commercial industries that produce goods and services. The 1,000 1,000 Non-commercial sector, goods and services industries in the business sector sell their products and buy their 900 900 800 800 intermediate inputs on the market: it is therefore possible to 700 700 measure value added by subtracting these industries’ 600 600 intermediate consumption from their output. Non-commercial 500 500 400 400 industries include non-market producers that produce goods and 300 300 services for individuals, businesses or the whole community 200 200 (e.g., defence, police and fire services or administrative 100 100 0 0 services). Their products are provided free of charge or at prices 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003
that do not reflect market prices. These industries’ value added Sources: Statistics Canada and Desjardins, Economic Studies cannot be measured like value added by business sector industries; it is instead assessed based on production costs. The weight of value added by the non-commercial sector in the economy as a whole is nonetheless relatively small.
In Canada, the latest data on yearly GDP per industry measured using value added can only be obtained with a lag of two or three years. However, the latest monthly and yearly estimates are published. They are not obtained directly using industry’s value added, but rather using indicators, such as output and employment indicators. ______12 See Gross Domestic Product at page 30.
Potential GDP
Definition Potential GDP13 is a measure of an economy’s output in a hypothetical situation of full employment and use of capital for a given level of technological development.
______13 See Gross Domestic Product at page 30.
32 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Potential GDP is also referred to as full employment GDP since Canadian potential GDP by definition, the labour market is in equilibrium when the economy is operating at full potential. When an economy uses In billions of CAN$ In billions of CAN$ 1,400 1,400 its capital and labour force more intensively, its output is above 1,300 1,300 potential. Conversely, if an economy does not use all the workers 1,200 1,200 interested in working and underuses its capital, its output is 1,100 1,100 below potential. 1,000 1,000 900 900 However, potential GDP is difficult to measure. Some estimation 800 800 700 700 methods rely on statistical techniques while others are based on 600 600 economic theory, as is the case with the U.S. Congressional 500 500 Budget Office (CBO), among others, which has constructed a 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 model to estimate the country’s potential GDP by relying on the Real GDP Potential real GDP change in hours worked and capital.14 Some models replace the Sources: Statistics Canada and Desjardins, Economic Studies variable of capital with labour productivity. There are also models with various equations that establish relationships between various macroeconomic variables which, under certain assumptions, make it possible to estimate potential GDP.
In the graph above, Canada’s potential GDP was estimated using the Hodrick-Prescott filter15, a statistical method used to smooth the GDP series. The reasoning behind this filter is that over the long run, GDP is supposed to be at potential, and in the short-term it swings around a trend16 (the smoothed series) close to potential. ______14 The Congress of the United States. CBO’s Method for Estimating Potential Output: An Update, August 2001, [http://www.cbo.gov/ftpdocs/30xx/doc3020/PotentialOutput.pdf]. 15 Quantitative Micro Software. Eviews5 – User’s Guide, United States, 2004, p. 344-345. 16 See Trend at page 174.
Output Gap
Definition The output gap is the difference in percentage between actual GDP and potential GDP17. A positive output gap means that GDP is above potential whereas a negative gap means it is below potential.
18 The expression “inflationary gap ” is used to describe a Canadian output gap situation where real GDP is above potential. Inflationary pressures are stronger when there is excess demand for labour, capital and In % of potential GDP In % of potential GDP 4 4 natural resources. Conversely, when real GDP is below potential, 3 3 19 the gap is referred to as “disinflationary ”. Labour, capital and 2 2 natural resources are underused, and wages and prices tend to 1 1 rise less quickly. When potential GDP is negative, it also means 0 0 there is excess output capacity. -1 -1 -2 -2 The graph tracks the Canadian output gap between -3 -3 -4 -4
1977 and 2007. -5 -5
______-6 -6 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 17 See Potential GDP at page 32. Sources: Statistics Canada and Desjardins, Economic Studies 18 See Inflation at page 57. 19 See Disinflation and Deflation at page 58.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 33 Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Consumption
Definition Within aggregate expenditure20, consumption expenditure is the value of the goods and services purchased by households. Factors that have an impact on consumption include disposable income, interest rates, household wealth and expected future income.
In Canada, consumption expenditure data is divided into four Consumption expenditure in Canada categories: durable goods, semi-durable goods, non-durable (CAN$ in 2002) goods and services. By definition, durable goods are used In billions of CAN$ In billions of CAN$ 800 800 repeatedly or continually for more than one year, such as vehicles Services and large household appliances. Semi-durable goods are goods 700 Non-durable goods 700 Semi-durable goods 600 600 that can be used several times and have an expected lifespan of Durable goods at least a year, like clothing. Non-durable goods include goods 500 500 that are only used once, like gas and food products, as well as 400 400 inexpensive goods that are used more than once, such as 300 300 household supplies. This graph depicts the movement of 200 200 21 Canadian consumption expenditure in real terms . The largest 100 100
share goes to services, followed by spending on non-durable 0 0 goods. 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006
Sources: Statistics Canada and Desjardins, Economic Studies Disposable income is a key factor in consumption levels: it is equal to total income minus taxes paid to governments. Consumption, disposable income and the value of the stock market, Canadian data, 1976 to 2006 Obviously, as disposable income goes up, so does potential Disposable income in billions of CAN$ S&P/TSX stock market index consumption. The fraction of additional disposal income that is 900 14,000 consumed is the marginal propensity to consume. Assuming 750 12,000 that this is constant, we can expect any increase in income to be 10,000 600 followed by a proportional increase in consumption. 8,000 450 Graphically, when we compare Canada’s consumption data with 6,000 300 the data on disposable income, we note that there is a fairly 4,000 stable linear relationship between the two variables. 150 2,000 0 0 50 200 350 500 650 800 Household wealth also has a positive influence on consumption. Consumption in billions of CAN$ As a household’s assets increase in value, the household has Relationship between consumption and disposable income (left) more purchasing power, which is reflected in its consumption Relationship between consumption and the value of the stock market (right) spending. This graph compares Canada’s consumer spending Sources: Statistics Canada and Desjardins, Economic Studies data with the Toronto Stock Exchange index. An increase in stock market valuation drives household wealth up and is followed by an increase in consumption. The relationship is not quite as clear as the one between consumption and disposable income. Household wealth can also be made up of residential, commercial and industrial assets.
Interest rates also have an impact on consumption. High rates encourage consumers to save more and cut back on consumption; they also make it harder for households to get credit, with the result that consumers must put off some major purchases, like a new car. Conversely, low interest rates encourage consumption and reduce saving. The graph at page 35 shows that Canadians tend to consume a larger share of their disposable income when interest rates are low. ______20 See Gross Domestic Product at page 30. 21 See Nominal and Real Value at page 176.
34 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Finally, according to economic theory, consumption can also be Consumption and interest rates in Canada influenced by households’ expectations regarding future income. The more they expect a high income, the more current In % of disposable income In % 100 22 consumption goes up. However, it is difficult to find out what 98 20 these expectations are. Consumer confidence indexes can 96 18 94 16 provide some of this information. The more confident consumers 92 14 are about the economy’s health and thus about their future 90 12 88 10 income, the more they tend to consume, and vice versa. 86 8 84 6 82 4 80 2 78 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Consumption/disposable income (left) Rate on 90-day commercial paper (right)
Sources: Statistics Canada and Desjardins, Economic Studies
Investment
Definition The investment expenditure considered in aggregate expenditure22 includes businesses’ purchases of equipment, machinery and buildings and new housing purchases by households. These investments can be called capital investments. To these we add businesses’ investments in stock, which correspond to the change in their inventories of raw materials, semi-finished products and finished products over a specific period.
The level of investment is generally influenced by the return Investment spending in Canada expected and interest rates. As businesses’ expectations of high (CAN$ in 2002) returns increase, the more likely they are to invest. Businesses In billions of CAN$ In billions of CAN$ 300 300 must still finance their investments, and interest rate levels play Residential construction 250 Non-residential construction 250 an important role here. All other things being equal, the level of Equipment and machinery investment falls as interest rates increase. Conversely, low 200 Inventory change 200 interest rates encourage businesses to invest more. The same 150 150 goes for households’ decisions about building new homes. 100 100
The graph shows how investment spending evolved in real 50 50 23 terms in Canada between 1976 and 2006. It is clear that 0 0 investment spending on equipment and machinery makes up -50 -50 the bulk of investment in Canada for the last several years. 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Investment in inventory constitutes a relatively small share, but Sources: Statistics Canada and Desjardins, Economic Studies it is highly volatile. It fluctuates based on economic cycles24 and business expectations. ______22 See Gross Domestic Product at page 30. 23 See Nominal and Real Value at page 176. 24 See Business Cycles at page 47.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 35 Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
Public Expenditure
Definition The public expenditures included in calculating aggregate expenditure25 are primarily composed of the current goods and services spending of various tiers of government. They also include public investment spending, such as expenditures for buildings, engineering construction and machinery and equipment (hospitals, roads, aircraft, etc.). The public expenditure calculation is rounded out by the change in government inventories.
In Canada, until 1981, government inventories only included Public expenditure in Canada uranium stocks. They now include inventories held by federal (CAN$ in 2002) agencies like the Canadian Dairy Commission. In billions of CAN$ In % of real GDP 300 28
275 27 Spending on health, education, transportation and security are 250 26 all public expenditures that are included in the aggregate 225 25 spending calculation. Interest payments on the debt, subsidies 200 24 and transfers to individuals are not recorded to prevent double 175 23 counting. In fact, someone who receives an interest payment 150 22
from the government or social assistance benefits is consuming 125 21
or saving these amounts. These expenditures are therefore 100 20 recorded with other components of aggregate spending: 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 consumption, investment and imports. Public expenditure (left) Portion of aggregate expenditure (right)
Sources: Statistics Canada and Desjardins, Economic Studies In Canada, in real terms26, public expenditure constitutes about 22% of aggregate spending. Previously, it oscillated around 27%. The clean-up of public finances in the mid-90s had repercussions on the proportion of public expenditure in aggregate spending.
The level of public spending can vary with government revenues, which depend on the revenues the economy generates; however, political and social decisions are what mainly determine the level of public spending. ______25 See Gross Domestic Product at page 30. 26 See Nominal and Real Value at page 176.
Net Exports
Definition Net exports are the value of exports minus imports. Subtracting imports is the same as subtracting consumer spending, public expenditures and investment spending on foreign products and services from aggregate spending. Aggregate spending27 is therefore representative of the value of goods and services produced in an economy. The factors that impact net exports are international prices, international trade agreements, domestic demand and global demand.
All other things being equal, when foreign prices are higher than domestic prices, domestic exports increase and imports decrease. Conversely, when foreign prices are lower than domestic prices, exports tend to fall while imports tend to rise.28 ______27 See Gross Domestic Product at page 30. 28 See Marshall-Lerner Criterion at page 108.
36 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Supply, Demand, Macroeconomics Equilibrium and Measures of the Economy
International trade agreements facilitate trade between countries, Canadian exports and imports boosting both exports and imports. For example, the North American Free Trade Agreement (NAFTA) has increased trade In billions of CAN$ In billions of CAN$ 600 550 between Canada, the United States and Mexico. 550 500 500 450 450 400 Lastly, when global demand grows, all other things being equal, 400 350 the quantity of domestic goods and services exported increases. 350 300 300 250 Moreover, when domestic demand rises, the quantity of imported 250 200 goods increases. The fraction of an increase in national income 200 150 150 100 that is allocated to the purchase of imported goods and services 100 50 50 0 is referred to as the “marginal propensity to import”. 0 -50 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006
Exports (left) Imports (left) Net exports (right)
Sources: Statistics Canada and Desjardins, Economic Studies
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 37 Macroeconomics / Labour Market
LABOUR MARKET
Labour Market
Definition The labour market is where labour resources and labour needs come together. On the labour market, workers are the suppliers and businesses are the buyers. Equilibrium is reached when, at a given wage, the supply equals the demand1.
The labour supply is determined based on the utility derived from the salary with respect to the loss of utility associated with the decline in time for other activities (leisure). The theory assumes that it is less painful to sacrifice the first few hours than the fortieth or fiftieth hour, for example. Therefore, for a worker to agree to work more, compensation must be increased to offset the growing pain caused by the additional sacrifice of leisure time. This explains why the labour supply has a positive slope. Labour demand is determined by labour productivity2. The first few hours worked usually help produce more than the last few hours; this is called diminishing marginal productivity. Businesses therefore want to pay lower wages as they use more workers, which is why demand for labour has a negative slope.
As the graph shows, for a given level of supply and demand, Labour market where a wage is higher than the equilibrium wage, the demand is
lower than the supply, which is an unemployment situation. To Real wage balance the market, unemployed workers offer their services for A wage that is too high causes Supply unemployment, as the supply is greater (workers) a lower wage, which increases the quantity of labour demanded than the demand. and decreases the quantity of labour offered until supply and demand are equal. Conversely, a wage that is below the market Equilibrium real wage A wage that is too low causes a equilibrium wage cause a shortage of workers: because the wage shortage of workers, as demand is paid is below the value of the labour’s marginal productivity, greater than the supply. companies can increase production if they attract new workers Demand by agreeing to pay them more. (business)
Quantity at Quantity There can be as many labour markets as there are types of jobs equilibrium of labour
and categories of workers: markets can differentiate themselves Source: Desjardins, Economic Studies by such things as the skill and experience of workers. This is why there is more than one equilibrium wage. Various things can keep markets from reaching their equilibrium point; there are some regulations that apply to work, such as minimum wage3 regulations, while long-term employment contracts keep wages rigid4 and hinder adjustment between supply and demand. ______1 See Law of Supply and Demand at page 27. 2 See Labour Productivity at page 42. 3 See Minimum Wage at page 45. 4 See Wage Rigidity at page 44.
38 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Labour Market
Employment
Definition The amount of labour used in an economy has major repercussions for production. In the near term, given that the level of technology and quantity of machines and equipment available do not change very much, the employment level is what mainly influences production5.
In an economy, naturally, not everyone in the population has a job. Within an economy’s total population, it is possible to isolate a group called the “working-age population”. In Canada, this population is made up of people 15 and older; in the United States, the population is those aged 16 and up. The working-age population can also be divided into two groups: the labour force and non-working population. The first group contains people who offer their services on the labour market. Most of them work, while a fraction of them are looking for work (unemployed). The non-working group contains people who are not active in the labour market: people who are not working and not looking for work. This group includes students, retirees, unemployable people and discouraged former job seekers. Finally, within the labour force, we can make a distinction between those who are working full time and those who are working part time. As the figure shows, approximately one of every two Canadians had a job in 2006; the rest of the population was either unemployed, inactive or too young to work.
Employment among Canada’s population in 2006 Employment in Canada from 1976 to 2006
In % of working-age population In % of labour force Total population 70 35
65 30 Working-age population 25 60 Non-working Population 20 Labour force population under age 15 55 15
Employed population Unemployed population 50 10
45 5 Full-time Part-time 40 0 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 0 5,000 10,000 15,000 20,000 25,000 30,000 Population (in thousands) Participation rate (left) Employment rate (left) Unemployment rate (right)
Sources: Statistics Canada and Desjardins, Economic Studies Sources: Statistics Canada and Desjardins, Economic Studies
The graph on the right, which illustrates how employment evolved in Canada from 1976 to 2006, presents various measures used to track the labour market from period to period. These measures are: the participation rate, the employment rate and the unemployment rate6.
labour force Participation rate 100 working - age population
working population Employment rate 100 working - age population
number of unemployed Unemployment rate 100 labour force
______5 See Okun’s Law at page 41. 6 See Unemployment at page 40.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 39 Macroeconomics / Labour Market
Unemployment
Definition Unemployment stems from the fact that some members of the labour force are unemployed. Depending on the reason, unemployment is referred to as frictional, structural, seasonal or cyclical.
In Canada, Statistics Canada compiles monthly unemployment data in its Labour Force Survey, which defines the unemployed as individuals who do not have a job, are prepared to work and fulfill one of the following three conditions:
1. Have actively looked for work in the past four weeks and were available for work. 2. Were on temporary layoff during the reference week with an expectation of recall and were available for work. 3. Had a new job to start within four weeks of the reference week and were available for work.
The definition of unemployed is therefore not limited to individuals collecting employment insurance benefits.
People are considered unemployed when they are fired, when they voluntarily quit their job or when they join the labour force. Unemployment rate in Canada People leave the unemployed population when they are hired or In % In % called back to work or when they withdraw from the labour force. 14 14 The unemployment rate is the number of unemployed people 13 13 divided by the labour force. The unemployment rate rose sharply 12 12 in Canada in the early ‘80s and ‘90s; in both cases, Canada was 11 11 in an economic recession. 10 10 9 9
8 8 Unemployment can be broken down into four categories. 7 7 Frictional unemployment stems from normal movements within 6 6 the labour force. Every day, people join the workforce; for Recessions 5 5 example, young people quit school, parents return to work and 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
discouraged job seekers make another attempt at finding a job. Sources: Statistics Canada and Desjardins, Economic Studies At the same time, others retire, quit their jobs and leave the labour force. However, a certain amount of time is required before the new arrivals on the labour market occupy the positions that are freed up, which creates a type of unemployment that is referred to as “frictional”.
Structural unemployment stems from major changes in the structure of an economy or in the location of jobs. This type of unemployment is often the result of a technological change or evolution in international competition. Structural unemployment affects job seekers for a longer period of time than frictional unemployment, because in many cases, these people will have to retrain or move to find a new job. At the end of the 1970s and early 1980s, structural unemployment was very high in Canada, as oil prices exploded and intensifying global competition eradicated jobs in traditional sectors such as the automobile and steel sectors. The labour market has since adjusted to meet, among other things, the new needs of the electronics, bioengineering and financial services sectors.
Seasonal unemployment stems from a recurring reduction in the number of jobs at a given time of year. In Canada, seasonal unemployment occurs primarily in the winter, because economic activity involving fishing, agriculture and construction falls during the cold season. The extent of seasonal unemployment varies from one region to the next, with the Atlantic Provinces more severely affected in this regard.
Changes in the unemployment rate resulting from changes in the pace of economic activity are referred to as cyclical unemployment. This type of unemployment increases during a recession and decreases when the economy is faring well. When aggregate demand falls, businesses must cut production, resulting in a decrease in manpower needs and, by extension, layoffs, until such time as demand rebounds sufficiently to call the workers back.
40 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Labour Market
NATURAL UNEMPLOYMENT Related to the four types of unemployment defined earlier, natural unemployment is the total frictional, structural and seasonal unemployment. Natural unemployment is a theoretical concept, because in practice, it is difficult to obtain an accurate measure of it. Some economists believe it is approximately 6% in Canada and 5% in the U.S. The natural unemployment rate is also referred to as the full employment rate. In the long term, an economy’s unemployment rate should trend towards the full employment rate.
The hysteresis hypothesis Some economists question the idea of a natural unemployment rate, suggesting instead that aggregate demand could very well affect output and employment in the long term. According to this hypothesis, recessions can leave permanent scars on an economy because of its impact on people who lose their jobs and who could lose some of their skills, expertise and ability to find a job even after the recession. Moreover, after being unemployed for a long period of time, a person’s attitude towards work may change such that he or she may want to work less. As such, recessions permanently inhibit the job search process and increase frictional unemployment.
Okun’s Law
Definition Okun’s law is defined as the relationship between the GDP growth rate and changes in the unemployment rate. According to this law, GDP growth increases if unemployment falls and slows if unemployment rises.
7 In 1962, by analyzing U.S. GNP from 1950 to 1960, economist Okun’s law applied to Canadian data Arthur Okun noted that a 1% increase in the unemployment rate reduced GNP by 3% in relation to its potential. However, this In % change in real GDP In % change in real GDP 8 8 rule can vary over time and from one country to another. 7 7 6 6 GRReal GDP = 3.36 – 1.48 ( ∆ U ) Certain publications present Okun’s law in algebraic form 5 5 4 4 3 3 GRRe alGDP U , where GR Real GDP is the real GDP growth rate, U is the change in the unemployment rate, is the real 2 2 1 1 8 GDP growth rate at full employment (potential GDP growth), 0 0 and is real GDP growth sensitivity vis-à-vis changes in the -1 -1 -2 -2 unemployment rate. Estimates based on U.S. data show that real -3 -3 GDP varies between 1% and 2.5% for each 1% change in -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 Change in unemployment rate unemployment. Sources: Statistics Canada and Desjardins, Economic Studies The graph illustrates Okun’s law applied to Canadian data. According to these estimates, Canadian real GDP growth would slow by 1.5% for each 1% increase in the unemployment rate, and vice versa. ______7 In the middle of the last century, Gross National Product (GNP) was more prevalent as a measure of output than GDP: see Gross Domestic Product at page 30. 8 See Potential GDP at page 32.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 41 Macroeconomics / Labour Market
Labour Productivity
Definition Labour productivity is generally defined and measured as output per total hours worked. From a macroeconomic perspective, the quantity produced may be measured by real GDP9. A productivity index can be calculated by dividing the GDP index by the Hours Worked index.
In Canada, productivity tends to increase from year to year, i.e., Canadian labour productivity from 1987 to 2006 (1987=100) output increases faster than hours worked. A number of factors can have an impact on productivity, for example, changes in Index Index worker assignment, education and experience. Technological 180 180 170 170
developments also help boost productivity, as does capital 160 160
intensity. In fact, the amount produced by a given quantity of 150 150 labour increases when there is more specialized machines and 140 140 equipment. 130 130 120 120 There is a link between productivity and wages. According to 110 110 100 100 10 economic theory, when the labour market is in equilibrium, 90 90 wages reflect the marginal productivity of labour, i.e., the increase 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 in output that results from a corresponding increase in labour Hours worked GDP Labour productivity * Data excludes the agricultural sector. input. In Canada and elsewhere in the world, wages tend to rise Sources: Statistics Canada and Desjardins, Economic Studies since the marginal productivity of labour tends to increase. ______9 See Gross Domestic Product at page 30. 10 See Labour Market at page 38.
Human Capital Theory
Definition Human capital theory argues that any expenditure that is likely to improve human capital will result in improving its productivity11 and the outlook for workers’ earnings.
Human capital is the stock of economically productive human capabilities. It is made up of innate abilities and investments in human beings. Among other things, the investments are related to education and professional development, health and nutrition, and healthy lifestyles. The investments increase productive capacity (and earnings outlook) at the expense of current consumption. Human capital theory thus states that investment in human capital is an intertemporal choice between current consumption and future consumption. People who believe that the sacrifice in current consumption is offset by the benefits of the investment in human capital will opt to invest in it. Of course, a person can get other benefits from these investments besides increasing his productivity and earnings, but the theory emphasizes the fact that the relationship between the purely economic returns and economic costs of these investments is the key factor in determining the investment in human capital. ______11 See Labour Productivity at page 42.
42 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Labour Market
Capital-Labour Substitution
Definition Capital substitutes for labour every time capital is used to replace labour in producing a good or service, and vice versa.
In reality, in the short term, capital-labour substitution is very imperfect. The level of technology and the time it takes to make capital operational mean that it is not possible to replace labour with capital speedily. Also, there is a degree of complementarity between labour and capital which makes it hard for one to completely replace the other. Even the most automated equipment requires workers to be hired to keep it maintained and running smoothly. In the long term, it is better for companies to opt for the best combination of capital and labour in order to reduce their costs and increase productivity. While every company needs a fairly limited number of workers, these workers get value, as adding capital has a beneficial effect on labour productivity and thus on workers’ wages. Their enhanced standard of living means they can consume more goods and services and, because of the increased demand, this stimulates job creation.
Division of Labour
Definition The division of labour is a fundamental feature of a modern industrial economy. This is the approach to production in which each worker specializes in a given step of the production process. The division of labour makes productivity gains possible.
Productivity gains come from eliminating the loss of time caused by shifting from one task to another and from the fact that workers become more effective at doing their own tasks. Also, given that people have different professional aptitudes and competencies, allocating tasks based on these aptitudes and competencies makes it possible to get more benefit out of the division of labour.
Labour Mobility
Definition Labour mobility refers to the ability of workers to change occupation or location of work (geographically). Labour mobility can affect an economy’s unemployment rate. When the labour force is mobile, it reduces frictional and structural unemployment12.
Different barriers can limit a labour force’s mobility. Within the European Union, linguistic differences constitute a natural barrier to labour mobility. Generally, education policies aimed at recycling workers’ skills and policies that encourage workers to move to areas where employment demand is high promote labour mobility. ______12 See Unemployment at page 40.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 43 Macroeconomics / Labour Market
Wage Rigidity
Definition In practice, wages are fairly rigid, i.e., they do not adjust (or adjust very slowly) to the labour market situation. Moreover, downward wage rigidity is more significant than upward wage rigidity to correct labour market imbalances.
More specifically, nominal wages are slower to adjust. Real wages, i.e., nominal wages adjusted for the price level, adjust slowly in response to situations where prices rise faster than nominal wages. Economic literature provides various explanations for wage rigidity, including the following:
• Collective agreements partially explain wage rigidity. Through these agreements, nominal wages and wage increases for a part of the workforce are set in advance for a given period of time; as these collective agreements expire, new wage conditions are negotiated to take into account the economic situation, but this is done over a long period of time.
• Another explanation is provided by the implicit contract theory, which postulates that employees prefer a stable wage since they have set financial commitments (rent, car payments, etc). For their part, businesses are better able to withstand market fluctuations because they usually have greater financial leeway and, in the event of a temporary shortage of funds, have easier access to credit than most wage earners. As such, businesses have an interest in providing some form of assurance to their employees by limiting wage fluctuations.
• The efficiency wage theory may explain why wages rarely go down. According to this theory, businesses have every interest to pay above average wages since compensation is directly tied to labour quality, turnover and productivity. Therefore, reducing wages could cost the company money.
• Minimum wage regulations may explain the fact that the wages of unskilled labourers do not go down.
Reservation Wage
Definition Reservation wage is a wage that makes an individual indifferent to working or not working.
Labour market theory in economics assumes that an individual can use his available time either to work or to do something else (leisure). Individuals see some measure of usefulness in working, because it allows them to increase their income; however, leisure time also affords a certain satisfaction. The number of hours people allocate to work and to leisure depends on individual preferences, their income and their non-work income, which can take the form of investment income, a pension, a scholarship, social assistance benefits, among others. When non-work income is low, people may choose to give up some leisure time to work more and boost their income. However, when non-work income is high, individuals become less inclined to give up leisure time to work to increase their income. To agree to work, the marginal utility13 of the work must be higher than the value placed on leisure. The market wage must be sufficiently high to prompt individuals to work, i.e., it must be more than their reservation wage. A millionaire heir is not likely to work for minimum wage14 whereas a poor student wouldn’t think twice. ______13 See Marginal Analysis at page 11. 14 See Minimum Wage at page 45.
44 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Labour Market
Minimum Wage
Definition Many countries have legislation that prevents businesses from paying their employees less than a certain wage. The purpose of this type of regulation is to increase the income of the economically disadvantaged.
While it ensures workers earn decent income, when it is too Minimum wage and unemployment rate in Canadian provinces high, the minimum wage can exert upward pressure on the unemployment rate. In fact, if there is too big a gap between 15 Minimum wage Unemployment rate the minimum wage and the equilibrium wage , the quantity of Canadian provinces (May 2007) (May 2007) labour demanded will be below the quantity demanded at market Newfoundland and Labrador $7.00 12.9% equilibrium and the quantity of labour offered will be above Nova Scotia $7.60 8.0% Prince Edward Island $7.50 10.0% market equilibrium. The difference between labour supply and New Brunswick $7.00 7.8% demand will cause an increase in unemployment. Québec $8.00 7.2% Ontario $8.00 6.3% Manitoba $8.00 5.2% In Canada, each province is allowed to set the minimum wage Saskatchewan $7.95 4.5% within its jurisdiction. British Columbia, Manitoba, Ontario and Alberta $7.00 3.8% Québec have the highest minimum wages while the Atlantic British Columbia $8.00 4.2% Provinces and Alberta have the lowest. However, a lower minimum wage does not always guarantee lower unemployment Sources: [http://canadaonline.about.com], Statistics Canada and Desjardins, Economic Studies as the data in the table above shows. For example, Alberta has a very low jobless rate, but this is not the case for the Atlantic Provinces. And despite a high minimum wage, British Columbia fares well in terms of employment. Institutional, cyclical or structural factors provide a better explanation of the differences in unemployment rates between provinces. Still, public decision makers must be prudent in setting minimum wages. ______15 See Labour Market at page 38.
Poverty Threshold
Definition People are said to live in poverty when they are unable to acquire the goods needed to survive (shelter, food and clothing). Theoretically, the poverty threshold corresponds to an income below which it is impossible to buy essential goods.
In practice, there are a number of methods for trying to assess Canadian measures of poverty threshold this theoretical threshold. Some approaches try to do a direct estimate of the cost of housing, feeding and clothing oneself; In CAN$ In CAN$ 22,000 22,000 other approaches are based on arbitrary statistical rules instead. Statistics Canada calculates “low-income cutoffs” based on 20,000 20,000 household size and its geographic location; in each case, the 18,000 18,000 cutoff corresponds to the income of a household that dedicates 16,000 16,000
20% more, in proportion to its revenue, to food, housing and 14,000 14,000 clothing than the average for an equivalent household. 12,000 12,000
10,000 10,000 For international comparisons, Statistics Canada also publishes 1992 1994 1996 1998 2000 2002 2004 2006
“low-income measures” (LIM), based on a family’s size and Low-income cutoff (1992 basis), 1 person living in large urban area, before taxes makeup. The LIM for a family of one equals 50% of the median Low-income measure, 1 adult, no children, before taxes family income, adjusted for family size. For bigger families, this Sources: Statistics Canada, catalogue 75F0002MIF and Desjardins, Economic Studies value is adjusted according to the family’s composition and size.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 45 Macroeconomics / Labour Market
Lorenz Curve and Gini Coefficient
Definition In general, the Lorenz curve is the representation of the concentration of a variable for a given population. Economists use it in particular to observe the concentration of an economy’s total revenue in its population.
To draw a Lorenz curve, we first classify the population by Lorenz curve income in increasing order from smallest to largest. The population is often divided into increments of 10%. The Lorenz Cumulative total income in % Cumulative total income in % 100 100 curve involves adding up the incomes of the population segment
as another segment is added. The first point on the curve thus 80 80 corresponds to the incomes of the first population segment; the second point corresponds to the incomes of the first two 60 Perfect equality 60
segments, and so on. The final point on the curve therefore 40 40 corresponds to the total of all the incomes of all segments of 20 20 the population. Increasingly imperfect equality 0 0 A perfectly straight Lorenz curve would mean that income is 0 102030405060708090100 divided equally among the population, which is unlikely. The Cumulative total population in % more the curve bulges down, the less income is divided equally. Source: Desjardins, Economic Studies The Gini coefficient is used to compare the distribution of wealth among countries. This coefficient is the ratio of the area located between the perfect equality line and the Lorenz curve to the total area located below the perfect equality line. A coefficient of 0 means perfect equality, whereas a coefficient of 1 means that the wealthiest person has all of the country’s wealth. In Canada, in 2005, the Gini coefficient was 0.364.16 This statistic is based on the distribution of the total income of economic families: families of two or more people. In terms of international data, in 2005, France had a Gini coefficient of 0.327 vs. 0.408 for the United States and 0.546 for Mexico.17 ______16 Statistics Canada, Income in Canada, Catalogue no 75-202-XIE, 2005, [http://www.statcan.ca/cgi-bin/downpub/ listpub.cgi?catno=75-202-XIE2005000], p. 81. 17 United Nations Human Development Report 2005, [http://hdr.undp.org/reports/global/2005/pdf/HDR05_complete.pdf], p. 55.
46 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Growth and Economic Cycles
GROWTH AND ECONOMIC CYCLES
Business Cycles
Definition Business cycles occur in modern market economies. They cause repeating cycles of economic expansion, slowdown, recession and recovery. On average, a cycle lasts eight years but, depending on the type of cycle, it can last from one to twelve years.
A period in which real gross domestic product regularly increases is a phase of economic expansion. This phase is followed by a slowdown phase, characterized by a drop in the speed at which economic activity increases; a slowdown can lead to a recession. Technically, for a recession to exist, real GDP must decrease for at least two straight quarters. A recession that lasts for a longer period, i.e., for more than eight quarters, can be called an “economic depression”. An economic recovery follows a slowdown or recession phase; the economy then shows marked signs of renewed growth.
Business cycle theory tries to explain the fluctuations experienced by market economies. These fluctuations have specific characteristics that have to do with how the economy itself operates; in precapitalist economies, these fluctuations were mainly caused by outside phenomena such as weather fluctuations that affected crops, when agriculture made a substantial contribution to total output. When there are some common features to these fluctuations over time, they are described as cycles which follow each other. A number of economists have tried to describe these cycles; here are some of the best known attempts.
SEASONAL CYCLES These are cycles that last one year. Some economic activities fluctuate according to the time of year. In the northern hemisphere, farm production and tourism vary a great deal over the year, with winter being a slow period and summer being associated with greater output.
KITCHIN CYCLES Kitchin cycles last about three years; they are often associated with activity by businesses to increase or get rid of inventory. Inventory management practices in fact cause fluctuations in output.1
JUGLAR CYCLES Longer than Kitchin cycles, Juglar cycles last just under ten years, approximately. According to the economist who discovered them, credit granted by financial institutions and investment play a big role: a period of easier credit is followed by a sharp reduction in credit.
KUZNETS CYCLES These are cycles lasting about 15 to 20 years that are based on changes in growth rates rather than phases of expansion and contraction by absolute economic activity. These cycles are named after Simon S. Kuznets, who focussed on America’s economic development in particular and found empirical evidence for these long-term cycles in many sectors, including real estate.
KONDRATIEFF CYCLES These cycles are very long, lasting an average of 50 to 60 years. These cycles feature two phases. In the first phase, technological innovation and its dissemination improve the profit outlook, justifying increased investment. Production and productivity increase in the first phase. In the second phase, technological innovations become generalized, leading to a decreased profit outlook. Maturing sectors then take the economy into a depression phase. ______1 See Investment at page 35.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 47 Macroeconomics / Growth and Economic Cycles
Real Business Cycle
Definition Real business cycle theory is an approach to economic cycles that was developed in the ‘80s. It shows that economic fluctuations are economic agents’ most efficient response to temporary productivity shocks. In other words, the theory suggests that the economy is always at an optimal level of production, but this level can change according to circumstances.
Robinson Crusoe, living alone on his island, is often invoked to explain the theory. On Robinson’s island, the economy has a single economic agent, Crusoe himself, who spends part of his time relaxing on the beach and the rest of his time working: he fishes and makes fishing nets. Fishing provides his food while the nets constitute an investment. The island’s GDP2 is the sum of fish caught and nets manufactured.
Robinson Crusoe always strives to maximize his welfare by efficiently allocating his time between leisure, fishing and making nets. Over time, the shocks he experiences modify his decisions and the island’s GDP. For example, if a big school of fish comes close to the island, the GDP goes up, for two reasons. First, Crusoe’s productivity increases. Because of the size of the school, the amount of fish Crusoe catches an hour increases. Second, Crusoe makes a rational decision to work more to get the most of this opportunity to increase his catch.
In another situation, if a storm hits the island, he cannot work outdoors, and productivity drops: every hour devoted to fishing and making nets yields less output. The island’s economy is in recession.
The example of Crusoe’s economy demonstrates that changes in output, employment3, consumption, investment and productivity are all a natural, desirable response by an individual to inevitable changes in his environment. The real business cycle theory suggests that our economies fluctuate in ways that are very similar to the fluctuations in Robinson Crusoe’s economy. The shocks that influence our capacity4 for producing goods and services modify the natural employment and production rates. Although these shocks are not all desirable, GDP, employment and other macroeconomic variables have to respond to them by fluctuating. ______2 See Gross Domestic Product at page 30. 3 See Employment at page 39. 4 See Potential GDP at page 32.
Golden Rule of Capital Stock
Definition This golden rule involves determining the savings rate5 that enables the greatest long-range per capita consumption.
In the long term, an economy’s output is determined by the level of technology, population and capital stock. Savings helps to fund capital investments; more savings therefore means more capital and a higher production capacity. However, what good would it do to have a savings rate of 100% and maximized production potential if nothing is consumed? People strive to maximize their consumption, and the golden rule shows that, at a given savings rate, long-term consumption is maximized. We’re referring to long-term consumption because, in the short run, saving more brings consumption down, but consumption increases in the long run because of the additional output generated by the growth in the capital stock. ______5 See Savings at page 49.
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The contribution of capital helps increase production capacity6, and thus consumption. It is also used to replace some of the production capacity (compensates for depreciation). The more the savings rate goes up, the more capital grows; also, the portion allocated to replacing production capacity increases. The additional increase in production increases national income and helps to save more but, assuming that the capital’s marginal productivity7 is declining, there comes a time when the capital contribution is not enough to offset the increase in depreciation, which leads to a net decline in the capital stock and, by ricochet, consumption. As long as new capital contributions offset the increase in depreciation, long-term consumption is higher. The golden rule thus involves choosing a savings rate that makes it possible to reach a quantity of capital whose marginal productivity equals the depreciation rate and to maximize long-term consumption.
There are some drawbacks to applying the golden rule, however. The adjustment occurs over a long period of time and economies that need to increase their savings rate must sacrifice some of their current consumption. Intergenerationally speaking, this means that one generation has to reduce its consumption to increase the consumption of later generations. ______6 See Potential GDP at page 32. 7 See Marginal Analysis at page 11.
Savings
Definition Savings means the portion of disposable income that is not spent. Individuals save for the future in order to cover the unexpected, to purchase goods and services, to build a retirement nest egg or to leave an inheritance. From the point of view of economic growth, savings fuel investment, which in turn leads to capital formation, thus increasing output capacity and economic growth over the long term.8 Different factors explain the level of savings, for example, interest rates, income, age and the wealth effect9.
The level of interest rates explains the strong fluctuations in savings: higher interest rates cause economic agents to save more whereas lower interest rates prompt them to save less. The following graph clearly shows the relationship between interest rates and savings in Canada. The savings rate, i.e., the portion of disposable income that is not spent, has followed the same trend as interest rates.
This phenomenon is referred to as intertemporal substitution in consumption. All other things being equal, when interest rates Savings and interest rates in Canada rise, the cost of current consumption increases, which ultimately Savings rate in % In % leads to less spending. The problem can also be analyzed from a 22 22 20 20 borrower’s perspective. Borrowing more is the same as dissaving, 18 18 whereas borrowing less means saving more. The higher the 16 16 14 14 interest rates, the less economic agents are inclined to borrow, 12 12 and vice versa. 10 10 8 8 6 6 Moreover, all other things being equal, disposable income, which 4 4 is total income minus taxes paid to the government, can also 2 2 0 0 affect savings. As income rises, so can savings and vice versa. 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 The portion of additional disposable income that is saved is the Savings/disposable income (left) 90-day commercial paper rate (right) marginal propensity to save. Moreover, wealthier households Sources: Statistics Canada and Desjardins, Economic Studies are more inclined to save than poorer ones. However, there is a
______8 See Potential GDP at page 32 and Golden Rule of Capital Stock at page 48. 8 See Whealth Effect at page 13.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 49 Macroeconomics / Growth and Economic Cycles
paradox in the link between savings and income (paradox of thrift): an increase in the marginal propensity to save, which leads to greater savings, can in fact cause an economy’s total savings to fall. The reasoning is that by saving more, aggregate consumption and spending fall, which is equivalent to a decrease in disposable income and hence a decrease in total savings.
Age also affects how much individuals save. Based on the lifespan theory, young people tend to save less, incurring debt to pay for their education and for their first house; as they age, they pay off their debts and save for retirement, at which time, they once again dissave. At the end of their life, they have spent all their savings or left an inheritance.
Finally, let us examine the relationship between the savings rate and the wealth effect. The wealth effect refers to an increase in consumption spending as a result of an increase in wealth. However, given that theoretically, disposable income can be allocated to spending or saving, an increase in wealth which increases consumption also causes a reduction in the savings rate. That said, a lower savings rate does not necessarily mean that an individual’s financial health is precarious; it can simply mean that his personal wealth, comprised of financial assets and real estate, has increased in value over time. Consequently, all other things being equal, the individual can afford to spend more and save less when his wealth increases. Conversely, a decrease in wealth could lead to an increase in his savings rate.
SAVINGS RATE AND HOUSEHOLD FINANCIAL SITUATION Some observers see a relationship betweens the savings rate and changes in the household financial situation, with a high savings rate reflecting a good financial situation and a low savings rate indicative of a more precarious one. In truth, the savings rate is not the best indicator for assessing household finances, because it does not take into account the change in household net worth.
Household net worth (or wealth) equals total assets minus liabilities. The greater the ratio between a household’s assets and liabilities, the greater is the household’s net worth, and hence, the more solid its financial situation. Net worth is not only influenced by household savings but also by the appreciation or depreciation in the value of assets (e.g., increase or decrease in the value of a property or stock market investments). The ratio between change in net worth and disposable income is therefore a better indicator of the evolution of household finances than the simple ratio between savings and disposable income (i.e., the savings rate).
Acceleration Principle
Definition According to the acceleration principle, a change in demand leads to a larger change in investment. In other words, small fluctuations in demand cause large fluctuations in investment.
Let us use a fictional example to illustrate the principle. Compare the annual variations in consumption and investment over three years. The first year, demand for consumer goods is set at 100. It is 120 for the second year and 130 the third year. Assume that the value of the capital needed to meet demand is three times greater than the demand: the ratio between capital and the production it can generate is called the capital-output ratio. We thus need a capital stock of 300 the first year, 360 the second year and 390 the third year. Also, assume a depreciation rate of 10%. Gross investment is equal to depreciation plus the increase in capital needed to meet an increase in demand. The second year, the capital stock must grow by 60, requiring a gross investment of 90 when depreciation is added to the net investment needed. The third year, the capital stock must increase by 30, requiring a gross investment of 66, down from the previous year. In percent variation, as shown in the table, consumption goes up by 20% from the first to second year, against a 200% increase in investment. From the second to the third years, there is an 8.3% increase in consumption, while investment fluctuates by -26.7%. This clearly illustrates the accelerator principle: small changes in demand lead to larger fluctuations in investment.
50 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Growth and Economic Cycles
Annual Annual change Annual change Demand for Capital stock Net Gross Year depreciation in consumption in investment consumer goods required investment investment (10%) (in %) (in %)
1 100 300 30 0 30 2 120 360 30 60 90 20.0 200.0 3 130 390 36 30 66 8.3 -26.7
Source: Desjardins, Economic Studies The accelerator principle has some limitations when put into practice, however. Companies must always use available capital to the fullest, which is not often the case. The theory assumes that gross investment can be negative and does not fundamentally consider the expectations that can influence investment. The principle also overlooks the fact that it sometimes takes years to build complex machines, and it assumes a constant capital-output ratio, which may not be true.
THE SAMUELSON OSCILLATOR U.S. economist Paul Anthony Samuelson showed analytically that, under some conditions, the accelerator principle and multiplier effect10 can be behind economic cycles. Demand growth initially stimulates investment. In turn, higher investment stimulates demand by increasing economic activity. The process continues until the economy reaches full capacity: then the economy’s growth rate falls. The slowdown in growth leads to a drop in investment spending and stockpiling. The economy goes into a recession.
______10 See Multiplier at page 79.
Productivity Cycle
Definition The productivity cycle is a cycle caused by the lag between the change in the output volume and the adjustment in the volume of employment. Given the lag between production and employment, productivity11 fluctuates, as measured by the ratio between the hours worked and the quantities produced.
Companies tend to take their time moving to the appropriate employment level; when production slows, employment remains steady for a while, bringing productivity down. Conversely, when production accelerates, it takes time for employment to increase, driving productivity up. Labour market regulations, businesses’ investment in human capital, scarcity of labour and the difficulty in knowing whether the economy is slowing or recovering are factors that dictate the magnitude of the cycle. ______11 See Labour Productivity at page 42.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 51 Macroeconomics / Growth and Economic Cycles
Creative Destruction
Definition Popularized by Joseph Schumpeter, creative destruction describes the process by which some activity sectors disappear and new economic activities are created. In capitalist economies, major technological innovations make part of the production capacity obsolete (destruction), helping to make way for new production capacities (creation), hence the name “creative destruction”.
According to Schumpeter’s vision of the economy, the innovation introduced by entrepreneurs is the driving force behind long-term economic expansion, even though it involves the decline of established businesses.
Mobility of Capital
Definition The mobility of capital refers to how easy it is for funds to circulate among different countries.
Theoretically, where all else is equal, capital should be invested in the sectors and locations that provide the highest return. This would make it possible to maximize global economic growth, as the increases in potential GDP12 that result from the increase in capital would be optimized. In practice, there are various barriers that hinder capital mobility: some countries limit the influx of capital using various regulations. Also, individuals prefer to invest their money in their own country, rather than going abroad. Economists call this the “home bias”. ______12 See Potential GDP at page 32.
Technical Progress
Definition Technical progress is a change in the production conditions that is mainly due to scientific discoveries and perfecting new techniques that increase productivity and the standard of living, and which are also behind new products.
There are many examples of new tools and new production methods that are generated by technical progress: fibre optics have brought down the cost of telecommunications and made it more reliable; advances in computing have increased processing capability a thousandfold in thirty years. It is also easy to think of new products that are generated by technical progress. Think of the cell phone, laptop, new video game consoles and new medical treatments.
Technological progress is at the heart of theories on economic growth. An economy’s production level is determined by its stock of labour, capital and natural resources, but its technological level has a big influence on the production volume and is a key variable in long-term economic expansion. The new theory of expansion, also known as the endogenous growth theory, considers technological change to be a product of the economic system. Previously, the theory assumed that technological change was a mysterious emanation generated by scientists and inventors, as if it were manna from heaven. On the contrary, technological progress depends on many factors. Investment in research and development, financing for fundamental research and protection of intellectual property rights are some of the factors that encourage technological advances and, by implication, foster economic growth.
52 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Growth and Economic Cycles
Multifactor Productivity
Definition Multifactor productivity measures the efficiency with which labour and capital are used to produce goods and services. Efficiency gains can stem from technological progress13 and other organizational changes. The expressions “total factor productivity” and “global factor productivity” are sometimes used.
An economy’s output level depends, in part, on the amount of labour and capital available. Everything else being equal, where the quantity of either of these production factors increases, it becomes possible to produce more goods and services. There is, however, another explanation for the increase in goods and services production: the efficiency with which labour and capital are used in the production process, i.e., multifactor productivity. Technological progress and other organizational changes are behind this efficiency.
In practice, multifactor productivity cannot be observed directly: we can only measure its fluctuations indirectly. Theoretically, the percent change in production (Y) can be explained by the percent change in the quantity of labour (L) and capital (K), and by the percent change in multifactor productivity (MFP). As the equation shows, given that we have data on production, labour and capital, we can obtain a remainder that approximates the percent change in multifactor productivity.
Y K L MFP MFP Y K L Y K L MFP MFP Y K L
The equation is not only useful for calculating MFP: it can also Evolution of multifactor productivity in Canada be used to break down economic growth into capital contribution, labour contribution and efficiency gains. Coefficients and Index 2002 = 100 Index 2002 = 100 105 105 respectively correspond to the relative weights of capital and labour used in the production process: in practice, these are the 100 100 average portion of nominal income generated by capital and the 95 95 average portion of nominal income generated by labour. 90 90
The graph depicts how multifactor productivity has evolved in 85 85 Canada. It grew sharply until the end of the ‘70s, oscillated until 80 80 the end of the ‘90s and reached a new plateau in the early part of this century. 75 75 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 ______Sources: Statistics Canada and Desjardins, Economic Studies 13 See Technical Progress at page 52.
Economic Indicators
Definition Statistical variables that make it possible to measure, analyze or predict the economy’s evolution. There are three types of indicators: leading indicators, trend indicators and lagging indicators.
Leading indicators’ movements are precursors of movements by general economic conditions; trend (coincident) indicators vary at the same time as conditions, and lagging indicators vary after the conditions. Here are some examples of the three types of indicators:
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Leading indicators Evolution of the U.S. Leading Index • Stock market indexes14 • Number of hours worked in the manufacturing sector Index Index 150 150 • Consumer confidence • Slope of the yield curve15 125 125 Trend indicators • Disposable income 100 100 • GDP growth16 75 75 Lagging indicators U.S. recessions 17 • Unemployment rate 50 50 • Inflation rate18 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Sources: Conference Board and Desjardins, Economic Studies. Indicators can also be composed of a number of variables.
Variables are weighted within a single indicator, making it Evolution of the Desjardins Leading Index possible to monitor a phenomenon’s evolution, or predict it. Index 2002 = 100 Index 2002 = 100 The Desjardins Leading Index is an example of a leading indicator 130 130 Recessions Slowdowns that is made up of a number of variables. It helps predict Québec’s 120 120 economic growth a few months ahead of time. A number of 110 110 economies have this type of indicator. In the United States, the 100 100 most popular such indicator is the Conference Board’s U.S. 90 90 Leading Index. As the graph shows, the U.S. Leading Index’s 80 80 70 70
growth has slowed or dipped before each recession in the United 60 60
States. 50 50 ______40 40 30 30 14 See Stock Market Indexes at page 159. 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 15 See Yield Curve at page 149. Source: Desjardins, Economic Studies. 16 See Gross Domestic Product at page 30. 17 See Unemployment at page 40. 18 See Inflation at page 57.
Carry-Over Effect
Definition On a given date in a current period, the carry-over effect corresponds to the growth achieved to date for the entire period, assuming that there will be no further growth until the period is over.
To illustrate the concept of carry-over effect, let us calculate it for Canada’s real GDP in the first quarter of 2007. During 2006, real GDP was, on average, $1,282 billion. In the first quarter of 2007, production was now valued at $1,300 billion. Assuming that GDP had remained at this level for the rest of the year, we would have an average real GDP of $1,300 billion. In Q1 of 2007, we therefore had a carry-over effect of 1.4%, i.e.,:
1,300 1,282 100 1.4 % 1,282
54 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Growth and Economic Cycles
To calculate the carry-over effect for the second quarter, we Example of carry-over calculated for Canada’s GDP in Q1 of 2007 compare the average for the first two quarters in relation to the previous year’s GDP, and so on. In billions of CAN$ In billions of CAN$ 1,340 1,340 The Q1 2007 carry-over corresponds to the annual growth that would occur if we assume the GDP will remain 1,320 constant for the coming quarters: in this case, it is 1.4%. 1,320
1,300 1,300 From 2005 to 2006, real GDP went up 2.8%. 1,280 1,280
1,260 1,260
1,240 1,240
1,220 1,220
1,200 1,200 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2005 2006 2007
Real GDP Annual average for real GDP
Sources: Statistics Canada and Desjardins, Economic Studies
Base Effect
Definition In current analysis, a “base effect” is sometimes used to explain a variable’s annual change. A base effect exists when the annual growth rate for a variable calculated for month “t” and month “t + 1” changes not because there was a change in the variable’s level between those two months, but rather because a change occurred in the last twelve months (for monthly data).
Here is a fictional example to illustrate a base effect. Suppose an economy’s prices consistently increase by 0.2% a month. Now suppose that, in April 2005, a monthly variation was higher than normal: price levels increased abruptly. Moreover, the annual growth rate, which compares evolution of prices between the current year’s month and the same month the year before, also went up sharply. Since April of 2005, the price index continued to grow at a normal monthly rate of 0.2% a month. However, the annual growth rate remained high because, when we compare the current month with the same month a year earlier, the variation that occurred in April of 2005, which pushed prices up higher, is implicitly included in our calculations. It is only twelve months later, in April of 2006, that the base effect that occurred in April of 2005 would disappear from the annual growth rate. The annual growth rate would then be the change in prices between April of 2006 and April of 2005. As there had not been any unusual variation between these two months, the annual growth rate for prices returns to normal.
Base effect simulation Example: Base effect on Canada’s consumer price index
Index In % Index In % 108 4.0 129 4.0 2) ... has an impact on the annual 2) ... has an impact on the annual 107 growth rate that lasts for 12 months. 3.5 128 inflation rate that lasts for 12 months. 3.5 127 3.0 106 3.0 126 2.5 105 2.5 125 2.0 3) In April 2006, the annual price 104 2.0 growth rate decreases. The decrease 124 1) An unusual 1.5 is not caused by any change in prices monthly change 3) In May 2005, the annual inflation 103 1.5 rate has, in part, declined following 1) An unusual between March and April 2006, but 123 that occurs in 1.0 because the April 2005 base effect has May 2004... the end of the May 2004 base effect. 102 monthly change 1.0 that occurs in ended. 122 0.5 April 2005... 101 0.5 121 0.0
100 0.0 120 -0.5 Dec. Mar. June Sept. Dec. Mar. June Jan. Apr. Jul. Oct. Jan. Apr. Jul. 2004 2005 2006 2004 2005 Monthly growth rate (right) Annual growth rate (right) Monthly price growth rate (right) Annual price growth rate (right) Consumer price index (left) Consumer price index (left)
Source: Desjardins, Economic Studies Sources: Statistics Canada and Desjardins, Economic Studies
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 55 Macroeconomics / Inflation
Concretely, something similar happened to Canada’s consumer price index (CPI) between May of 2004 and May of 2005. As the graph to the right shows, in May of 2004, there was a large monthly variation in the Canadian CPI’s movement. This pushed the annual price growth rate (inflation rate) up for twelve months. In May of 2005, the decrease in inflation was partly due to the end of the base effect that occurred a year earlier.
Sustainable Development
Definition Sustainable development is a mode of development inspired by the desire to reconcile improving the welfare of current generations and saving the natural environment for future generations.
The notion of sustainable development was first put forward in 1987 in the report by the World Commission on Environment and Development (Bruntland Report: Our Common Future) and enshrined in 1992 at the United Nations Conference on Environment and Development (UNCED) Earth Summit in Rio and by the World Bank report. Sustainable development takes a very long view. It involves meeting the needs of current generations without compromising the possibility of meeting the needs of future generations.
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INFLATION
Inflation
Definition Inflation is the name used to designate the phenomenon of price growth. There may be multiple causes of inflation, but the common syndrome is that prices go up. When price growth hits very high levels, the name usually used becomes “hyperinflation”. A popular measure of the inflation rate is growth in the consumer price index (CPI).
There are three types of inflation: monetary inflation, demand-pull inflation and cost-push inflation. Monetary inflation results from excess money being issued. All other things being equal, the more money there is in circulation, the less it is worth. Consequently, prices adjust upward in order to take into account the decreased value of money. The adjustment is not always instantaneous. An increase in the money supply stimulates demand for goods and services (economic agents have more money to spend). If prices and salaries are flexible1, they increase rapidly so as to neutralize the effect of demand. Production remains unchanged, but prices have increased. If prices and wages are rigid, the adjustment period is greater. Production may exceed its short-term potential2, but as prices and salaries adjust, production returns to its potential and prices increase.
The money supply is not the only thing that influences demand for goods and services: any change in consumption, investment, public expenditures or net exports can bring about demand-pull inflation. Lastly, cost-push inflation is characterized by an increase in business costs. For example, these could be wage costs, input costs (energy, raw materials), financial costs and the business’s desire to maintain its profit margins.
As shown by the following graphs, for prices to go up continually, either demand has to go up continually or supply has to go down. Often, the inflation we see stems from continual increases in demand, promoted by such things as successive but reasonable increases in the money supply. A cost-push inflation spiral is slightly rarer. Usually, costs increase temporarily, causing production to slow and prices to increase. Prices will increase more dramatically in response to a production slowdown that is due to a cost increase, if policies are implemented to stimulate demand. Costs may again increase and the inflation spiral could continue as long as further cost increases are accompanied by new increases in demand.
Demand-pull inflation spiral Cost-push inflation spiral
Price Price
Supply2 Supply2
Supply1 Supply1
Supply0 Supply0
Demand2 Demand2
Demand1 Demand1
Demand0 Demand0
Potential GDP Income, production Potential GDP Income, production
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
______1 See Wage Rigidity at page 44 and Price Rigidity at page 62. 2 See Potential GDP at page 32.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 57 Macroeconomics / Inflation
MEASURING INFLATION Canadian inflation as measured Inflation can be measured using various price indexes. by annual All-items CPI growth and core CPI growth Fundamentally, there are two types of indexes; the Laspeyres In % In % 5.0 5.0 index and the Paasche index. The Laspeyres index consists of 4.5 4.5 following the evolution of prices for a given basket of goods 4.0 4.0 and services; the Paasche index involves following the evolution 3.5 3.5 3.0 3.0 of prices for a basket of goods and services for the current period. 2.5 2.5 The drawback of the Paasche index is that it is more expensive 2.0 2.0 to tabulate, as the makeup of the consumption basket has to be 1.5 1.5 updated constantly. The Laspeyres type index is therefore used 1.0 1.0 0.5 0.5 more frequently. 0.0 0.0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 In Canada, various consumer price indexes (CPI) are published. All-items CPI* Core CPI* * Consumer price index. These can depict price evolution for a category of products or Sources: Bank of Canada and Desjardins, Economic Studies for all products. The most popular are the All-items CPI (total CPI) and the core CPI, which is used by the Bank of Canada. The core CPI excludes eight of the total CPI’s most volatile components: fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation and tobacco products. The CPI’s core basket is updated periodically in order to take into account changes in the composition of consumer spending. Since May 2007, the basket representing the makeup of expenses for 2005 has replaced the 2001 basket.
Disinflation and Deflation
Definition Disinflation means a reduction in the inflation rate (prices increase less rapidly), whereas deflation refers to a situation where prices are going down rather than up (the opposite of inflation).
The graph depicts the evolution of the inflation rate in Japan Examples of deflation and disinflation and Brazil from 1997 to 2006. It is clear that the Japanese inflation rate remained during a lapse of time at a rate below 0%, In % In % 5 20 Brazilian signifying that prices were falling rather than rising. Japan was 18 4 disinflation therefore in a deflationary period. For its part, Brazil shows period 16 3 disinflation. Between 2003 and 2006, the Brazilian inflation 14 2 12 rate went down, but remained positive. Price growth in 2006 1 10
was less rapid than price growth in 2003, meaning that 0 8 6 disinflation occurred. -1 4 -2 Japanese deflation period 2 -3 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Japan’s inflation rate (left) Brazil’s inflation rate (right)
Sources: Statistics Bureau of Ministry of Internal Affairs and Communication, Instituto Brasileiro de Geografica e Estatística and Desjardins, Economic Studies
Inflation Target
Definition The inflation target is the inflation rate that monetary authorities strive to maintain over the medium and long terms.
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Since the ‘90s, a number of central banks have been orienting Canadian inflation target and evolution of the inflation rate their monetary policy decisions based on a low, stable inflation rate. New Zealand, Canada, the United Kingdom and other In % In % 5.0 5.0 countries have official inflation targets; others, including the 4.5 4.5 United States, strive to limit inflation without going so far as to 4.0 4.0 3.5 Top of the 3.5 have a precise target. If the inflation rate is above the target, fluctuation range 3.0 3.0 interest rates are raised to slow the economy; when inflation is 2.5 Target 2.5 midpoint under the target, interest rates are lowered to stimulate the 2.0 2.0 economy. A central bank must accurately analyze and forecast 1.5 1.5 1.0 1.0 inflationary trends when making its decisions. It can take one or Bottom of the 0.5 fluctuation range 0.5 two years for a decision to pass through to inflation through 0.0 0.0 various monetary policy3 transmission channels. There are many 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 economic advantages to having a low, stable inflation rate. Here All-items CPI* Core CPI* Inflation target * Consumer price index. are a few: Sources: Bank of Canada and Desjardins, Economic Studies
• Low inflation makes it possible for consumers to better see the evolution of the prices of various products they may choose to consume. This allows them to make more informed consumer decisions that foster a more efficient allocation of resources and thus an increase in the economy’s productive potential.
• Price stability makes it possible to reduce the costs of protecting oneself from uncertainty over inflation. This keeps interest rates lower than in periods of uncertainty or high inflation. This benefits investment and consumption.
• A low, stable rate of inflation reinforces itself. When companies and people are convinced that the inflation rate will remain stable over the medium and long terms, they are less inclined to react to short-term price fluctuations. The salary demands of workers and business price increases tend to follow the inflation rate which is targeted by monetary policy. Expectations of low inflation make it easier to battle inflation4.
• Low inflation protects the purchasing power of people whose incomes do not increase at the same pace as prices do; this is particularly the case for seniors and other individuals who receive government benefits, as these benefits are not necessarily indexed to the cost of living. The government may also benefit from inflation to increase its tax revenues by not indexing tax tables to inflation, which penalizes taxpayers. ______3 See Monetary Policy at page 72. 4 See Disinflation and Deflation at page 58 and Disinflation and the Coefficient of Sacrifice at page 61.
Stagflation
Definition Stagflation is a phenomenon that combines a period of inflation and unemployment.
Canada went through a period of high unemployment and inflation during the oil shocks of 1973-74 and 1979-1980. The increase in oil prices had driven companies’ production costs up; in response to the higher costs, companies cut output and laid off workers. Unemployment went up, and the increase in costs and decline in supply pushed the inflation rate up. The aggregate supply and demand model5 explains the phenomenon (see graph on the right at page 59). ______5 See Law of Supply and Demand at page 27.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 59 Macroeconomics / Inflation
Period of high unemployment and inflation in Canada Stagflation
In % In % Price 13 13 Supply following an increase in costs 12 11 3) ... and drives up 11 prices. 10 9 1) An increase in costs brings down the supply in Initial 9 the short run, ... 7 supply
8 P1 5 7
6 3 5 P0 1 4 2) ... slows 3 -1 production... Aggregate demand 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007
Unemployment rate (left) Inflation rate (right) Potential GDP Income, production
Sources: Statistics Canada and Desjardins, Economic Studies Source: Desjardins, Economic Studies
Phillips Curve
Definition Fundamentally, the Phillips curve shows the relation between inflation and unemployment. The curve indicates that a low inflation rate is associated with a high unemployment rate, and that a high inflation rate is associated with a low unemployment rate. Over time, the concept of the Phillips curve was refined to take inflation expectations6 and supply shocks7 into account.
Modern debate about the connection between inflation and unemployment really began after the publication of a study by economist Alban William Phillips. It demonstrated an inverse, non-linear, stable relation between the rate of change in wages and unemployment in the United Kingdom. Since then, the concept of the Phillips curve has evolved substantially. The modern Phillips curve pinpoints three sources for inflation: “expected” inflation, the gap between unemployment and its natural rate and supply shocks (e.g., oil shock). We now also distinguish between the short-run Phillips curve and the long-run Phillips curve.
Short-run Phillips curve Long-run Phillips curve
In the long run, the unemployment rate is at the full-employment point. Prices evolve independent of the unemployment rate. Inflation corresponds to expected inflation. An unexpected increase in aggregate demand makes unemployment go down and inflation go up.
Expected inflation rate
An unexpected decrease in aggregate demand makes unemployment go up and inflation go down. Inflation rate Inflation Inflation rate Inflation In the short run, an increase in expected inflation moves the Phillips curve upward and vice versa. Full-employment rate of unemployment
Unemployment rate Unemployment rate
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
______6 See Expectations at page 61. 7 See Supply Shock at page 81.
60 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Inflation
In the short term, the Phillips curve shows the relation between inflation and unemployment for a given expected inflation rate and a given natural unemployment rate8. When aggregate demand unexpectedly goes up, companies raise the prices of their products to prevent an inventory shortage and use more inputs (workers, raw materials, etc.) to increase output. Stronger demand for workers makes unemployment go down, but also tends to make wages go up. The same logic applies to the other inputs: their prices tend to rise with demand. An unexpected increase in demand thus pushes the inflation rate up and brings the unemployment rate down. Using this logic, an unexpected decrease in demand will push the inflation rate down and make the unemployment rate go up.
An increase in expected inflation makes the Phillips curve move up, while a decrease in expected inflation takes it down. An increase in the natural unemployment rate pushes the curve to the right, while a decrease in this rate pushes it to the left. Supply shocks can also make the Phillips curve move up or down. In the long run, as the economy is at full employment (natural employment rate), the unemployment rate no longer has an impact on the inflation rate. It will depend on economic agents’ expectations. ______8 The natural unemployment rate is the unemployment rate that is recorded with a full-employment economy. See Unemployment at page 40.
Expectations
Definition Expectations are the forecasts made by companies, governments and consumers as to how economic variables like inflation and GDP will evolve.
Economic agents regularly reflect on how a number of economic variables are evolving in order to make decisions. For example, an employee who is negotiating a salary will predict how prices are going to evolve; an investor will want to know future interest rates, etc. Some economic models need to know the nature of these expectations. These expectations can be based on the past or can be based on all available information.
EXPECTATIONS BASED ON THE PAST These expectations are either “extrapolative” expectations or “adaptive” expectations. For the first, an economic variable’s expected level at a future date depends on the same variable’s known levels for a number of prior periods. For the second, we add a rule for adjusting for expectation errors. For example, we predicted inflation would be 3%, but it was 2% during the last period, so the new forecast will be closer to 2%.
RATIONAL EXPECTATIONS Unlike past-based expectations, rational expectations assume that, in addition to past information, agents use current information and reason in shaping their expectations. For example, a person notes that the inflation rate is often around 3%, but finds out that day that the central bank wants to slow the economy’s growth. The person will thus expect a lower inflation rate, knowing that today’s central bank decision will have a downward impact on the inflation rate.
Disinflation and the Coefficient of Sacrifice
Definition Based on the idea that a country that wants to reduce its inflation rate must go through a period of higher unemployment associated with economic tightening, the “coefficient of sacrifice” refers to the economic growth that must be sacrificed to reduce the inflation rate by one percent.
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The Phillips curve9 is the relation between the unemployment rate and inflation, while Okun’s law10 is the relation between GDP growth and changes in the unemployment rate. Based on these two relations, we can make the connection between GDP growth and the inflation rate. To reduce inflation, GDP growth must be reduced. The GDP growth that is sacrificed to reduce the inflation rate by one percent is called the “coefficient of sacrifice”. Although the coefficient of sacrifice varies widely, the estimates tend to be around five: i.e., in order to bring the inflation rate down by one percentage point, we have to sacrifice the equivalent of about five percentage points of economic growth. In other words, if the economy is growing at an annual 5%, to bring the inflation rate down from 4% to 3%, we would have to bring economic growth down to 0% for one year or 4% for five years.
The concept of the coefficient of sacrifice is very debatable when we include the concept of rational expectations11. If economic agents’ expectations are formed rationally, the coefficient of sacrifice can be substantially reduced; as the expectations are reasonable, policy statements designed to combat inflation should reduce economic agents’ inflation expectations. Everything else being equal, a decrease in inflation expectations would allow the economy to have a lower inflation rate. Theoretically, this involves the Phillips curve moving downward. A decrease in expected inflation thus tempers the need to bring unemployment up to combat inflation and, by ricochet, reduces the portion of economic growth that must be sacrificed.
If pushed to the extreme, the rational expectations theory shows that it is possible to achieve an inflation target without making any concessions with respect to economic growth. However, for this to happen, two requirements must be met: first, inflation reduction policies must be announced before workers and companies (who determine salaries and prices) form their expectations; second, workers and companies must believe the announcements. In terms of the fight against inflation, we can assert that the Bank of Canada has built substantial credibility, which makes it easier to reach an inflation target in Canada. Countries whose anti-inflation policies are not very believable must deal with a higher coefficient of sacrifice. ______9 See Phillips Curve at page 60. 10 See Okun’s Law at page 41. 11 See Expectations at page 61.
Price Rigidity
Definition In economics, price rigidity means that prices do not adjust quickly to fluctuations in aggregate supply and demand12.
In the short term, when demand fluctuates, companies are more willing to adjust production than prices. Generally, companies have some reserve production capacity so that they can produce more, as shown by the fact that the United States’ production capacity utilization rate rarely exceeds 90%. The economic literature provides several explanations for the phenomenon of price rigidity. Here are a few:
• It can be expensive for a company to change prices. Restaurants that print menus and manufacturers that print sales catalogues have to pay for new menus or catalogues when prices change. Companies thus prefer to change their prices once in a while, rather than on an ongoing basis. • Production costs can play a big role in price setting. For many companies, labour costs are an important component of production costs, and wage rigidity13 limits fluctuation by these costs. Companies’ profit margins thus remain fairly stable. They adjust their prices when their costs change and affect their margins. • Some prices, like $9.99 and $99.99, have special psychological resonance. Changing them can make sales decline a lot. • Administrative delays can slow price-setting decisions. • Prices can be set by contracts that cover specific periods. • Companies prefer to cause inventory to fluctuate, rather than their prices. It is riskier for a company to change its prices, because it does not know much about how its clients and competitors will respond. ______12 See Law of Supply and Demand at page 27. 13 See Wage Rigidity at page 44.
62 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Money
MONEY
Role of Money
Definition Money, which constitutes the stock of assets most easily mobilized to make transactions, has three functions in the economy. It is used as a store of value, a unit of account and a medium of exchange.
As a store of value, money is a means of transferring purchasing power from the present to the future. Money earned today can be saved and spent tomorrow, next week or next month. However, money is a store of value to be treated with caution, because when prices rise, the real value of money decreases. Also, given that money usually pays less interest than other types of assets, keeping it involves a cost that corresponds to the return that is said to be given up.1
Money also acts as a unit of account in that it makes it possible to measure and directly compare the value of goods and services. Rather than saying that a shirt is worth ten pairs of socks, money makes it possible to state the price of the two articles in terms of a common unit of measure. A shirt is worth $50 and a pair of socks is worth ten times less, i.e., $5.
Finally, money acts as a medium of exchange. Without money, trade would be impossible unless there were a double coincidence of needs. Two individuals wanting some sort of goods that belongs to the other must agree to trade these goods. In most countries, fiat (paper) money is used. This is money that has little or no intrinsic value, but the state has given it value by law or fiat. In other monetary systems, the value of the currency can be based on gold reserves. Moreover, coins made from this precious metal have already been used as money. Gresham’s law2 states, however, that it is the currency with the least intrinsic value (market value) which tends to be used as the medium of exchange. ______1 See Demand for Money at page 66. 2 See Gresham’s Law at page 68
Money Supply
Definition The money supply corresponds to the quantity of money in an economy that can easily be exchanged for goods and services.
The definition of the money supply varies greatly. Even though the basic idea remains the same, there is every reason to ask what sorts of assets to include in the money supply. The various monetary aggregates (M1, M2, M2+, etc.) are the distinct measures of the money supply. The more restrictive aggregates include only the most liquid assets such as currency in circulation (bank notes and coins) and sight deposits at financial institutions, while broader aggregates include assets that are slightly less liquid but still susceptible to being used as means of payment.
Here are some of the measures of the money supply in Canada:
• M1: Includes the fiat money (bank notes and coins) in circulation plus personal chequing accounts and current accounts at banks.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 63 Macroeconomics / Money
• M2: Includes M1, personal savings accounts and other Evolution of Canadian monetary aggregates M1, M2 and M2+ chequing accounts, term deposits and non-personal from 1980 to 2007 deposits requiring notice before withdrawal. In billions of CAN$ In billions of CAN$ 1,100 1,100 1,000 1,000 • M2+: Includes M2, all deposits at non-bank deposit-taking 900 900 800 800 institutions, money-market mutual funds and individual 700 700 annuities issued by life insurance companies. 600 600 500 500 400 400 300 300 200 200 100 100 0 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
M1 M2 M2+
Sources: Statistics Canada and Desjardins, Economic Studies
Monetary Base
Definition The monetary base is the sum of coins and bills in circulation and the banks’ deposits held at the central bank (bank reserves). The components of the monetary base are the most liquid financial assets in the economy.
There is a link between the monetary base and the monetary supply3. In a way, the monetary base determines the quantity of money in circulation in an economy. Given that:
• B, the monetary base defined by the sum of coins and bills in circulation (C) and bank reserves (R) • rc, the reserve coefficient, i.e., the fraction of deposits that banking institutions keep in the form of reserves • cc, the cash coefficient, i.e., the portion of sight deposits (D) that people want to hold as cash (C) • M, the money supply defined as the sum of coins and bills in circulation (C) and sight deposits (D).
It can be shown that:
cc 1 M B M m B, where m represents the money multiplier. cc rc
Therefore, according to this result, each dollar added to the monetary base causes an increase of m dollars in the money supply.4
DEMONSTRATION C 1 M C D cc 1 cc 1 D M B B C R C R cc rc cc rc D D
______3 See Money Supply at page 63. 4 See Money Creation Process at page 65.
64 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Money
Money Creation Process
Definition When the money base increases, a series of steps follow that increase the amount of money in the economy5. Financial institutions are at the heart of this process. The loans and deposits that follow the new liquidity in the financial system create new money.
The central bank can increase the money supply through open-market operations. When the central bank purchases securities, it reduces the amount left on the market and increases banking system reserves. These reserves can be used to grant new loans, which in turn will result in new deposits, ultimately increasing the money supply. The following example explains each step of the money creation process.
Step 1: The central bank purchases $100,000 of securities from a financial institution, which now has $100,000 in excess reserves that it can use to issue loans (step 2). Two thirds of these loans take the form of deposits in financial institutions, and the remaining one third is in cash (step 3)6. At this stage, the money supply has been increased by $100,000, i.e., $66,667 in new deposits and $33,333 in cash. However, the money creation process does not stop there: now that deposits are up, banks can lend more. In step 4, they lend $60,000, assuming they hold back 10% of the deposits as reserves. This process is repeated many times over such that the new reserves (which equal 10% of the deposits) and cash will equal $100,000 (increase in the monetary base), and the quantity of money will have increased by $250,000 (increase in the money supply).
Cumulative increase in money according to the step in progress Money creation process (money = deposits + cash)
Step Step Deposits Cash Money 1 $100,000 1 - - - 2 $100,000 2 - - - 3 $66,667 $33,333 $100,000 3 $66,667 $33,333 4 $66,667 $33,333 $100,000 4 $60,000 $6,667 5 $106,667 $53,333 $160,000 5 $40,000 $20,000 6 $106,667 $53,333 $160,000 7 $130,667 $65,333 $196,000 6 $36,000 $4,000 Increase in monetary base 8 $130,667 $65,333 $196,000 7 $24,000 $12,000 Loans 9 $145,067 $72,533 $217,600 8 $21,600 $2,400 Reserves ------Deposits n* $166,667 $83,333 $250,000 9 $14,000 $7,200 Cash
* Corresponds to last hypothetical step of the money creation process. Sources: Parkin, 2000, p. 275 and Desjardins, Economic Studies Source: Desjardins, Economic Studies
In practice, central banks seeking to control the money supply must carefully weigh the impact of a change in the monetary base, something that is not easy to do. Today, they tend to target the money market interest rate rather than the rate of money- supply expansion. ______5 See Monetary Base at page 64 and Money Supply at page 63. 6 Economic agents hold money in the form of deposits or cash. In this example, the currency drain (proportion of money kept in cash) is assumed at 33.3%.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 65 Macroeconomics / Money
Demand for Money
Definition Demand for money is the quantity of money demanded by economic agents. This demand fluctuates according to the level of prices, interest rates, income and financial innovations.
To eliminate the price effect, money demand is expressed in constant money (real demand), i.e., the nominal money demand is divided by the level of prices (any price index). The real demand for money (referred to simply as demand for money) is independent of the level of prices.
The money demand curve is typically illustrated as a function of the interest rate, which is the cost of holding money. People can either invest their money to earn interest or hold it as cash (a liquid form that generates little or no interest). Therefore, the higher the interest rate, the more expensive it becomes to hold money, causing the quantity of money demanded to fall and a negative slope in the money demand curve.
The graph illustrating the demand for money in relation to the rate of interest also shows the effect of income on the quantity of money demanded. People need more money when their income rises, and conversely, the demand decreases when income drops. Income can be represented by GDP7 or any other variable measuring an economy’s total output or total income. Graphically, the effect of income appears as a shift in the money demand curve. For example, when income increases at a given interest rate, demand also increases, and the money demand curve shifts to the right. Conversely, when income drops, the curve shifts to the left.
Demand for money Shift in the money demand curve
Interest rate in % Interest rate in % Interest rate in % Interest rate in % 20 20 20 20
18 18 18 For a constant interest rate, 18 16 when income increases, demand 16 16 16 for money increases. 14 14 14 14 12 When interest rate increases, 12 12 12 the quantity of money demanded decreases. When interest rate decreases, 10 10 10 the quantity of money 10 8 demanded increases 8 8 8 6 6 6 6 4 4 4 For a constant interest rate, 4 when income decreases, 2 2 2 demand for money decreases. 2 0 0 0 0 0 50 100 150 200 250 300 350 400 450 500 0 50 100 150 200 250 300 350 400 450 500 Quantity of money (M/P) Quantity of money (M/P)
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
Financial innovations can also affect the demand for money, but the impact depends on how this demand is measured. For example, in the ‘70s, increase in Canadian demand for M1 was much less than for the larger monetary aggregates8. It will be recalled that M1 comprises only physical currency and demand deposits while the other aggregates include a greater number of monetary assets. The creation of daily-interest chequing accounts and automatic transfers between chequing and savings accounts are some of the innovations that boosted demand for money in the larger monetary aggregates to the detriment of M1. ______7 See Gross Domestic Product at page 30. 8 See Money Supply at page 63.
66 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Money
Money Market
Definition In economic theory, the money market illustrates the balance between the money supply and demand. The money market is at equilibrium when the quantity of money demanded is equal to the quantity supplied. In practice, “money market” means the financial market where short-term securities are traded and where, among others, financial institutions can borrow the liquidity they need for their daily operations.
Market forces will always function to equalize supply and demand, resulting in equilibrium, which occurs when supply and demand9 intersect. The interest rate associated with money equilibrium is the money market equilibrium interest rate. As the graphs below shows interest rates are sensitive to movements in money supply and demand.
Demand for money and the monetary market Money supply and the money market
Interest rate in % Interest rate in % Interest rate in % Interest rate in % 20 20 20 20 18 18 18 18 An increase in demand for money causes the A decrease in money supply 16 16 16 16 money market interest rate to rise. drives the interest rate up. 14 14 14 14 12 12 12 12 10 10 10 10 An increase in the money supply 8 8 8 8 drives the interest rate down. 6 6 6 6 A decrease in demand for money causes 4 the money market interest rate to fall. 4 4 4
2 2 2 2 0 0 0 0 0 50 100 150 200 250 300 350 400 450 500 0 50 100 150 200 250 300 350 400 450 500 Quantity of money (M/P) Quantity of money (M/P)
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
A PRACTICAL EXAMPLE Let us assume that demand for money grows following an increase in the economy’s total income (money demand curve shifts to the right). People want to hold more money. What happens? When people hold more money, financial institutions face a shortage of liquidity and turn to the money market to finance their shortfall. Those with a surplus can lend to those in deficit. Since the overall need for liquidity has increased, the liquidity is obtained at a higher interest rate. To avoid an increase in short-term rates, the central bank may decide to lend more funds to the financial system (increase the money supply). However, if the monetary authorities do not intervene, financial institutions will try to increase their liquidity by raising their interest rates (on deposit certificates for example). Because higher interest rates make people less inclined to hold cash, the demand for money will decrease as interest rates rise (movement along the demand curve). Equilibrium is reached when the demand for money equals the supply. In this example, interest rates rose to equalize the market.
______9 See Law of Supply and Demand at page 27.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 67 Macroeconomics / Money
Gresham’s Law
Definition According to Gresham’s Law, when good and bad money have the same exchange value (same legal tender), the bad money drives the good money out of circulation.
In 1558, Sir Thomas Gresham pointed out to Queen Elizabeth I that the lighter, worn and clipped coins were used as a means of exchange while the newly minted, full-weight pieces were not circulating. Gresham explained the situation as follows: Money has two values, a legal exchange value and a market value associated with the value of the materials used in its production. By definition, good money is currency whose exchange value approaches its market value. In contrast, the exchange value of bad money is greater than its market value. Therefore, those who hold good money may be tempted to hoard it for its market value (in the case of coins, the metal can be sold if its value is greater than its legal value) and use the bad money as a means of exchange.
Quantity Theory of Money – QTM
Definition The QTM states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. According to the QTM, any change in the money supply results in a change in prices. In other words, any increase in the money supply will be followed, sooner or later, by a proportional increase in prices.
The equation of exchange clearly explains the relation between Relation between money supply and prices, the money supply and the general level of prices. This equation Canadian data, 1986 to 2006 is: M X V = P X Y, where M = the money supply, V = the velocity Money supply in billions of CAN$ Money supply in billions of CAN$ 1,100 1,100 of circulation (or the number of times in a year a dollar is used to 1,000 1,000 purchase goods and services), P = the price level, and Y = annual 900 900 800 800 output. In the original equation, Y was replaced by the number 700 700 600 600 of transactions “T”, but given that it is easier to measure total 500 500 output than the number of transactions, the current form of the 400 400 300 300 equation is the most common. The equation says that the total 200 200 amount spent must equal the value of goods and services 100 100 0 0 produced. This equation shows that if one of the variables 45 55 65 75 85 95 105 115 125 135 changes, one or more other variables must also change to Consumer price index (CPI) maintain the equality. M1 M2 M2+
Sources: Statistics Canada et Desjardins, Economic Studies Assuming V is a constant velocity of circulation and is the output level predetermined by business and Y consumer behaviour with respect to market equilibrium (potential GDP10), the equation of exchange becomes: M V P Y . Thus, by setting the values of V and Y, any change to the quantity of money can only be offset by a change in prices. However, we know that in reality, potential GDP grows in tandem with output capacity. By keeping V constant, the increase in prices equals the difference between money supply growth and potential GDP growth.
This theory has important applications, notably, for projecting inflation over the longer term. Central banks, among others, are interested in the relationship between the money supply and prices. However, they have to choose how to measure the money supply. The graph above compares the evolution of prices and money supply measured by the M1, M2 and M2+ aggregates11. Technological innovations by financial institutions alter the relationships between prices and the monetary aggregates. ______10 See Potential GDP at page 30. 11 See Money Supply at page 63.
68 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Money
Neutrality of Money
Definition Neutrality of money is a concept that states that the money supply has no impact on the number of jobs or real output but only on the general level of prices.
In reality, this concept is borne out more in the long than short term. This is because prices and wages are more rigid12 in the near term and consequently, a change in the money supply could affect employment and output. When consumers, businesses or the state have more money, aggregate demand increases, prompting businesses to hire and boost production. However, in the long term, prices adjust based on changes in the money supply. Although people have more money, they cannot spend it because prices rise; therefore, the effect on jobs and output is cancelled out. ______12 See Price Rigidity at page 62 and Wage Rigidity at page 44.
Money Illusion
Definition This is the illusion to which economic agents fall victim when they observe monetary changes in current value rather than constant value13. For example, individuals are victims of a monetary illusion if they believe themselves to be richer following an increase in revenue in spite of a proportional increase in prices.
Money illusion occurs when individuals believe that their purchasing power is greater following an increase in their revenue. This could be true, but only if the prices of the goods and services consumed do not increase proportionately. There is debate among economists concerning the money illusion. Some believe that the illusion does not exist, i.e., that agents have a clear perception of real changes in their purchasing power. Others claim the opposite, going even further by suggesting that this phenomenon might be beneficial to economic growth. Believing their purchasing power to be greater following an increase in salary, individuals are more inclined to consume, therefore stimulating the economy in the short term. Furthermore, if we assume that companies are better informed than their employees about the evolution of prices, we can imagine that a sudden upswing in prices would not necessarily be counterbalanced by salary increases and, consequently, the real cost of labour would be reduced. Faced with this sort of situation, companies are inclined to increase hiring, which reduces unemployment and stimulates the economy. ______13 See Nominal and Real Value at page 176.
Real Balance Effect
Definition The “real balance effect” is the direct effect of variations in the real value of money balances on the demand for goods and services. Variations in real balances can result from either a change in the money supply or a change in prices. The real balance effect is also known as the “Pigou effect”.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 69 Macroeconomics / Money
Real balances are defined by the expression M/P, where M corresponds to the money supply and P corresponds to the level of prices. Real balances increase when M rises or P declines. Inversely, real balances decrease when M declines or P rises. Assuming that individuals want to maintain their real balances at a constant level, the real balance effect states that, all other things being equal, an increase in these balances should encourage them to use part of this increase for additional consumption of goods and services, and vice versa.
PIGOU EFFECT VS. KEYNES EFFECT With the help of this theory, the economist Arthur Cecil Pigou claimed that the unemployment problem could be reduced by an increase in real balances. In response to Arthur Pigou’s assertions, economist John Maynard Keynes criticized the real balance effect, claiming that interest rate was the key. An increase in real balances would cause a decrease in interest rate (equivalent to an increase in the money supply), and it is not clear that the demand for goods and services would react sufficiently to a drop in rates to be able to solve the unemployment problem.
However, the mechanism that Keynes describes in his criticism of the Pigou effect does not correspond to the definition of the real balance effect. The real balance effect is the direct impact of a variation in real balances on demand, whereas the effect described by Keynes is the indirect impact of a variation in real balances on demand.
Seigniorage
Definition Seigniorage is the direct financial advantage resulting from issuing currency. It is equal to the revenue coming from issuing fiat currency, less the cost of its production, circulation and maintenance (replacement of worn currency).
In Canada, the Royal Canadian Mint is responsible for issuing coins, which are sold to financial institutions at their face value. The seigniorage revenue produced by these coins corresponds to the value of the coins issued less their cost of manufacturing and distribution. If the nominal value of a coin is less than its cost of production and distribution, the seigniorage revenue is affected negatively. An example of this is the Canadian cent whose nominal value is less than its production cost.
The Bank of Canada is responsible for issuing bank notes. In return for issued notes, the Bank of Canada receives interest- bearing securities. The seigniorage revenue resulting from issuing bank notes corresponds to the difference between the interest revenue from the securities minus the cost of production and distribution of the bills. The more bills issued by the bank, the more securities it receives and the more the seigniorage revenue increases.
Seigniorage is a source of revenue for the government. In Canada, the Royal Canadian Mint and the Bank of Canada turn over their profits to the government. In a public deficit situation, seigniorage can represent an easy source of revenue for the government.14 To cover its deficit, the central bank can buy government debt securities, but in doing so, it increases the quantity of money in circulation. As explained by the quantitative theory of money15, the more the quantity of money increases, all other things being equal, the greater the rise in the level of prices. It could be called an “inflation tax” since the population pays the price for this measure with a decrease in its purchasing power. The use of this source of revenue has been at the origin of some periods of hyperinflation in the history of countries such as Argentina and Germany. Usually, the more a central bank is autonomous, the lower the risk that the government will use seigniorage to finance its deficits. ______14 See Deficit at page 132. 15 See Quantity Theory of Money at page 68.
70 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Monetary Policy
MONETARY POLICY
Central Bank
Definition A central bank is the institution responsible for monetary policy. In other economies, it can be called the “Monetary Authority” (Hong Kong), “Reserve Bank” (India) or “Federal Reserve” (United States). A central bank can also be assigned other mandates. In Canada, for example, the central bank also makes sure the financial system is efficient, issues bank notes and acts as the federal government’s financial agent.
A central bank is said to be independent when it is completely autonomous in conducting its monetary policy. Central bank independence allows it to formulate a monetary policy that aims for longer range goals, like price stability, and shields the economy from partisan political pressure generated by short-term election-minded concerns. The central banks of Canada, the United States and the euro zone are regarded as autonomous. On the other hand, central banks such as China’s are more dependent on political powers.
Central bank transparency also varies from country to country. Central banks can demonstrate their transparency by setting a specific target for the conduct of their monetary policy (frequently, these are inflation or exchange rate targets), or publishing dates for monetary policy decision announcements ahead of time, among other things. In Canada, as is the case in more and more countries, the main goal of monetary policy is clearly defined as an inflation target1, and the calendar of central bank decisions is known ahead of time. ______1 See Inflation Target at page 58.
Key Rate
Definition The key rate is the interest rate set by monetary authorities that directly or indirectly regulates financial institutions’ interest rates and thus market credit conditions. More broadly, the key rates at central banks can influence the expansion of economic activity, the inflation rate and the exchange rate.2
For some central banks, such as the central banks of the United States and Canada, the target for the overnight rate is the main key rate. The overnight rate is the rate at which major financial institutions lend each other money for one day on the inter- bank market. This rate is reflected in the economy’s savings and credit conditions.
In Canada, to influence the effective inter-bank market rate, the central bank sets the rates at which authorized financial institutions can borrow from it or earn on deposits with it. The rate at which the Bank of Canada can lend money to eligible financial institutions is called the discount rate. It is 25 basis points higher than the target for the overnight rate the central bank announces. For its part, the rate for deposits at the central bank is 25 basis points below the target rate. The rate on deposits and the discount rate form an operating band that encourages financial institutions to deal on the money market at a rate that is very close to the target announced by the central bank. It is not in an institution’s interest to borrow funds at a rate higher than the rate offered by the central bank, nor is it in its interest to lend money at a rate below the rate it would receive if it deposited the money at the central bank. To get the overnight rate more in line with its target, the Bank of Canada can decide to inject ______2 See Monetary Policy at page 72.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 71 Macroeconomics / Monetary Policy
liquidity into the money market or remove liquidity. If the rate is Bank of Canada key rate too high, the Bank removes liquidity by selling securities. If it is too low, the Bank adds liquidity by selling securities. The graph In % In % 7 7 shows how the Bank of Canada’s key rate and operating band evolved between 1997 and 2007. 6 6 5 5
4 4
3 3
2 2
1 1
0 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Target for the overnight rate (key rate) Deposit rate Discount rate
Sources: Bank of Canada and Desjardins, Economic Studies.
Monetary Policy
Definition Monetary policy is an intervention by monetary authorities that is designed to achieve the macroeconomic targets set by acting on economic and financial variables (money supply, volume of credit, exchange rate). In most cases, the goals are healthy economic growth and low, stable inflation.
Banks conduct monetary policy by controlling how much liquidity is in the financial system. The three main types of tools that are used to control the money supply are:
1. Mandatory reserves: Financial institutions keep reserves (cash or deposits) at the central bank so that they can meet the needs of their clients. A central bank can require mandatory reserves. All other things being equal, as the mandatory reserves increase in size, there is less money in circulation (decrease in the money supply), and vice versa.
2. Lending and deposit facilities: A central bank can offer financial institutions lending and deposit facilities. When a loan is made to a financial institution, the money supply increases, and it decreases when a financial institution makes a deposit at the central bank. If a central bank wants to set the money market’s interest rate, the interest rate on loans must be higher than the target rate, while the interest rate on deposits must be lower than the target rate. For money market players, these are penalizing rates, which prod them to balance their cash surpluses and deficits among themselves at a rate that is close to the rate targeted by the central bank. The central bank’s deposit interest rate is thus an interest rate floor for the money market, whereas the lending rate constitutes a ceiling rate.
3. Open-market operations: Central bank sales and purchases of government securities on the open market have an influence on the money supply and money market equilibrium. When the central bank buys securities (pays back the debt), it injects new cash into the financial system (central bank payment to holders of debt securities); when it sells securities (borrows), it reduces the amount of money in the financial system (payment to the central bank by those who are buying debt securities). If the central bank wants to set the money market’s interest rate, it issues securities (decreases the money supply) when the market rate is below the target rate, and buys back securities (increasing the money supply) when the market rate is above the target rate.
In some countries, as in Hong Kong, monetary authorities are restricted to keeping a fixed exchange rate3; in such cases, regulating the money supply and interest rates can be used only for this purpose. That means that a country that is in a ______3 See Exchange Rate Systems at page 95.
72 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Monetary Policy recession cannot modify its interest rates to stimulate demand, because this would harm exchange rate stability4. To maintain a currency’s value against that of another currency, monetary authorities have to make sure that the expected return for deposits denominated in each of the currencies are equivalent. If a currency is tending to depreciate, interest rates have to be raised (reducing the money supply). On the other hand, if a currency is tending to appreciate, interest rates have to be lowered (increasing the money supply).
CHANNELS FOR TRANSMITTING MONETARY POLICY Monetary policy decisions are transmitted through various economic channels. It can take from nine to twenty-four months for a decision by monetary authorities to pass through to the economy. Here is a description of the channels for transmitting monetary policy to economic growth and inflation. Monetary policy is said to be expansionist if it encourages economic expansion, and restrictive if it restricts economic growth.
Transmitting an expansionist monetary policy Transmitting a restrictive monetary policy
Monetary policy decision (increase in the money supply and Monetary policy decision (decrease in the money supply and decrease in money market interest rates) increase in money market interest rates)
Expectations (people believe that Decrease in bank and market Exogenous Expectations (people believe that Increase in bank and market Exogenous real GDP growth and inflation will interest rates shocks real GDP growth and inflation will interest rates shocks go up) go down)
Credit is more Value of assets Currency depreciates on the Credit is less Value of assets Currency appreciates on the accessible increases exchanges accessible decreases exchanges
Consumption and investment Consumption and investment Net exports increase Net exports decline increases decline
Wages go up Aggregate demand Import Wages go down Aggregate demand Import goes up prices goes down prices increase decrease
Real GDP growth and Real GDP growth and inflation increase inflation decrease
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
Following a change to the money supply, short-term interest rates, including rates offered on bank deposits and loans, quickly adjust to take into account the new money market5 conditions. Also, expectations regarding future monetary policy decisions can affect longer-term interest rates. There is less of an effect on long-term rates than short-term rates, as long-term rates are largely dependent on long-term economic growth trends and inflationary trends. Thus, unless they bring on a change in expectations regarding long-term economic trends, the central bank’s actions mainly affect short-term rates.
The impact on interest rates and expectations is transposed to exchange rates, the price of assets and, by a ripple effect, to savings, spending and investment decisions. An increase in interest rates usually helps bring up the exchange rate and bring down the price of assets (stock prices, for example), and vice versa. An increase in rates combined with a decrease in the price of assets has an impact on savings, consumer spending and investment. Firstly, all other things being equal, higher interest rates usually motivate households to save rather than consume. A decrease in consumption can also be caused by a decrease in the credit available to a household. As rates go higher, the risk involved in granting credit increases, since some borrowers might no longer be able to pay back their loans as easily. In the same way, investment can suffer from an increase in credit risk. The cost of credit also has a direct impact on the volume of investment: higher interest rates mean that investments are less profitable. Lastly, given that variations in asset prices have repercussions for the wealth of households, this modifies their behaviour. Assets which gain in value increase household wealth, which can motivate households to consume more, and vice versa.6 In short, due to these combined effects, an increase in interest rates leads to a decrease in aggregate demand (decrease in investment and consumption). Conversely, a decline in interest rates should bring it up. ______4 See Mundell’s Triangle of Incompatibility at page 103 and Interest Rate Parity Condition at page 99. 5 See Money Market at page 67. 6 See Wealth Effect at page 13.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 73 Macroeconomics / Monetary Policy
Let’s return to the exchange rate. Modifying the exchange rate changes the ratio between the prices of domestic products and the prices of foreign products. When a nation’s currency loses value (depreciates), foreign goods cost more in national currency, which brings up the cost of imported goods and services. On the other hand, foreign demand responds positively to a depreciation, encouraging net exports and aggregate demand. Conversely, an increase in the value of a nation’s currency (appreciation) causes import prices to decline instead and causes aggregate demand to fall. The evolution of import prices influences the overall movement of an economy’s prices: if imported goods are used as inputs, costlier imports tend to increase the price of locally produced goods and services, and vice versa. Moreover, an increase in the price of imported products can allow some local businesses to raise the price on products that are competing with the imported products.
In short, we can see that the impact on investment, consumption and net exports drives aggregate demand up with an expansionist monetary policy and drives demand down with a restrictive monetary policy. The law of supply and demand7 dictates that prices tend to increase when demand increases, and vice versa. Due to the effect on demand, monetary policy can affect the labour market. For example, stronger demand stimulates production and hiring and, by implication, has an upward influence on wages. Also, if increased demand drives the economy’s production to exceed its capacity, this can intensify the effect on wages. The same goes for the other inputs used in the chain of production. Wages and input prices put pressures on production prices, which can in turn transfer into the overall growth of an economy’s prices.
Lastly, as the diagrams at page 73 show, there are two other transmission channels. First, a central bank that targets an inflation rate, as is the case in Canada, can have a direct and substantial influence on price evolution if it uses a credible monetary policy in attaining its inflation targets. It thus shapes economic agents’ inflation expectations, and how they determine an economy’s wages and prices. Finally, “exogenous” shocks (shocks that are not controlled by monetary authorities) can affect various aspects of a nation’s economy. These include changes to the global economy, changes in governments’ fiscal policy and changes in prices for raw materials, such as oil. Because of their impact on the economy, these shocks can have major effects on price evolution and economic growth. ______7 See Law of Supply and Demand at page 27.
Liquidity Trap
Definition A liquidity trap is a situation where interest rates are so low that the demand for money becomes perfectly elastic8. If an economy is in such a situation, any attempt to increase aggregate demand by lowering interest rates will have no impact.
The liquidity trap theory is considered a criticism of traditional monetary policy9 because it shows that in a hypothetical situation, monetary policy can be ineffective. This theory postulates that liquidity demand (demand for money10) becomes infinite when interest rates become sufficiently low (demand for money becomes perfectly elastic). In such a situation, if the central bank decides to increase the money supply as part of an expansionist policy, this will only increase the quantity of money available in the economy, and interest rates will remain unchanged. As such, the effect of lowering rates on investment and on consumption is limited, and the output of the economy stagnates. ______8 See Concept of Elasticity and Inelasticity at page 12. 9 See Monetary Policy at page 72. 10 See Demand for Money at page 66.
74 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Monetary Policy
Some economists believe that expansionist monetary policy can The liquidity trap is a situation have an effect on the public’s inflation expectations, leading to where demand for money is perfectly elastic 11 a reduction in real interest rates and revitalizing investment 0 and consumption despite very low nominal interest rates. This 0 is why, in order to avoid the liquidity trap, monetary authorities 0 tend to set an inflation target higher than zero. If there is no 0 0 According to the liquidity trap theory, at a inflation, real interest rates cannot fall below zero, which sufficiently low interest rate, liquidity demand 0 becomes perfectly elastic. increases the liquidity trap risk. Canada’s inflation target is 2% rate Interest 0 per year, which makes it possible to bring real interest rates 0 down to -2% and gives the central bank some latitude. 0
______0
11 0 See Nominal and Real Interest Rate at page 150. 0 500 1000 1500Quantity 2000 of 2500 money 3000 (M/P) 3500 4000 4500 5000
Source: Desjardins, Economic Studies
Sensitivity of Investment Demand
Definition Interest sensitivity of investment demand can affect the effectiveness of monetary policy. The less sensitive investment is to changes in interest rates, the less monetary policy affects aggregate demand.
This issue is a point of contention among economists. If Sensitivity of investment demand investment demand is insensitive to changes in interest rates, a Interest change in the money supply will affect interest rates but not rate Inelastic investment investment, thus limiting the impact of monetary policy on aggregate demand. In Canada, it is well known that monetary policy does have an impact on investment. However, it is just
12 1) For a given one channel, among others, of monetary policy transmission. change in ______interest rate, ... Elastic 12 See Monetary Policy at page 72. 2) ... investment investment varies little if demand is relatively inelastic... 3) ... and varies more if it is relatively elastic.
Investment
Source: Desjardins, Economic Studies
Goodhart’s Law
Definition According to Goodhart’s law, once an economic indicator is made a target for the purpose of conducting economic policy, then it will lose the information content that qualifies it to play such a role.
Applied to monetary policy, Goodhart’s Law stipulates that simply targeting a given monetary aggregate to manage monetary policy renders it unstable in the medium term and therefore inappropriate. This law shows that it is better for central banks to base their decisions on a complex analysis of many variables and different monetary policy transmission channels rather than on a simple rule.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 75 Macroeconomics / Monetary Policy
Monetary Conditions
Definition Monetary conditions refer to the combined effect of short-term interest rates and exchange rates. Restrictive monetary conditions tend to dampen demand for goods and services, whereas more flexible monetary conditions help boost demand for goods and services. The more open a country is to international trade, the greater the impact the exchange rate will have on its monetary conditions and its economy.
Until December 2006, the Bank of Canada published the Canadian monetary conditions index Monetary Conditions Index in Canada. This index provided a measure of the easing (MCI decrease) or tightening (MCI Index (January 1987 = 0) Index (January 1987 = 0) 4 4 increase) of the monetary conditions in relation to the base 2 2 period, i.e., January 1987. 0 0 Desjardins has continued to calculate a monetary conditions -2 -2 index (MCI) for Canada based on the old Bank of Canada index. -4 -4 This index is calculated by combining the change in 90-day -6 -6 commercial paper interest rates since 1987 and one third the -8 -8
percentage change in the Canadian dollar exchange rate in -10 -10
relation to its exchange rate of January 1987. The Canadian -12 -12 dollar exchange rate is measured by an exchange rate index 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 weighted according to its main trading partners. This index Sources: Statistics Canada and Desjardins, Economic Studies places three times more weight on interest rates than on the exchange rate. This weighting varies from one country to the next depending on how much of an impact the foreign sector has on the economy.
Taylor Rule
Definition The Taylor rule is a formula developed by economist John Taylor as a way to determine the best monetary policy for the United States. According to the rule, the federal funds rate must be equal to an equilibrium real rate plus the annual inflation rate and the differences between, on the one hand, inflation and the central bank’s inflation target and, on the other, the economy’s GDP and its potential.
For an equilibrium real rate set at 2.5% and an inflation target of 2%, the Taylor rule takes the following form:
nominal inter - bank inflation 2.0 output gap inflation 2.5 interest rate 2 2
where the output gap equals the difference in percentage between real GDP and estimated potential GDP.13
As such, according to this equation, the real inter-bank interest rate is 2.5% when inflation is 2% and GDP is at potential. Moreover, every time inflation exceeds its target by 1%, the inter-bank rate must increase 0.5%. The same holds true in the event of an output gap. The graph at page 77 compares the results of the Taylor rule with the Federal Reserve’s overnight rate target. ______13 See Potential GDP at page 32 and Output Gap at page 33.
76 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Monetary Policy
The Taylor rule can be described in other terms. For example, Taylor rule estimate in the United States instead of using current inflation, some use expected inflation. To adjust the rule for other countries, the parameters associated In % In % 10 10 with equilibrium real rates, inflation targets and the weight 9 9 assigned to the inflation differential vis-à-vis its target and to 8 8 the output gap can be modified. 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1991 1993 1995 1997 1999 2001 2003 2005 2007
Taylor rule Federal funds target rate
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics and Desjardins, Economic Studies.
Neutral Interest Rate
Definition Neutral interest is a rate consistent with output equalling potential and stable inflation, around its target.
In an economy where output equals potential, an interest rate above neutral levels would reduce aggregate demand and bring the inflation rate down below its long-term trend. Conversely, an interest rate below the neutral interest rate would increase aggregate demand and inflation.
The neutral rate cannot be tracked like standard interest rates. The Taylor14 rule is one of the methods used to estimate neutral rate. Empirically, after estimating parameters and in the equation, we can isolate the estimated real neutral rate to which the effective or expected inflation rate is added to obtain the nominal neutral interest rate.
inflation inflation target output gap nominal inter - bank rate inflation real neutral rate
When a central bank keeps the money market interest rate below neutral, monetary policy is said to be accommodating (facilitates economic expansion). Conversely, when the money market rate is kept above neutral, monetary policy is considered restrictive. ______14 See Taylor Rule at page 76.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 77 Macroeconomics / Fiscal Policy
FISCAL POLICY
Fiscal Policy
Definition Fiscal policy is a government economic policy conducted using the state’s budget that helps modify the economy’s aggregate expenditure according to macroeconomic targets. To conduct fiscal policy, the government can act on public expenditure or tax revenues. In the latter case, the expression “taxation policy” is also used.
In the United States, the Kennedy and Reagan administrations U.S. fiscal policy used fiscal policy to stabilize the American economy. When the ‘60s began, President Kennedy proposed sizeable tax cuts to Variations in annual average (in %) 1 = Recession 24 1.0 help the economy shake off the sluggishness it was experiencing 20 0.9 at the time. However, when military spending increased in 1965- 16 0.8 0.7 1966, GDP began to exceed its potential1, and inflation became 12 0.6 8 an issue. Inflation was controlled by creating a temporary 0.5 4 additional tax which helped to curb the U.S. economy. Later, in 0.4 0 the early ‘80s, President Reagan used fiscal policy to kick-start 0.3 -4 0.2 the American economy again by decreasing taxes and increasing -8 0.1 -12 0.0 public expenditure. More recently, in 2001, President George W. 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007
Bush substantially lightened Americans’ tax burdens. Recessions (right) U.S. federal government revenues (left) U.S. federal government spending (left)
The effects of a fiscal policy extend over a long period. First, Sources: Department of the Treasury, National Bureau of Economic Research and Desjardins, Economic Studies there is a direct impact on aggregate expenditure, which means there is a direct impact on production and income2; after that, the increase in income drives consumption up, which once again pushes aggregate expenditure and income up: this is called the multiplier effect3. The impact of a fiscal or taxation policy is magnified by the multiplier effect of an increase in income.
The public expenditure multiplier depends on the marginal propensity to consume4 income. For those who argue that the marginal propensity to consume remains relatively stable, successive increases in income lead to successive increases in consumption that are proportional to the marginal propensity to consume. Alternately, other theorists claim that consumers only increase their consumption if their permanent income increases. As an increase in public expenditure is, in principle, temporary, the income increase that corresponds to the increase in public expenditure will not have much impact on consumption, as permanent income is not affected. By implication, this limits the multiplier effect and the effectiveness of fiscal policy. The reality is probably somewhere between these two ways of analyzing consumption. If the government sends out a surprise $200 cheque to all citizens, some will spend it fairly promptly (efficient fiscal policy), while others will not change their consumption habits and will opt to save a sizeable portion of the amount they received (inefficient fiscal policy).
As for taxation policy, the multiplier effect depends on the changes in disposable income. Disposable income is total income minus taxes paid to the government. A change in taxation affects disposable income, and disposable income influences consumption which, in turn, influences income, and so on. The successive increases in income and consumption that are derived from an initial change in taxation and disposable income are the taxation policy’s multiplier. Once again, there is no ______1 See Potential GDP at page 32. 2 See Gross Domestic Product at page 30. 3 See Multiplier at page 79. 4 See Consumption at page 34.
78 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Macroeconomics / Fiscal Policy consensus among theorists about the multiplier effect: some think that, following a tax cut, economic agents will expect future tax increases to offset the deficits that have been amassed to carry out the taxation policy5. This means that there will be only a limited increase in consumption.
In closing, some of fiscal policy’s impact on the economy can be wiped out by changes in investment and net exports. In the case of an expansionist fiscal policy, an increase in income will increase the demand for money, interest rates and the exchange rate, which will help curb investment and net exports. Conversely, a restrictive fiscal policy will be offset by an increase in investment and net exports. These effects are called the crowding out effect and the international crowding out effect.6 Therefore, where an economy is open to international trade, as Canada’s economy is, fiscal policy is often deemed less effective than monetary policy. In Canada, it is in fact monetary policy that is used to regulate inflation and economic growth. ______5 See Ricardian Equivalence at page 135. 6 See Crowding Out Effect at page 80 and International Crowding Out Effect at page 80.
Multiplier
Definition A change in aggregate expenditure can cause a bigger change in national income. The multiplier is the ratio between the increase in national income and the initial increase in aggregate expenditure (increase in investment, public spending or exports, or several of these components).
The multiplier shows us that, following an initial increase in The multiplier effect step by step aggregate expenditure, there will be a larger final increase in income. The place to start to understand how the multiplier Increase in income Increase in income 400 400 works is the relationship between consumption and income. The 350 350 7 marginal propensity to consume determines the proportion of 300 300 income that is consumed. Any increase in income thus drives 250 250 consumption up but, given that consumption itself makes 200 200 national income increase, we witness a series of successive 150 150 income increases. The key to the magnitude of the income 100 100 50 50 increases is the marginal propensity to consume: as it increases, 0 0 so does the portion of the income increase consumed, and the 123456789101112131415 Steps more income grows further. Increase income during the current step Cumulative increase in income during previous steps
The graph depicts how the multiplier works step by step. In Sources: Michael Parkin et al. 2000, p. 194 and Desjardins, Economic Studies step 1, national income goes up 100 for some reason (an increase in investment, increase in exports or increase in public expenditures). Here, we assume that the marginal propensity to consume equals 0.75. Thus, in step 2, income goes up by 75, equalling the increase in consumption generated by the initial increase in income (0.75 x 100 = 75). In step 3, as income went up by 75 in the previous step, assuming that marginal propensity to consume is still 0.75, consumption will now go up by 56.25 (i.e., 0.75 X 75). From step to step, due to the impact of the relationship between consumption and income, the initial increase of 100 in the national income will translate into a cumulative increase of 400. This is a multiplier of four: income increase by four times the initial increase. ______7 See Consumption at page 34.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 79 Macroeconomics / Fiscal Policy
Crowding Out Effect
Definition The crowding out effect is said to exist when an interest rate increase that results from an increase in government spending causes investment to decline.
The crowding out effect reduces the impact of an expansionist fiscal policy. An expansionist fiscal policy is characterized by an increase in public spending or a tax decrease8; it drives up demand for goods and services, and therefore demand for money, which pushes interest rates9 up. Given the inverse relationship between investment and interest rates, a rate increase tends to make investment decline. In turn, lower investment causes aggregate spending to decline, which cancels out some of the expansionist fiscal policy’s initial impact. The crowding out effect is said to be a partial or full eviction of investment, depending on whether or not the decrease in investment equals the increase in public spending. The magnitude of the crowding out effect depends on how sensitive investment10 is to interest rates: the more investment fluctuates based on interest rates, the larger the crowding out effect is. ______8 See Fiscal Policy at page 78. 9 See Money Market at page 67. 10 See Sensitivity of Investment Demand at page 75.
International Crowding Out Effect
Definition There is an international crowding out effect when an expansionist fiscal policy makes net exports decline.
An expansionist fiscal policy is characterized by an increase in public expenditure or a decrease in taxes11. It drives up demand for goods and services, including demand for money, which pushes interest rates12 up. In an open economy, the rate increase not only impacts investments13, but also the exchange rate. All other things being equal, an interest rate increase draws foreign capital and increases demand for the national currency, thus driving up the currency’s value on foreign exchange markets. In international trade, a stronger currency means less expensive imports; however, it also means that exported products will be more expensive on foreign markets. In all, the increase in imports and decline in exports triggered by the national currency’s appreciation results in a decline in net exports. Note that, like the crowding out effect on investment, the international crowding out effect cancels a part of the impact of the expansionist fiscal policy on aggregate expenditure. The impact of the international crowding out effect depends on the elasticity of import and export demand14. ______11 See Fiscal Policy at page 78. 12 See Money Market at page 67. 13 See Crowding Out Effect at page 80. 14 See Marshall-Lerner Criterion at page 108.
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SUPPLY SIDE ECONOMICS
Supply Shock
Definition A supply shock is a brutal change in the costs of production or in productivity that has an impact which is both serious and unexpected on the overall supply of an economy. In response to a supply shock, real GDP1 and the general level of prices change unexpectedly. As an example, a supply shock could result from a change in the world price of energy, a change in environmental regulations or a change in the weather.
The sudden increase in the price of oil during 1973-1974 created A supply shock presented an abrupt increase in the costs of production. This supply shock in the aggregate supply and demand model Price was followed by a period of higher unemployment and inflation. 1) A supply shock (surge in oil prices) increases price levels... Supply A supply shock can be easily illustrated using an aggregate 1 supply and demand model2. The surge in energy prices results Supply in an increase in companies’ production costs, causing them to 0 P1 reduce production (represented by the shift from the supply0 P curve to the supply1 curve). Prices climb, reaching P1, and the 0 real GDP declines below its potential.
2) ... and decreases the economy’s level of Demand Supply shocks are often presented in a context where costs production (reduction increase, referred to as negative supply shocks. However, they in real GDP). can occur in a context where costs decrease. In this case they Potential GDP Income, production are called positive supply shocks, and their impact on prices Source: Desjardins, Economic Studies and production is reversed. ______1 See Gross Domestic Product at page 30. 2 See Law of Supply and Demand at page 27.
Supply Side Policies
Definition Supply side policies are a set of economic policy measures aimed at stimulating growth by affecting supply.
Traditional macroeconomic policies intervene on the side of aggregate demand.3 In theory, their effectiveness can be seen when a problem occurs on the demand side, but this effectiveness is seriously limited when the source of the problem is on the supply side. Following a negative supply shock, the illustrations at page 82 show how macroeconomic policies that influence demand can worsen the situation while trying to make it better. A negative supply shock brings with it both inflationary pressures and economic slowdown. Traditional policies can resolve inflation or recession but generally not both entirely.
During the ‘70s, a number of central banks had reacted to the increase in the price of oil by stimulating demand in order to return to production potential, which put additional upward pressure on prices. However, the general price increase motivated the oil ______3 See Fiscal Policy at page 78 and Monetary Policy at page 72.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 81 Macroeconomics / Supply Side Economics
Effect of a policy aimed at restoring GDP to its potential Effect of a policy aimed at stabilizing prices in response to a supply shock in response to a supply shock
Price Price 1) A policy that stimulates demand restores the economy to 1) A policy that cuts back demand in order to stabilize its potential, ... Supply1 Supply1 prices at P0 ...
P2 Supply0 Supply0
P1 P1
2) ... further widens the negative P0 P0 gap between real GDP and its potential.
Demand1
2) ... but causes Demand0 Demand0 increased inflation. Demand1 Potential GDP Income, production Potential GDP Income, production
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
producers to further increase the price of black gold (late ‘70s, early ‘80s) in order to keep their purchasing power constant. This time, in order to avoid an unacceptable surge in prices, the central banks decided not to react and to allow production in their respective economies to slow to below their potential. After a while, a weakening of the coalition between oil producers brought the price back down to a normal level, which by implication positively stimulated the aggregate supply (moving the aggregate supply curve to the right).
Rather than intervening on the demand side, governments can implement different measures to stimulate supply by contributing to the growth of productivity in companies. Here are a few examples:
• Education and training policy: Aims to improve worker productivity.
• Research and development policy: Influences the rate of technological progress.
• Public investment policy: Better infrastructure favours corporate performance.
• Fiscal and social policy: Incentives to encourage saving, to facilitate corporate financing, to increase the geographical and professional mobility of the work force, etc.
• Competition policy: Encourages companies to modernize in order to preserve their competitiveness in international markets.
Say’s Law
Definition Also called “Say’s Law of Markets”, this law suggests that supply creates demand.
This law stems from the work of Jean-Baptiste Say who stated: “When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it, for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products”. In summary, as soon as an individual creates a product (a supply), he creates ipso facto a “vent” (a demand) for other products. However, this law is more difficult to validate in a monetary economy since those who sell their goods can choose to hoard their money, without its value diminishing, rather than trying to trade it as quickly as possible for another good or service.
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Kaldor-Verdoorn’s Law
Definition This law establishes a causal relationship between the rate of growth of production and the rate of increase in both productivity and employment. According to this law, economic growth is at the origin of increased productivity, and not the reverse. Moreover, increased productivity would stimulate employment.
The hypothesis of increasing returns to scale4 explains in part the increase in productivity for a given level of technology. Among other explanations given in support of this law, it is said that a strong rate of growth allows for a more rapid integration of technical advances in equipment, which is then more rapidly downgraded and replaced. It is also said that when there is economic growth, prospects are more favourable for investments in research and development, which in themselves are more easily financed. ______4 See Economies of Scale at page 20.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 83 Macroeconomics
Additional references:
SUPPLY, DEMAND, MACROECONOMICS EQUILIBRIUM Labour Productivity AND MEASURES OF THE ECONOMY Graham Bannock et al. 1998, p. 334. Law of Supply and Demand Douglas Greenwald. 1984, p. 925. Bernard Guerrien. 2002, p. 305-307. Michael Parkin et al. 2000, p. 68-83. Human Capital Theory Gregory N. Mankiw. 2003, p. 286-299 and 415-427. Bernard Guerrien. 2002, p. 54-55. Douglas Greenwald. 1984, p. 112-114. Gross Domestic Product Michael Parkin et al. 2000, p. 129-136. Capital-Labour Substitution Graham Bannock et al. 1998, p. 180-181. Alain Beitone et al. 2001, p. 395. Paul R. Krugman. 2001, p. 345-352. Alain Bruno et al. 2005, p. 447-448.
Value Added Division of Labour Yves Bernard and Jean-Claude Colli. 1996, p. 1401. Douglas Greenwald. 1984, p. 242-243. Claude-Danièle Echaudemaison. 2003, p. 507. Graham Bannock et al. 1998, p. 111-112. Statistics Canada. 2002. Labour Mobility Potential GDP Graham Bannock et al. 1998, p. 237. Joseph E. Stiglitz. 2004, p. 547-548. Douglas Greenwald. 1984, p. 792-796. Wage Rigidity Douglas Holtz-Eakin. March 2004. [http://www.cbo.gov/ Joseph E. Stiglitz. 2004, p. 679-682. showdoc.cfm]. Dwayne Benjamin et al. 1998, p. 630-645.
Output Gap Reservation Wage Graham Bannock et al. 1998, p. 140-141 and 308-309. Dwayne Benjamin et al. 1998, p. 40-42. Michael Parkin et al. 2000, p. 165 and 199. Minimum Wage Consumption Graham Bannock et al. 1998, p. 274. Michael Parkin et al. 2000, p. 179-184 and 376-382. Michael Parkin et al. 2000, p. 363. Joseph E. Stiglitz. 2004, p. 692-696. Joseph E. Stiglitz. 2004, p. 231-232, 343.
Investment Poverty Threshold Michael Parkin et al. 2000, p.165-185 and 371-376. Graham Bannock et al. 1998, p. 324. Joseph E. Stiglitz. 2004, p. 550-551 and 696-700. Statistics Canada. Catalogue #: 75F0002MIE, May 2007, 37 pages. Wikipedia. [http://en.wikipedia.org/wiki/Poverty_level]. Public Expenditure Claude-Danièle Echaudemaison. 2003, p. 137. Lorenz Curve and Gini Coefficient Michael Parkin et al. 2000, p. 184-185. Bernard Delmas. 2000, p. 137. Claude-Danièle Echaudemaison. 2003, p. 299-300. Net Exports Douglas Greenwald. 1984, p. 164-165. Michael Parkin et al. 2000, p. 185-187. Joseph E. Stiglitz. 2004, p. 702-703. GROWTH AND ECONOMIC CYCLES Business Cycles LABOUR MARKET David Glasner et al. 1997, p. 62-78. Labour Market Vincent Trémolet. 2004, p. 93-94. Joseph E. Stiglitz. 2004, p. 186-195. Alain Beitone et al. 2001, p. 118-120. Janine Brémond et al. 2002, p. 92-93. Douglas Greenwald. 1984, p. 228. Gilbert Abraham-Frois et al. 2002, p. 259-261. Government of Canada. [www.canadianeconomy.gc.ca/english/ economy/business_cycle.html]. Employment Michael Parkin et al. 2000, p. 347-351. Real Business Cycle Alain Beitone et al. 2001, p. 120-121. Unemployment Gregory N. Mankiw. 2003, p. 601-610. Michael Parkin et al. 2000, p. 352-356. David Glasner et al. 1997, p. 557-560. Dwayne Benjamin et al. 1998, p. 616-621. David Romer. 2001, p. 168-216. Gregory N. Mankiw. 2003, p. 440. Graham Bannock et al. 1998, p. 396, 191-192. Golden Rule of Capital Stock Gregory N. Mankiw. 2003, p. 226-234. Okun’s Law David Romer. 2001, p. 5-43. Paul A. Samuelson and William D. Nordhaus. 2005, p. 657-658. Bernard Guerrien. 2002, p. 433-434. Gregory N. Mankiw. 2003, p. 43-44. Graham Bannock. 1998, p. 302-303.
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Savings Phillips Curve Douglas Greenwald. 1984, p. 376-380. Michael Parkin et al. 2000, p. 467-469. Graham Bannock et al. 1998, p. 311 and 369-370. Claude-Danièle Echaudemaison. 2003, p. 128 and 188-189. Expectations Claude-Danièle Echaudemaison. 2003, p. 19-21. Acceleration Principle Douglas Greenwald. 1984, p. 48 to 51. Paul A. Samuelson and William D. Nordhaus. 2005, p. 474-475. Douglas Greenwald. 1984, p. 761-763. Disinflation and the Coefficient of Sacrifice Bernard Guerrien. 2002, p. 19-21 and 395-396. Gregory N. Mankiw. 2003, p. 436-439. Alain Beitone et al. 2001, p. 7. Price Rigidity Productivity Cycle Joseph E. Stiglitz. 2004, p. 671-672 and 681-682. Alain Beitone et al. 2001, p. 117. Gregory N. Mankiw. 2003, p. 616.
Creative Destruction Gilbert Abraham-Frois et al. 2002, p. 100 and 358-361. MONEY Wikipedia. [http://en.wikipedia.org/wiki/Creative_destruction]. Role of Money Janine Brémond et al. 2002, p. 201-202. Mobility of Capital Gregory N. Mankiw. 2003, p. 95-96. Graham Bannock et al. 1998, p. 276. Money Supply Technical Progress Michael Parkin et al. 2000, p. 244-246. Paul A. Samuelson and William D. Nordhaus. 2005, p. 114-115, Bank of Canada. Canada’s Money Supply, 561-564 and 569-571. [http://www.bankofcanada.ca/en/backgrounders/bg-m2.html]. Bernard Guerrien. 2002, p. 419-422. [http://www.economist.com/research/Economics/alphabetic.cfm]. Monetary Base Gregory N. Mankiw. 2003, p. 580-581. Multifactor Productivity Michael Parkin et al. 2000, p. 273. Gregory N. Mankiw. 2003, p. 272-278. Graham Bannock et al. 1998, p. 279. Yves Bernard and Jean-Claude Colli. 1996, p. 1126-1130. John R. Baldwin and Tarek M. Harchaoui. April 2005. Money Creation Process [www.statcan.ca/english/research/11F0026MIE/ Michael Parkin et al. 2000, p. 273-275. 11F0026MIE2005004.pdf]. Demand for Money Economic Indicators Michael Parkin et al. 2000, p. 252-256. Josette and Max Peyrard. 2001, p. 137-138. David Glasner et al. 1997, p. 383-387. Money Market Wikipedia. [http://en.wikipedia.org/wiki/Economic_indicator]. Michael Parkin et al. 2000, p. 256-257. Douglas Greenwald. 1984, p. 591-593. Base Effect Central Bank of Luxembourg. [http://www.bcl.lu/en/index.php]. Gresham’s Law Douglas Greenwald. 1984, p. 564-566. Sustainable Development Wikipedia. [http://en.wikipedia.org/wiki/Gresham%27s_law]. Claude-Danièle Echaudemaison. 2003, p. 143. Quantity Theory of Money Gregory N. Mankiw. 2003, p. 101-107. INFLATION Douglas Greenwald. 1984, p. 1062-1066. Inflation Graham Bannock et al. 1998, p. 343. Douglas Greenwald. 1984, p. 503-519. Claude-Danièle Echaudemaison. 2003, p. 265-266. Neutrality of Money Bernard Delmas. 2000, p. 169-187. Janine Brémond et al. 2002, p. 204-206. Michael Parkin et al. 2000, p. 458-462. Gregory N. Mankiw. 2003, p. 128, 284 and 608-610. Statistics Canada. The Consumer Price Index, Graham Bannock et al. 1998, p. 296-297. [http://www.statcan.ca/bsolc/english/bsolc?catno=62-001-XIE]. Money Illusion Disinflation and Deflation Claude-Danièle Echaudemaison. 2003, p. 253-254. Graham Bannock et al. 1998, p. 96-97 and 109. [www.economist.com/research/Economics/alphabetic.cfm].
Inflation Target Real Balance Effect Joseph E. Stiglitz. 2004, p. 673-674 and 717-700. Douglas Greenwald. 1984, p. 1012-1015. Gregory N. Mankiw. 2003, p. 469. Graham Bannock et al. 1998, p. 320. Desjardins, Economic Studies. Guide to monetary policies of the main industrialized and emerging countries. 2005, p. 20. Seigniorage Gregory N. Mankiw. 2003, p. 580 Stagflation Bank of Canada. [www.bankofcanada.ca/en/backgrounders/ Gregory N. Mankiw. 2003, p. 298. bg-m3.html]. Olivier Coispeau. 1999, p. 395. Wikipedia. [http://en.wikipedia.org/wiki/Seigniorage]. Michael Parkin et al. 2000, p. 462.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 85 Macroeconomics
MONETARY POLICY SUPPLY SIDE ECONOMICS Central Bank Supply Shock Michael Parkin et al. 2000, p. 266. Paul A. Samuelson and William D. Nordhaus. 2005, p. 739. Desjardins, Economic Studies. Guide to monetary policies of the Gregory N. Mankiw. 2003, p. 298-301. main industrialized and emerging countries. 2005. Gilbert Abraham-Frois et al. 2002, p. 31-34. Supply Side Policies Bank of Canada. What we do, [http://www.bankofcanada.ca/en/ Gregory N. Mankiw. 2003, p. 298-301. about/do.html]. Claude-Danièle Echaudemaison. 2003, p. 384.
Key Rate Say’s Law Thomas P. Fitch. 2000, p. 257. Bernard Guerrien. 2002, p. 468. Bank of Canada. Key interest rate. [http://www.bankofcanada.ca/en/ Claude-Danièle Echaudemaison. 2003, p. 448-449. monetary/target.html]. Douglas Greenwald. 1984, p. 566-567. Wikipedia. [http://en.wikipedia.org/wiki/Overnight_rate]. Kaldor-Verdoorn’s Law Monetary Policy Claude-Danièle Echaudemaison. 2003, p. 284-285. Desjardins, Economic Studies. Guide to monetary policies of the main industrialized and emerging countries. 2005, p. 15-20. Gilbert Abraham-Frois et al. 2002, p. 320-325. Michael Parkin et al. 2000, p. 267-280.
Liquidity Trap Gregory N. Mankiw. 2003, p. 337-338 and 358. Michael Parkin et al. 2000, p. 307. Olivier Coispeau. 1999, p. 428.
Sensitivity of Investment Demand Michael Parkin et al. 2000, p. 307-308.
Goodhart’s Law K. Alex Chrystal. November 2001. Wikipedia. [http://en.wikipedia.org/wiki/Goodhart’s_law].
Monetary Conditions Bank of Canada. Monetary Conditions, [www.bankofcanada.ca/en/ backgrounders/bg-p3.html]. Bank of Canada. The role of monetary conditions and the monetary conditions index in the conduct of policy, [www.banqueducanada.ca/ fr/revue/1995/r954c.pdf].
Taylor Rule Gregory N. Mankiw. 2003, p. 469-471. John B. Taylor. 1993, p. 195-214.
Neutral Interest Rate Graham Bannock et al. 1998, p. 212. John C. Williams. October 31, 2003. Desjardins, Economic Studies. Will we see a return to higher interest rates? Economic Viewpoint. August 8, 2005.
FISCAL POLICY Fiscal Policy Paul A. Samuelson and William D. Nordhaus. 2005, p. 485-501. Gilbert Abraham-Frois et al. 2002, p. 313-316. Michael Parkin et al. 2000, p. 217-230.
Multiplier Joseph E. Stiglitz. 2000, p. 584-586. Michael Parkin et al. 2000, p. 191-195. Bernard Guerrien. 2002, p. 363-365.
Crowding Out Effect Michael Parkin et al. 2000, p. 300-301.
International Crowding Out Effect Michael Parkin et al. 2000, p. 300-301.
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PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 87 88 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES International Economics and Finance / Balance of Payments
BALANCE OF PAYMENTS
Balance of Payments
Definition The balance of payments measures all of the transactions that occur between residents and non-residents for a given period according to their nature (financial and non-financial). There are two major accounts in the balance of payments: the current account and the capital account. In theory, the current account balance and capital account balance should add up to zero. However, for this identity to occur in practice, we have to add a statistical adjustment that corresponds to the difference between the two balances.
CURRENT ACCOUNT The current account balance is the balance of exports and imports. Within the current account, exports and imports are distributed into three more specific categories: the first category concerns merchandise trade; the second category covers investment income, i.e., the payment of interest and dividends among countries [note that it is the latter component that differentiates between gross national product (GNP) and gross domestic product (GDP)1]; the final category records exports and imports of services, including spending by tourists and transportation costs.
Aside from exports and imports, the current account also records net unilateral transfers. These are international payments that are not connected with the acquisition of any good, service or asset, for example, gifts. Note that the GNP calculation does not take net unilateral transfers into account. Gross national disposable income (GNDI) is GNP plus net unilateral transfers.
GNP, GDP, GNDI AND THE CURRENT ACCOUNT One of the reasons for analyzing the current account is that its balance has an impact on the economy’s income. However, the estimated impact can vary, depending on which variable is used to measure income. If we use GDP, it does not consider net investment income from foreign sources or net unilateral transfers. GNP, on the other hand, only leaves out net unilateral transfers, while GNDI contains all of the components of the current account. Thus, with a balance of +$2 billion for trade in goods and services, $500 million for net foreign investment income and net unilateral transfers of -$300 million, GDP would go up by $2 billion, GNP would go up by $1.5 billion and GNDI would go up by $1.2 billion. In general, these differences are fairly small for developed countries like Canada since the balance of net foreign investment income and that of net unilateral transfers have a fairly small weight in income calculation. However, a country that depends extensively on international aid could see its GNDI go up substantially compared with its GDP or GNP.
CAPITAL ACCOUNT The capital account, also called the capital and financial account, records all international sales and purchases of assets. It is the counterpart of the current account. In order for a country to import more than it exports, it must have a net capital inflow (purchase of assets). Conversely, for a country to export more than it imports, there must be a net capital inflow to the other countries.
In practice, the data on asset transactions is divided into two accounts: the capital account and the financial account. The capital account contains net capital transactions such as debt forgiveness, transfer of immigrants’ net worth and donations made abroad to acquire fixed capital (e.g., grants to build roads or hospitals in another country). It also includes the net value of acquisitions/disposals of non-produced, non-financial assets such as brand names, copyright and patents. The other asset ______1 GNP = GDP + net income from abroad. The GDP calculation does not include net income from abroad. See Gross Domestic Product at page 30.
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transactions are recorded in the financial account. The financial account contains three broad asset categories: the assets that make up official reserves, direct investment (long-term investment) and portfolio investment (indirect investment, short-term investment). In each asset category, international sales of national assets are recorded against the foreign assets purchased by residents.
CANADA’S BALANCE OF PAYMENTS Canada’s balance of payments in 2006 (in millions of CAN$) Opposite is Canada’s balance of payments for Balances 2006. In the balance of payments, any Current account transaction that leads to a payment to another country is recorded as a debit (minus sign), Exports of goods and services 522 926 Imports of goods and services -486 789 and any transaction that results in an inflow from abroad is noted as a credit (plus sign). Net investment income -11 847 Exports of goods and services and foreign Net unilateral transfers -712 dividend income are credited to the current Current account balance 23 578 account, while imports of goods and services and dividends paid abroad are debited from Capital and financial account it. Also, for the capital and financial account, Net capital transfers and acquisitions/disposals of non-produced, 4 201 given that capital inflows are construed as non-financial assets
imported assets, they are recorded as debits. Variation in Canadian foreign assets -165 340 Conversely, capital outflows are credited to including variation in official international reserves -1 014 the capital account. Variation in foreign investment in Canada 142 598 (Canadian liabilities with non-residents) STATISTICAL ERROR Given that the current account and capital Balance of the capital and financial account -18 541 account use different data sources, there is a risk that the balance of payment’s basic Statistical error -5 037 identity will not be respected. To balance the Sources: Statistics Canada and Desjardins, Economic Studies two accounts, a “statistical error” component is used. Global data indicates, moreover, that the error primarily stems from the current account. Overall, the planet has a substantial current account deficit which, in theory, is impossible. It is possible for some countries to have a current account deficit while others have a surplus but, overall, as the planet can be seen as a single closed economy, its current account balance must equal zero. One of the most plausible reasons for this bias is that beneficiaries rarely declare foreign interest income to the authorities in their home countries. In many cases, such interest payments are credited directly to a foreign bank account and do not even cross the border. This hypothesis is especially credible as the global bias evolves based on global interest rates. When rates are high, the bias seems to grow, and vice versa. Another explanation for the bias lies in how maritime cargo is recorded. Much of the world’s fleet is registered in countries that do not transmit data on cargo revenues to the International Monetary Fund2, which is mandated to publish the data globally. ______2 See International Monetary Fund at page 94.
Link Between Savings and the Current Account
Definition There is a connection between saving and the current account. Analytically, it is possible to show that, for a given country, the current account balance corresponds to savings minus investment minus the public deficit.
First, let us define savings. A country’s savings (national savings) is derived from both individuals and corporations (private savings) and from the government (public savings). Private savings is the portion of revenue that is not consumed or used for
90 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES International Economics and Finance / Balance of Payments paying taxes. Public savings is the difference between what the government spends and what it takes in. When a government posts a deficit, public savings is negative and vice versa. This equation sums it up:
S S p S g S (GNDI C T) (T G) GNDI C G
Where:
• S refers to a country’s total savings (or national savings)
• Sp is private savings
• Sg is public savings • GNDI is gross national disposable income • C refers to consumption • T refers to taxes • G refers to government expenditure.
To spotlight the relationship between savings and the current account, we start with the equation for calculating income, in which CA means the current account balance3 and I means investment.
GNDI = C + 1 + G + CA
By moving the terms of the equation around, we can see that the current account balance is equal to revenue minus consumption, minus investment, minus government spending.
CA = GNDI – C – G
Using the savings equation, we can replace GNDI – C – G with national savings S. We then find that a country’s current account balance depends on the difference between national savings and investment.
CA = S – 1
In other words, if a country’s investments are lower than national savings, the country will lend its surplus savings to other countries so that they can buy the country’s current account surplus. Conversely, if investment is higher than savings, the country must then borrow internationally to finance its current account deficit. Breaking national savings down into private savings and public savings gives us the relationship between the current account, private savings, the public deficit and investment.
CA = Sp + Sg – 1
This equation shows us that a government that does not do a good job of controlling its expenditures (Sg is negative) has a negative impact on the current account balance. It is based on this reasoning that some economists believe that the U.S.’ repeated public deficits are behind the repeated U.S. current account deficits.4 ______3 See Balance of Payments at page 89. 4 See Twin Deficits at page 134.
Domestic Absorption
Definition An economy’s domestic absorption is the sum of consumer spending, investment spending and government spending.
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Domestic absorption is a measurement of the portion of national revenue that an economy spends on goods and services. If this share is less than its revenue, it means that the economy is saving internationally, and if it is above its revenue, it means that the economy is borrowing internationally instead.5 An increase in public spending can make domestic absorption higher than national revenue and make the economy borrow internationally. As the table shows, in 2006, Canada’s economy was saving internationally, while the U.S. economy was borrowing internationally.
Domestic absorption in Canada and the United States in 2006 Domestic Gross national absorption (1) disposable income (1) (2)
Canada (in billions of CAN$) 1,409 1,434 United States (in billions of US$) 14,009 13,155
(1) In current dollars (2) = GDP + net foreign investment income + net unilateral transfers Sources: Statistics Canada, Bureau of Economic Analysis and Desjardins, Economic Studies
______5 See Link Between Savings and the Current Account at page 90.
Capital Flow
Definition Most countries allow capital to flow in from other countries and out toward them. International capital flows can be broken down into direct investment and portfolio investment.
Direct foreign investment is the capital that is invested abroad to carry out long-term activities. It can be to build plants, create subsidiaries, buy foreign corporations (or buy an important share of a foreign corporation’s capital), etc. Portfolio investment, also called indirect investment, is capital that is invested abroad from a nearer term perspective. Among other things, it can be used to buy the shares or bonds of foreign corporations or foreign governments’ securities. Indirect investment is made up of more liquid assets than direct investment.
FLIGHT OF CAPITAL There is a flight of capital when investors decide as a body to remove their assets from a country. Usually, portfolio investments are more vulnerable to rapid movements of capital; an economy that is not attracting much direct investment is more likely to be hurt by a flight of capital.
Official International Reserves
Definition Official international reserves are foreign assets held by each nation. These reserves are composed of gold, financial assets in foreign currencies (mainly denominated in U.S. dollars and euros) and special drawing rights, and include the International Monetary Fund (IMF)6 reserve position.
______6 See International Monetary Fund at page 94.
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Fluctuations in official reserves are included in the balance of Value and makeup of Canada’s official reserves payment’s capital and financial account.7 Since the capital and financial account’s balance must be reflected in the current In billions of US$ In billions of US$ 40 40 account’s balance, a current account deficit can be offset by IMF reserve position 35 Special drawing rights 35 decreasing the reserves, while a current account surplus can Currency reserves result in increased reserves. 30 Gold reserves 30 25 25 Official reserves are especially important for countries that decide 20 20 to have a fixed exchange rate or that want to control fluctuations 15 15 in their exchange rate. Managing reserves allows countries to 10 10 influence what their currencies cost. To make domestic currency 5 5 increase in value, a central bank must make it scarcer by removing 0 0 some from the market in exchange of foreign currencies 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 (decreasing official international reserves). On the other hand, Sources: Statistics Canada and Desjardins, Economic Studies to bring domestic currency’s value on the market down, the amount in circulation must be increased by buying foreign currencies against the local currency (increasing official international reserves). These operations are called foreign exchange operations. ______7 See Balance of Payments at page 89.
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INTERNATIONAL MONETARY SYSTEM
International Monetary Fund – IMF
Definition The IMF is an international organization created in 1944 at the Bretton Woods Conference (New Hampshire) and which has a membership of 185 nations. It’s purpose is to promote the smooth expansion of global trade and exchange rate stability, discourage the use of competitive depreciation and facilitate the orderly resolution of balance of payment problems.
To fulfill its mandate, the IMF monitors how economic and financial policies and situations are evolving globally as well as in each member nation. It also provides its expertise and advice and grants loans to member nations that are in financial difficulties. Such loans not only temporarily alleviate a country’s problems, but also help to implement measures that recreate the foundations for sustainable economic growth. The borrowing country must take the measures it has committed to for solving its financial problems.
The IMF and World Bank1 have complementary roles: the IMF emphasizes macroeconomic results and macroeconomic and financial policy, while the World Bank focuses primarily on long-range development and combating poverty.
The IMF’s financial resources primarily come from the quotas that countries deposit when they join. These quotas depend mainly on the relative size of each country’s economy and are revised periodically. A country’s quota dictates not only how much it must deposit in the fund, but also the number of votes it has. Twenty-five percent of the quota subscriptions to the IMF are deposited in Special Drawing Rights (SDR) or in major currencies such as the U.S. dollar and yen. SDRs are an international reserve instrument created by the IMF in 1969 to respond to members’ concerns; members feared that, at the time, the inventory of international reserves was not large enough to support the rapid expansion of global trade. The SDR’s value is set every day based on a basket of four major currencies: the American dollar, the euro, the pound sterling and the yen. ______1 See World Bank at page 94.
World Bank
Definition The World Bank is an international organization created at the same time as the IMF2 at the Bretton Woods Conference in July of 1944. It has 185 member nations. Initially, its mission was to support the post-war reconstruction and development process. Now, the World Bank’s mandate focuses on poverty reduction and improving people’s standards of living worldwide.
The World Bank is made up of two separate development bodies, the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). Through these two bodies, the World Bank grants market-rate, low-interest-rate or zero-interest loans to countries that do not have access to international credit markets or would be able to access credit only under poor terms. ______2 See International Monetary Fund at page 94.
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The IBRD grants market-rate loans. The funds come from the sale of AAA-rated bonds on international capital markets, reserves that have been accumulated over the years and the capital paid to the Bank by 185 member nations, which are shareholders. The IDA handles low-interest-rate and zero-interest loans as well as grants. Its resources are topped up every three years by 40 contributing nations. The IBRD’s revenues also contribute to the IDA’s financing.
Finally, sometimes the expression “World Bank Group” is used. It refers to a group made up of the World Bank (IBRD and IDA), as well as the International Finance Corporation (IFC), the International Centre for Settlement of Investor Disputes (ICSID) and the Multilateral Investment Guarantee Agency (MIGA).
Exchange Rate Systems
Definition In general, there are two exchange rate systems; the floating exchange rate system and the fixed exchange rate system. In a flexible, or floating, exchange rate system, the currency’s value fluctuates along with foreign exchange market supply and demand; in a fixed exchange rate system, monetary authorities take steps to keep the currency’s value the same from day to day. There are variants of both exchange rate systems. A floating currency may be subject to some interventions that are designed to restrict exchange rate fluctuation, while a fixed exchange rate can sometimes be permitted to fluctuate within an operating band.
Fixed exchange rates were the norm for many years but, these days, most industrialized countries use a floating exchange rate. Also, countries may not use a completely fixed or completely floating exchange rate regime. Existing variants include exchange rates that are pegged to currency baskets, exchange rates that are allowed to fluctuate within a target band against one currency or another, and “managed floats”, where monetary authorities intervene on the foreign exchange market when they believe the market’s exchange rate is not in line with their macroeconomic objectives.
Each regime (fixed or floating) naturally has its advantages and drawbacks. Over the course of modern history, countries have sought to set up an international monetary system. Before the mid-70s, fixed exchange rates were in favour with leaders, and the international monetary system was based on this type of exchange rate. The box below sums up the history of the international monetary system.
HISTORY OF THE INTERNATIONAL MONETARY SYSTEM (FROM 1870 TO THE PRESENT)
The gold standard period (1870-1914) Under the gold standard system, economies had to set the price for their respective currencies based on gold. Central banks had to maintain enough gold reserves to back the amount of currency that was in circulation.
Interwar period (1918-1939) At the start of World War I, the gold standard system was dropped. During the ‘20s, an attempt was made to reinstitute the gold standard system; unlike the old system, some countries could set their exchange rates based on a strong currency that was pegged to gold. The gold standard’s resurgence was short-lived. There were a number of competitive devaluations, and the Great Depression was prodding nations to deal with their domestic and international imbalances by using trade restrictions and restrictions on capital transactions. Following the gold standard system’s brief renaissance, the international monetary system was rather chaotic.
The Bretton Woods period (1946-1973) After the war, a new international fixed exchange rate system was implemented. Under this system, exchange rates were fixed against the American dollar, and gold’s value was pegged at a $35 an ounce; central banks no longer had to keep gold reserves. U.S. dollar assets were an important part of their reserves, and central banks
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could exchange dollars for gold with the U.S. Federal Reserve (Fed). And, while the Fed guaranteed it would sell gold at $35, it was not obliged to match the size of its gold reserves to dollars in circulation. This flaw, combined with a growing demand for dollar reserves, led to a loss of confidence in the existing international monetary system. The Americans had printed so much money that they were no longer able to guarantee complete dollar to gold convertibility. Confidence in the dollar thus began to wane; increasingly, banks demanded gold in exchange for dollars. On August 15, 1971, the United States unilaterally decided to stop converting the dollar to gold. A little later, in 1973, the end of the Bretton Woods system was official.
Floating rate period (since 1973) Since the Bretton Woods system ended, the value of most currencies on the exchanges has been floating. A number of economies have instituted measures to limit exchange rate movements. In Europe, certain countries participated in a common monetary system that restricted the fluctuations of their respective currencies. The convergence of European currencies gave rise to the euro, a common currency now shared by thirteen countries. Other countries still restrict their currency’s fluctuation to a range against the euro, U.S. dollar or a weighted basket of currencies.
A radical way to set an exchange rate involves using a currency board. Hong Kong uses this type of system. The entire monetary base must be supported by foreign assets denominated in the currency that the national currency is pegged against. Monetary authorities must make sure they have a large enough currency reserve to convert the entire monetary base. An automatic adjustment mechanism adjusts interest rates in accordance with an increase or decrease in the demand for the national currency, thus stabilizing the value of the exchange rate. When demand for the national currency increases (influx of foreign capital), financial institutions can convert their foreign currencies into the national currency at the set exchange rate. This increases the level of liquidity in the banking system, and interest rates negotiated in this market tend to drop. The decline in interest rates in turn triggers a decline in the demand for the national currency, wiping out upward pressure on the currency’s value. Conversely, a drop in demand for the national currency is offset by an increase in interest rates, which drives up demand for the currency and wipes out downward pressure on its value.
Those who defend fixed exchange rate regimes assert that they provide for greater discipline by governments and monetary authorities, foster trade and international investment, and enable economic policies to be coordinated so as to encourage international growth. Because they have to keep the exchange rate fixed, governments and monetary authorities cannot modify the money supply as they please. Under this type of regime, it is impossible to modify the money supply for any reason other than to keep the exchange rate fixed. A fixed exchange rate system can foster trade and international investment by reducing foreign exchange risk substantially. Lastly, this type of system encourages countries to coordinate by keeping a single country from having an exchange rate policy that could, in the long run, penalize its trade partners and itself.
Defenders of a floating exchange rate system say that it allows monetary policy3 to be independent, symmetry between nations and the economy to stabilize automatically. True, a floating exchange rate system allows each country to have its own monetary policy. Each economy can control the amount of money that is in circulation based on its own macroeconomic objectives (in Canada, for instance, the monetary policy tries to keep annual inflation at between 1% and 3%). Moreover, all countries have the same opportunities to manage their exchange rates, which was not the case for the United States under the former Bretton Woods fixed exchange rate regime. The U.S. could devalue its currency as long as all the other countries agreed to revalue their own currencies against the dollar. In closing, even without active monetary policy, rapid exchange rate adjustment would help countries reach economic balance. Under a fixed exchange rate regime, a country that is recording repeated current account4 deficits must voluntarily decide to adjust its exchange rate to correct the imbalance, which saps market confidence in its currency. Also, when this type of imbalance exists, markets can instantly start speculating against the currency, which immediately forces the country to limit its money supply and raise interest rates to keep the exchange rate fixed. This curbs domestic demand. Under a floating exchange rate system, this period of instability does not occur because the exchange rate adjusts automatically. ______3 See Monetary Policy at page 72. 4 See Balance of Payments at page 89.
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Exchange Rate Movements
Definition Under a floating exchange rate system, appreciation corresponds to an increase in the currency’s value, while depreciation corresponds to a decrease in the currency’s value. Under a fixed exchange rate regime, revaluation corresponds to an upward adjustment in the currency’s fixed value, while devaluation means a downward adjustment to its fixed value.
The graph depicts a fictional currency’s exchange rate Fluctuations by a fictional exchange rate movements against the U.S. dollar. Until the end of 1996, we can assume that the currency was under a fixed exchange rate system. fictional$/US$ fictional$/US$ 1.55 1.55 Initially, the exchange rate was set at one fictional dollar vs. one 1.50 1.50 American dollar. In 1990, the exchange rate was devalued to 1.5 1.45 1.45 1.40 1.40 Revaluation fictional dollars per U.S. dollar. The fictional currency was then 1.35 1.35 worth less than the U.S. dollar, as it now took 1.5 units of the 1.30 1.30 1.25 Devaluation Depreciation 1.25 fictional currency to buy an American dollar. Currency was 1.20 1.20 revalued in 1995, to a rate of 1.25 fictional dollars per U.S. dollar. 1.15 1.15 1.10 1.10 In 1997, the fictional currency began to float against the U.S. 1.05 1.05 1.00 1.00 dollar. Until 2000, the fictional currency appreciated against the Appreciation 0.95 0.95 greenback. It took fewer and fewer fictional dollars to buy an 0.90 0.90 American dollar. Finally, between 2001 and 2006, the fictional 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 currency depreciated. Source: Desjardins, Economic Studies
Nominal and Real Exchange Rate
Definition Two exchange rates can be defined: the nominal exchange rate and the real exchange rate. The nominal exchange rate is the relative price of two countries’ currencies. The real exchange rate is the relative price of two countries’ goods and services.
The nominal exchange rate is the exchange rate that is usually used. The word “nominal” is rarely used to differentiate it. There are two ways of expressing the exchange rate for two countries’ currencies: it is expressed as the value of Country A’s currency vs. a unit of Country B’s currency, or vice versa. Usually, when we talk about the Canadian dollar’s exchange rate, we express the value of the Canadian dollar based on a unit of a foreign currency, for example: CAN$1.15 for US$1. This type of notation refers to an indirect exchange rate (quantity quotation). The reverse notation instead refers to a direct exchange rate (price quotation). Using the same example, the direct exchange rate between the Canadian dollar and U.S. dollar would, here, be US$0.8695 for CAN$1.
The real exchange rate is the nominal exchange rate adjusted according to price movement. The Canadian dollar’s real exchange rate against the U.S. dollar is:
price US$ Real exchange rate exchange rate CAN$ US$ priceCAN$
This exchange rate indicates the rate at which Canadian goods are exchanged for goods from the United States. For example, if a car sells for US$20,000 in the United States and CAN$25,000 in Canada, with an exchange rate of CAN$1.15/US$, the real exchange rate would be 0.92 American cars for one Canadian car. The American car would be cheaper than the Canadian car. By generalizing to all goods, the real exchange rate gives us the value of a basket of goods in the United States in relation
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to the same basket of goods in Canada. Theoretically, when the Nominal exchange rate and real exchange rate real exchange rate equals 1, U.S. goods are worth the same as Canadian goods. A real exchange rate that is less than 1 means CAN$/US$ US basket/CAN basket 1.70 1.70 that American goods are less expensive than Canadian goods: 1.65 1.65 1.60 1.60 we say that there has been a real increase in the value of Canadian 1.55 1.55 1.50 1.50 goods. Conversely, a real exchange rate that is higher than 1 1.45 1.45 means that American goods are more expensive than Canadian 1.40 1.40 1.35 1.35 goods: we then say that there has been a real decrease in the 1.30 1.30 1.25 1.25 value of Canadian goods. 1.20 1.20 1.15 1.15 1.10 1.10 1.05 1.05 In practice, given that we use price indexes, the real exchange 1.00 1.00 rate cannot indicate whether prices are higher or lower in Canada 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 or the United States, as explained above. In the graph, to calculate Real exchange rate (right) Nominal exchange rate (left) * To calculate the real exchange rate, the Canadian and American price indexes were reset (1985 = 100). the real exchange rate, the values of the price indexes for baskets Sources: Statistics Canada, Bureau of Labor Statistics and Desjardins, Economic Studies of U.S. and Canadian goods were set at 100 in 1985. At the outset, therefore, the real and nominal exchange rates are the same. After that, between 1985 and 1994, the Canadian price index stayed higher than the U.S. price index. The numerical value of the real exchange rate therefore tends to be “lower” during this time. Finally, from 1994 to 1996, the price index for the Canadian basket tends to remain below the price index for the U.S. basket, so the numerical value of the real exchange rate is higher than the numerical value of the nominal exchange rate. Here, a drop in the numerical value of the real exchange rate corresponds to real appreciation by the exchange rate, while an increase in its value corresponds to real depreciation by the exchange rate.
Effective Exchange Rate
Definition The effective exchange rate measures a currency’s value base to the average of bilateral exchange rates weighted by relative trade with each foreign partner.
Let Country A have an exchange rate of 1.15 with Country B and Trade-weighted U.S. exchange rate index an exchange rate of 1.33 with Country C. Assuming that 40% of Country A’s trade is with Country B and 60% of its trade is with Index Index 165 165 Country C, the effective exchange rate would be equal to: (0.4 X 1.15) + (0.6 X 1.33) = 1.258. Moreover, if we assume that the 155 155 exchange rate between Country A and Country B goes from 1.15 145 145 to 1.25, the effective exchange rate would now be equal to: (0.4 X 135 135 1.25) + (0.6 X 1.33) = 1.298. 125 125 115 115
The effective exchange rate is usually expressed as an index. By 105 105
putting the initial value of the exchange rate at 100, the second 95 95
value equals: (100/1.258) X 1.298) = 103.18. The graph shows the 85 85 movement of the effective U.S. exchange rate weighted for trade 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 with its main trading partners. A decrease in the index means the Sources: Bank of England and Desjardins, Economic Studies U.S. dollar’s value has gone down against the currencies of its major trading partners, and vice versa.
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Interest Rate Parity Condition
Definition Interest rate parity is the condition on which the returns expected on deposits in given currencies are equal when they are measured in the same currency. According to this theory, the foreign exchange market is in equilibrium if deposits in various currencies provide the same expected rate of return.
If we compare the expected return in dollars to the expected return in euros, the interest rate parity condition can be expressed by the following equation:
e E$ / euro E$ / euro i$ ieuro 1 ieuro E$ / euro
e in which i$ is the interest rate on dollar deposits, ieuro is the interest rate on euro deposits, E is the expected exchange rate and E is the market exchange rate.
Among other things, interest rate parity shows that an increase in the interest rate on dollar deposits must be offset by dollar appreciation to maintain interest parity and exchange market equilibrium. Conversely, a drop in the interest rate on U.S. dollar deposits should be followed by depreciation by the dollar. In practice, this condition is difficult to verify as there is no one interest rate, and expectations for future exchange rates vary from person to person. Nonetheless, the logic behind the condition provides a partial explanation for exchange rate movements.
Suppose that the interest rate on deposits in dollars is 6%, and the rate on deposits in euros is 4%. Also, suppose that the exchange rate is $1.10/euro, and the value of the dollar is expected to decline by 5% to $1.55/euro. An American who wants to invest $1,000 can invest it in either dollars or euros. If the money is invested in dollars, the saver expects to get a yield of 6%. In the end, the deposit would then be worth $1,060. If the money is invested in euros, the saver is instead expecting a yield of 4% in euros, as well as a gain from the dollar’s expected depreciation. In fact, the American initially converts $1,000 into euros at the exchange rate of $1.10/euro or 0.909 euro/$, for a deposit of 909.09 euros. The deposit would yield 4% in interest, bringing its value up to 945.45 euros. The exchange rate is also expected to go to $1.55/euro. Once converted, the euro deposit would be worth $1,092. Here, the interest parity condition is not met, and the American should pick the euro deposit over the dollar deposit. The preference for the euro will bring down the dollar’s value against the euro. If the returns expected in both currencies were equivalent, the American would not care whether he invested in dollars or euros. The dollar must therefore depreciate until the interest parity condition is met. In this example, where all else is equal, the exchange rate must go to $1.132/euro to meet the interest parity condition and stabilize the foreign exchange market.
Currency Arbitrage
Definition Arbitrage opportunities arise when the exchange rates for a given currency are different from market to market. Arbitragers rebalance foreign exchange markets by buying currencies on markets where they are underpriced and selling them on markets where they are overpriced.
Here is an example of an exchange market arbitrage opportunity: suppose that CAN$1.1 can buy US$1, that US$1 can buy 0.80 euros and that, on another exchange market, it takes CAN$1.333 to buy 1 euro. An arbitrager can make a profit by buying CAN$1.1 for US$1. Then, on the second market, he can buy 0.825 euros with CAN$1.1 at an exchange rate of CAN$1.333/euro. Finally, the arbitrager takes his profits by selling 0.825 euros at the rate of 0.8 euro for US$1. This sale in fact allows him to buy US$1.031 for a net gain of $0.031.
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Through arbitrage operations, currency prices balance on various markets. With the above example, the initial Canadian dollar purchase makes the Canadian dollar go up on the first market, while selling the dollar on the second market helps to bring it down. If the Canadian dollar appreciates to CAN$1.09/$US on the first market and depreciates to CAN$1.34/euro on the second market, the arbitrager’s profit falls to US$0.016. If there is no opportunity for gain, this means the markets are in equilibrium.
Purchasing-Power Parity – PPP
Definition Purchasing power corresponds to the quantity of goods and services that a sum of money can buy. Purchasing-power parity (PPP) between two countries is respected when an individual can buy the same basket of goods and services in each of the two countries for the same sum of money. According to the theory of purchasing-power parity, the exchange rate between the currencies of the two countries should be equal to the ratio of the price levels between those countries.
While supposing that the same basket of goods and services can correctly measure the purchasing power between two countries (take as an example Canada and the United States), the PPP theory stipulates that the exchange rate of the Canadian
dollar in relation to the American dollar ECAN$/US$ should be equal to the ratio between the price of the basket in Canadian dollars
(PCAN$) and the price of the same basket in American dollars (PUS$).
PCAN$ E CAN$/US$ PUS$
In this way, if the basket costs CAN$2,300 in Canada and US$2,200 in the United States, in order to respect PPP, the exchange rate should be at CAN$1.15 for US$1 (2,300/2,000 = 1.15).
If the exchange rate here is at CAN$1.10 rather than CAN$1.15/US$, Canadians would then want to buy their basket in the United States. They would convert their Canadian dollars to American dollars which would reduce the value of the loonie in relation to the greenback. Part of the adjustment could also result from prices: a weaker demand for the basket in Canada would push its price down, while a stronger demand for the basket in the U.S. would push its price up.
ABSOLUTE PPP AND RELATIVE PPP The preceding example of PPP would fall under the heading of absolute PPP. Relative PPP describes a situation where the percentage variation of the exchange rate between two countries is equal to the difference between the percentage changes in the domestic prices of the two countries. In this way, according to relative PPP, if prices increase by 3% in Canada and by 2% in the U.S., the CAN$/US$ exchange rate should increase by 1%,
which would correspond here to a decrease in the value of the Purchasing-power parity and the exchange rate, Canadian dollar compared to the U.S. dollar. Canada and the United States
PPP* 1976 = 100 Exchange rate CAN$/US$ In practice, given that countries don’t make a habit of keeping 125 1.7 1.6 data on the price of an internationally standard basket of goods 120 1.5 and services, absolute PPP becomes more difficult to apply. 115 1.4
Theoretically, it only makes sense if the price of an identical 110 1.3
basket of goods and services is being considered, since it is 1.2 105 evident that different baskets would have different prices. On 1.1 100 the other hand, relative PPP can be used even if, fundamentally, 1.0 the price changes are calculated using different baskets. The 95 0.9 graph opposite shows the evolution of the exchange rate and 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Exchange rate CAN$/US$ (right) PPP* (left) the absolute PPP between Canada and the United States PPP* with production price index (left) * Purchasing-power parity. estimated by using consumer price and production price indices. Sources: Statistics Canada, Bureau of Labor Statistics and Desjardins, Economic Studies
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The PPP calculated using production prices seems to more Relative PPP and the variation in the exchange rate, accurately capture the evolution of the exchange rate between Canada and the United States Canada and the United States. Relative PPP* (in %) Exchange rate variation in % 25 25
20 20
The following graph shows instead the evolution of the relative 15 15 PPP calculated using consumer prices and variations in the 10 10 exchange rate. Between the start of 1985 and the end of 2006, 5 5 Canadian prices increased 14% less than American prices while 0 0 the exchange rate improved by about 14%, thus predicting the -5 -5 theory of relative PPP. Nevertheless, it is clear that the -10 -10 -15 -15 relationship between the two curves diverges substantially at -20 -20 certain times. Up until the beginning of the ‘90s, the Canadian 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 dollar appreciated, and yet prices increased more rapidly in Variation in the exchange rate CAN$/US$ (right) Relative PPP* (left) * Purchasing-power parity. Canada. Thereafter, the inverse was true: the Canadian dollar Sources: Statistics Canada, Bureau of Labor Statistics and Desjardins, Economic Studies depreciated in spite of the fact that Canadian prices had increased less rapidly than American prices. The PPP seems to hold true in the very long term, but in the short term there are other factors that guide the exchange rate.
FACTORS THAT CAN REDUCE THE VALIDITY OF THE PPP Fundamentally, the PPP theory assumes that goods are traded in competitive markets that are exempt from transportation costs and official trade barriers. In practice, this is rarely the case. Moreover, a number of goods and services cannot easily be traded. Even if it is more expensive to have your hair cut in London than in Montréal, the exchange rate will not adjust itself accordingly. What’s more, the tradable goods are not always perfect substitutes for one another. Some car owners prefer Toyota while others prefer GM. As a result, the relative prices for Toyota and GM products could vary up to a point.
Exchange Rate Overshooting
Definition There is said to be overshooting when the immediate reaction of the exchange rate to a disruption is more pronounced than its long-term response.
Exchange rate overshooting is a phenomenon which helps in part to explain why exchange rates undergo such pronounced daily variations. The explanation supplied by economic theory is based on the concepts of the interest rate parity condition5 and short-term price rigidity6. Prices being rather rigid in the short term, a change in the money supply modifies the real supply of money in the economy and, as an indirect result, interest rates. According to the interest parity condition, an increase in the return on deposits held in the domestic currency must be compensated for by an increase in that currency in order to maintain the interest rate parity condition and equilibrium in the exchange market, and vice versa. In the long term, prices adjust, the real money supply returns to its initial level and the exchange rate resumes its path towards long-term equilibrium. In a hypothetical world in which prices adjust instantaneously, the real money supply would remain constant, and the exchange rate would not need to overshoot in the short term in order to maintain the interest rate parity condition. It should be noted that in practice, speculation and the absence of perfect information are also at the origin of daily fluctuations in the exchange rate. ______5 See Interest Rate Parity Condition at page 99. 6 See Price Rigidity at page 62.
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Theory of the International Fisher Effect
Definition Theory of the international Fisher effect states that, in the long term, exchange rates depreciate when interest rates rise and appreciate when interest rates fall.
At first sight, such a result would seem to contradict the interest rate parity condition7 theory. In the long term, an increase in inflation results in an increase in the nominal interest rate without changing the real interest rate8. For example, if Canadian inflation were to show a permanent increase from an annual rate of 2% to an annual rate of 5%, the interest rate on dollar deposits would adjust itself to this higher inflation by increasing three percentage points. Real interest rates, however, would remain constant. As the relative PPP shows9, all other things being equal, a more rapid rise in prices in a country contributes to a depreciation in the currency of that country, and vice versa. For example, if prices were to rise by 5% in Canada and 2% in the United States, the relative PPP tells us that the Canadian currency should depreciate by 3% relative to the greenback. All in all, in the long run, the inflation rate has an impact both on the nominal interest rate and on the exchange rate. The impact of inflation on these two economic variables means that in the long term we can observe that an increase in nominal interest rates is similar to a depreciation of the currency, and vice versa. ______7 See Interest Rate Parity Condition at page 99. 8 See Nominal and Real Interest Rate at page 150. 9 See Purchasing-Power Parity at page 100.
Dollarization
Definition Dollarization is the use of the American dollar, or another foreign currency, as a domestic currency. However, when the currency involved is the euro, it is also referred to as euroization.
Dollarization is said to be de facto when the foreign currency is used by various individuals in a country without the state officially recognizing its use. Official dollarization consists of adopting a foreign currency as the domestic currency. Panama, in 1904, Ecuador, in 2000 and Salvador, in 2001, have officially adopted the American currency. A country that unilaterally adopts a foreign currency as its domestic currency loses the autonomy of its monetary policy. Up to this point in time, all of the countries that have adopted the American dollar as their domestic currency have done so unilaterally. American monetary policy decisions do not take into account the economic situation in these countries. If there were an agreement between the dollarized country and the currency-issuing country, the term used would be monetary union10 rather than dollarization. ______10 See Economic Integration at page 113 and Optimal Currency Area at page 113.
Sterilization
Definition Central banks sometimes execute reverse operations in the open market (interior and exterior) in order to counteract the impact of exchange rate interventions on the domestic money supply. This procedure is called “sterilization” or sterilization operation.
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When foreign capital enters a country, the central bank supplies Evolution of the balance sheet of a fictitious central bank domestic currency in exchange. On the balance sheet of the during a sterilization operation central bank, assets increase (more foreign assets) as well as Initial balance sheet liabilities (more domestic currency in circulation). The central Liabilities bank can decide to sterilize this increase by selling domestic Domestic assets: $100M Bank deposits: $50M Exterior assets: $100M Currency in circulation: $150M securities (reducing domestic assets) in exchange for liquid assets coming from the market (reducing the liability of the Inflow of foreign capital Assets Liabilities bank by taking currency out of circulation). As shown in the Domestic assets: $100M Bank deposits: $50M example opposite, following the sterilization operation, both Exterior assets: $150M Currency in circulation: $200M total assets (domestic and exterior) and total liabilities of the Sterilization 11 central bank remain unchanged. The monetary base remains Assets Liabilities the same in spite of the inflow of foreign capital. Domestic assets: $50M Bank deposits: $50M Exterior assets: $150M Currency in circulation: $150M
By keeping the monetary base unchanged, the money supply Source: Desjardins, Economic Studies also remains unchanged. When the money supply changes, it affects various macroeconomic variables such as interest rates, inflation and the exchange rate.12 However, sterilization operations can limit the impact of an inflow of capital on inflation and the exchange rate. ______11 See Monetary Base at page 64. 12 See Money Market at page 67, Quantity Theory of Money at page 68 and Interest Rate Parity Condition at page 99.
Mundell’s Triangle of Incompatibility
Definition Mundell’s Triangle of Incompatibility illustrates the macroeconomic policy objectives that an economy open to international trade could choose. Of the three main macroeconomic objectives—stability of exchange rates, autonomy in monetary policy and free capital movement—it would appear that only two can be chosen at any one time.
One way to illustrate this “trilemma” is to use a triangle in which Exchange rate stability each of the points represents an objective that countries are striving for. The sides of the triangle constitute the means to take in order to attain each of the three possible combinations of two objectives.
A country that wants to control the autonomy of its monetary Control of capital Currency board policy and the stability of its exchange rate at any cost will be constrained in controlling its capital flows. If it seeks freedom of capital movement while maintaining an independent monetary policy, it must then opt for a floating exchange rate. If the objective Floating exchange rate is freedom of capital movement with stable exchange rates, the Autonomous Free capital country will then have to abandon its independent monetary monetary policy flow policy and choose a currency board. What is meant by Source: Desjardins, Economic Studies “independent monetary policy” is the ability of a country to influence its economy by intervening in the money supply and, consequently, in short-term interest rates.13 In the case of an open economy, manipulating interest rates not only impacts the level of investment or consumption in that economy, it also impacts the exchange rate. Moreover, all other things being equal, if interest rates increase, foreign capital attracted by more ______13 See Monetary Policy at page 72.
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interesting returns enters the country resulting in an increase in the exchange rate, and vice versa. Thus, except for controlling capital flow to other countries, independent monetary policy results in a loss of exchange rate stability.
Some economists are debating as to which would be the best combination. The relative importance of each of these objectives can vary from one country to another. For example, exchange rate stability is usually of more importance to a developing country, since they are less able to modify their terms of trade14 than a developed country, and the stability of their national currency plays a more decisive role in containing inflation. On the other hand, an independent monetary policy has the advantage of allowing a country to set its own macroeconomic objectives, e.g., price stability. Finally, free capital movement allows for a better allocation of resources, which ensures long-term economic competitiveness. ______14 See Terms of Trade at page 107.
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INTERNATIONAL TRADE
Theory of Comparative Advantage
Definition The theory of comparative advantage explains how trade between two countries can be beneficial for both in spite of the fact that one of the countries may produce all of the goods traded at a lower cost. To arrive at such a conclusion, the theory is based on the relative cost of production of the goods traded rather than on the absolute cost.
When a country can produce a good at a lower cost than another country, we say that it has an absolute advantage in the production of that good. Moreover, when a country can produce a good while giving up a less important part in the production of other goods than another country, we say that it has a comparative advantage in the production of that good.
In order to understand how comparative advantage can increase production of the world economy, it is common to use a simple example of two countries each producing two goods: food and cars.
Suppose Country A needs 100 hours of work to produce a car and 50 hours to produce a ton of food; suppose also that Country B needs 180 hours to produce a car and 60 hours to produce a ton of food. The production of the two countries is limited by the total number of hours that they can provide. Therefore, if one of the countries chooses to produce more cars, it must reduce its production of food, and vice versa. It should be noted that in this example, Country A has an absolute advantage in the production of both food and cars.
Production costs expressed in hours of work, by country and by good produced Country A Country B Food 50 hours/ton 60 hours/ton Cars 100 hours/car 180 hours/car
The theory of comparative advantage tells us that even if Country A has all of the absolute advantages, it is possible for the two countries to gain from trade. To understand this gain, we need to examine relative costs. The 100 hours that are required to produce a car in Country A come at the sacrifice of producing two tons of food. However, producing a car in Country B comes at the sacrifice of three tons of food. It costs relatively more for Country B to produce cars; Country A thus has a comparative advantage in the production of cars. When it comes to producing food, Country A has to sacrifice a half a car in order to produce a ton of food, whereas Country B has to sacrifice only a third of a car. Hence, Country B has a comparative advantage in producing food.
Relative cost of production, by country and by good produced Country A Country B Food 0.50 car/ton 0.33 car/ton Cars 2 tons/car 3 tons/car
World production can be increased if each of the countries specializes in producing the good for which they have a comparative advantage. In this way, the two countries can benefit from an increase in their standard of living by sharing in the gain from increased world production.
Suppose that each of the two countries could devote 3,600 hours of work. If there is no trade, each of the countries must produce both food and cars. To feed their respective populations, the countries each produce 24 tons of food; the remainder of the available hours goes to building cars. Country A produces 24 tons of food and 24 cars while Country B produces 24 tons
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of food and 12 cars. In total, the world economy produces 48 tons of food and 36 cars. Now suppose that there is trade between the two countries. Country B, having a comparative advantage in the production of food, will produce more food than it needs and trade the surplus for cars produced by Country A. Country B now produces 48 tons of food and 4 cars. Country A can now concentrate on what it produces best—cars—and import the food it needs from Country B in exchange for cars. It now produces 36 cars and no food. In total, the world economy still produces 48 tons of food, but now it produces 40 cars. Trade between the two countries has resulted in increased production. How this surplus is shared between the two countries will depend on the price at which the food and cars are sold. Country A will be able to trade each car for two to three tons of food. Country A will refuse to sell a car for less than two tons, since at this price it could produce the food itself. Country B will refuse to pay more than three tons for a car, since at that price it could produce its own cars. That said, Country B would be able to trade each ton of food for 1/3 to 1/2 of a car.
Heckscher-Ohlin Theorem
Definition According to the Heckscher-Ohlin theorem, where international trade is concerned, a country should specialize in production that uses most intensively the factor of production with which it is relatively the best endowed.
The Heckscher-Ohlin theorem is complementary to David Ricardo’s theory of comparative advantage1, which explains that countries specialize in the production of goods and services in which they are the most productive. The Heckscher-Ohlin model goes further in explaining that differences in productivity are the result of variations in the endowment of factors of production from one county to another. The Heckscher-Ohlin theorem is one of the main conclusions obtained from this model.
The abundance of a factor of production in a country implies a lower price for this factor and hence an advantage in terms of production costs. Inversely, the relative scarcity of a factor leads to a higher price for that factor and a higher cost for the production of goods that require that factor. Therefore, a country will have a competitive advantage if it specializes in production that uses most intensively the factor of production with which it is relatively the best endowed. To obtain this result, the theorem is based on a certain number of hypotheses. One of these is that factors of production cannot be traded between countries. In practice, this is rarely the case, since capital, technologies, natural resources and labour circulate among countries with varying degrees of fluidity. Certain factors such as climate are immobile. For example, it is the climate and the presence of sugar maples that bestow on Canada a competitive advantage in the production of maple syrup. ______1 See Theory of Comparative Advantage at page 105.
New Trade Theory
Definition The new trade theory uses economies of scale and imperfect competition to explain trade flows.
The theory of comparative advantage states that a country should specialize in the production of goods for which it has a comparative advantage and trade these goods for those produced in other countries. However, empirical data on trade flows indicates that two countries can trade the same good (e.g., cars), which seems contrary to the predictions of the theory of comparative advantage.
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The new trade theory is more in harmony with the empirical data of international trade. Even though countries seem to specialize in the production of some goods more than others, a number of products could be both exported and imported by the same country. The theory explains this phenomenon by the presence of imperfect competition and economies of scale. In the first place, the goods being traded are not necessarily identical. For example, cars produced locally and those that are imported could have differences that please certain consumers. What we have here is monopolistic competition rather than pure or perfect competition.2 Secondly, by having access to international markets, companies can profit from economies of scale3: the more the size of a company increases, the more it becomes profitable. International trade contributes to the development of companies that benefit from such economies of scale. ______2 See Perfect Competition at page 16 and Monopolistic Competition at page 17. 3 See Economies of Scale at page 20.
Degree of Openness of an Economy
Definition To measure the openness of an economy regarding international trade, we compare the sum of its exports and its imports in relation to the value of its production. The higher that value, the more the economy is said to be open to international trade.
The following table shows the degree of openness of certain countries. The average value of the sum of exports and imports is divided by the average value of GDP for each of the periods represented. Between 2001 and 2005, the value of Canada’s trade corresponded on average to 75% of its GDP as compared to 25% for the United States, 40% for Australia, 23% for Japan and 331% for Hong Kong.
Degree of openness to trade of certain countries Canada United States Australia Japan Hong Kong 1986-1990 0.52 0.19 0.33 0.19 2.42 1991-1995 0.61 0.21 0.36 0.17 2.72 1996-2000 0.80 0.24 0.40 0.20 2.63 2001-2005 0.75 0.25 0.40 0.23 3.31
Sources: Statistics Canada, Bureau of Economic Analysis, Australian Bureau of Statistics, Japan Cabinet Office, Census and Statistics Department and Desjardins, Economic Studies
Terms of Trade
Definition Terms of trade are the ratio between the price of goods and services exported and the price of goods and services imported by a given country.
There is an improvement in the terms of trade when the prices of exports increase more, or decrease less, than the prices of imports. Inversely, there is a deterioration of the terms of trade when the prices of imports increase more, or decrease less, than the prices of exports.
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The graph opposite shows the evolution of Canada’s terms of Evolution of Canada’s terms of trade trade between 1997 and 2006. We can see that they improve between 2002 and 2006. The increase in the price of energy Price of exports/price of imports US$/CAN$ 1.25 1.00 and raw materials caused the value of Canadian exports to 0.95 increase and contributed to the improvement in the terms of 1.20 0.90 trade. At the same time, we can see a similarity between the 1.15 0.85 recent improvement in the terms of trade and the increase in 1.10 0.80 value of the Canadian dollar. All other things being equal, a 1.05 0.75 1.00 rise in the prices of exports creates an increase in demand for 0.70
the Canadian dollar, which raises its value. 0.95 0.65
0.90 0.60 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Exchange rate US$/CAN$ Terms of trade (left)
Sources: Statistics Canada and Desjardins, Economic Studies
Prebisch-Singer Thesis
Definition This thesis suggests that the terms of trade between raw materials and manufactured products tend to deteriorate over time. In other words, the sale of a given quantity of raw materials would allow for the purchase of fewer and fewer manufactured goods.
According to the Prebisch-Singer thesis, developing countries Evolution of the price of certain raw materials in real terms whose exports are primarily raw materials undergo a deterioration between 1980 and 2006 in their terms of trade4 as the value of their exports diminishes in Index 1986 = 100 Index 1986 = 100 545 545 relation to that of their imports. To remedy this problem, these economies must succeed in developing their manufacturing 470 470 sector. Today, given that a number of developing countries 395 395 produce some manufactured goods, the Prebisch-Singer thesis 320 320 tends to be used to show that there is a deterioration in terms of 245 245
trade between low-value-added and high-value-added 170 170
manufactured goods (e.g., clothes vs. airplanes). 95 95 ______20 20 4 See Terms of Trade at page 107. 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 Wheat Coffee Sugar cane Cotton
Sources: Datastream and Desjardins, Economic Studies
Marshall-Lerner Criterion
Definition The Marshall-Lerner criterion shows that a devaluation of the national currency improves the trade balance only if the sum of the elasticities5 of the demand for exports and the demand for imports is greater than one.
Algebraically, the Marshall-Lerner criterion is: * 1, where:
X e e X
108 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES International Economics and Finance / International Trade is the elasticity of the demand for exports (X) as a function of the exchange rate (e) and
M e * e M is the elasticity of the demand for imports (M) as a function of the exchange rate.
The reasoning behind this criterion is the following. A currency devaluation results in two opposite effects on the trade balance of a country: on the one hand, the volume of exported goods and services tends to rise, but on the other hand, the average price of imported goods and services also goes up. If the volume of exports increases, the balance of trade improves, but if imports become more expensive, all other things being equal, the trade balance will not be improved. As a rule, an increase in the price of imports ought to decrease the volume of these imports and exert downward pressure on the total value of imported goods and services, thus improving the balance of trade. However, this decrease in the volume of imports depends on the elasticity of demand for the imported goods. The more consumers reduce their consumption of the imported products, the more chance there is that the trade balance will improve. Moreover, the more sensitive other countries are to consuming national products (a more noticeable increase in exports), the more the trade balance should improve following a decrease in the value of the currency. ______5 See Concept of Elasticity and Inelasticity at page 12.
J-Curve
Definition The immediate effect of a decrease in the value of a currency on the trade balance is rarely positive. At first there is deterioration in the trade balance followed by a progressive adjustment that, after a period of time, leads to an improvement over the initial trade balance. Graphically, the adjustment in the trade balance over time takes the shape of a “J”, hence the term “J-Curve”.
The first effect of a reduction in the value of a currency is a Theoretical representation of the J-Curve sudden increase in the cost of imports; in the short term, the quantity imported does not adjust immediately, and the total Balance of trade Balance of trade 120 120 value of imports increases rapidly. On the export side, other 100 1) The decrease in the value of the 100 national currency results in a 80 sudden increase in the value of 80 countries don’t rush out from one day to the next to buy the less imports, which causes a deficit in expensive products of the country with the devalued currency. 60 the trade balance. 60 40 40 3) End of the J-Curve. From here on, the trade It takes a certain period of time before the increase in exports 20 balance starts its positive evolution. 20 becomes significant. Moreover, stronger demand for the exported 0 0 products could push up their price and further delay the -20 -20 -40 -40 expansion of exports, while domestic producers adjust to the -60 -60 -80 -80 new demand. 2) Export and import volumes adjust themselves -100 over time. -100 -120 -120 As import and export levels adjust themselves, the balance of Unit of time trade improves. The concept of the J-Curve can be tied to the Source: Desjardins, Economic Studies Marshall-Lerner criterion6. In the short term, the elasticities of demand for exports and imports are rather weak, but they can gain sufficient strength in the longer term to lead to an improvement in the balance of trade. ______6 See Marshall-Lerner Criterion at page 108.
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Dutch Disease
Definition Dutch disease is the name given to an economic malady which occurs when exploitation of natural resources leads to a decline in the manufacturing sector. The reason for this decline is that an increase in revenue from natural resource exploitation will result in a rise in the exchange rate and a loss of competitiveness in the manufacturing sector.
In 1977, The Economist magazine used the term “Dutch disease” to describe the decline in the Netherlands’ manufacturing sector following the discovery of natural gas in the ‘60s. Over the last few decades, a number of countries have probably suffered from the same syndrome, such as Mexico following its oil boom of the ‘70s and early ‘80s. The climbing price of oil since the early 2000s and the continuing upward trend of energy prices could contribute to making Canada a candidate for the list of Dutch disease victims.
The negative pressure on the manufacturing sector doesn’t come uniquely from the effect of the exchange rate. A sudden boom in the exploitation of a natural resource increases the need for labour in this sector. Labour usually comes from a less productive sector, in this case manufacturing. Furthermore, the additional revenue generated by the exploitation of a resource also increases the demand for non-tradable goods produced inside the country—primarily services—which further accentuates the transfer of labour from manufacturing to other sectors.
The harmful effects of Dutch disease appear when the previously booming sector undergoes a decline because of a drop in the international price of the natural resource being exploited or because the resource runs out. The economy then experiences a sharp decrease in revenue which cannot be compensated for by rapid growth in the already weakened manufacturing sector. In fact, several years could go by before the manufacturing sector becomes competitive and contributes once more to supporting the economy.
There are measures that can be taken to minimize the effects of Dutch disease. One of these is to sterilize the influx of capital into the booming sector by saving part of this new revenue abroad. Subsequently, the country could decide to slowly repatriate these savings in order to avoid a too abrupt increase in revenue. As an example, Norway redirects part of the revenue flowing from the sale of its oil into a national savings fund where the assets are held in foreign currencies. Another approach is to grow national savings. This can be done by applying measures that encourage consumers and companies to save more, or by reducing the government’s budgetary deficit (or increasing its surplus). The increase in national savings reduces the need to borrow abroad and alleviates the need for direct foreign investment. Finally, investing part of the revenue in education and in infrastructure could also help the manufacturing industry to remain competitive.
Commercial Policy
Definition Commercial policy includes the measures taken by a government regarding international trade to either protect its domestic markets (protectionism) or to facilitate trade with other countries.
The main instruments of commercial policy are tariffs, export subsidies, import quotas, voluntary export restraints, domestic content requirements, administrative barriers and competitive devaluation. Here is a brief description of these instruments.
• Tariffs: Are taxes levied on imported products. Since these products are then sold at a higher price on the domestic market, they offer less competition for domestic products. This measure penalizes consumers while favouring domestic producers.
• Export subsidies: Are payments made to a firm or individual who is selling goods or services abroad. Export subsidies increase the price of products in the domestic market (because the domestic supply is reduced) and decrease the price abroad (because the supply abroad is increased).
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• Import quotas and voluntary export restraints: Place a direct limit on the quantity of a good that can be imported. The United States limits, among other items, their imports of sugar. By limiting imports, consumers in the importing country have to pay more for the products affected by these measures (Americans pay more for their sugar). A voluntary export restraint is like an import quota except that in this case it is the exporter who voluntarily limits his exports. Between 1981 and 1985, Japan agreed to a voluntary export restraint aimed at limiting the number of Japanese cars exported to the United States.
• Domestic content requirements: Stipulate that a certain part of an imported product must be manufactured in the importing country. For example, an airplane imported from another country might be required to contain a motor or other parts manufactured in the importing country.
• Administrative barriers: Are an informal way of limiting imports. Restrictions related to health, the environment or security could be implemented in order to prevent, either completely or partially, the importation of certain products. Occasionally, these measures are justified, but it is not always the case. The classic example in this area is the French decree in 1982 that required all Japanese tape recorders to go through the small customs office at Poitiers.
• Competitive devaluation: A country could decide to voluntarily devalue7 its currency in order to lower the price of exported goods and services and push up the price of imported goods and services. This is a form of disguised protectionism aimed at transferring a country’s economic difficulties over to its trading partners. ______7 See Exchange Rate Movements at page 97.
Dumping
Definition Dumping is the practice of selling goods and services abroad at a lower price than on the domestic market after having taken into account the differences due to costs for transportation, tariffs and other justified costs.
Two conditions are necessary for there to be dumping: first, the industry must operate under imperfect competition, so that companies are in a position to set their own price instead of being subject to a market price; second, markets must be segmented so that domestic residents cannot easily access goods destined for export.
Dumping is often considered to be an inequitable practice, and a number of countries have passed antidumping laws. In the United States, a specific tax is levied on companies that are considered guilty of dumping. This tax corresponds to the difference between the effective sale price and the “fair price”.
Balassa-Samuelson Effect
Definition The Balassa-Samuelson effect explains the problem that arises when PPP8 is used to estimate an exchange rate between a developed country and a less developed country. General price levels tend to be systematically lower in less developed countries. In real terms, the developing country’s currency then appreciates. The explanation lies in the difference in productivity between the tradable goods and services sectors of the two countries.
______8 See Purchasing-Power Parity at page 100.
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The Balassa-Samuelson effect assumes that the economy can be divided into two sectors: one that produces tradable goods and services and the other that produces non-tradable goods and services. It is also assumed that productivity in the tradable goods sector is higher in developed countries, while productivity in the non-tradable goods sector tends to be the same in the two types of countries. The prices of the traded goods and services tend to be the same, but the prices for non-tradable goods and services tend to be lower in the less developed countries. This is explained by the fact that a lower productivity in the tradable goods sector contributes to lower remuneration for the workers. These lower salaries are reflected in the prices and salaries in the non-tradable goods and services sector. Overall, the general price level is lower in the less developed countries than in the developed countries.
Because of their impacts on price level, the differences in Evolution of the yen in relation to the U.S. dollar compared productivity between the tradable goods and non-tradable to the evolution of prices in the two economies goods sectors can explain the gap between PPP and the exchange Price index 1950 = 100 Exchange rate yen/US$ 850 360 rate. An example is the Japanese yen in relation to the American 800 750 335 dollar. Between 1950 and 1971, Japan had fixed its currency in 700 310 650 285 terms of the greenback at a rate of 360 yen per dollar. During the 600 550 260 period that the yen was fixed, prices increased more in Japan 500 235 450 210 than in the United States. However, after the yen started to float, 400 350 185 it appreciated significantly in relation to the dollar. According to 300 160 250 135 PPP, this is the opposite of what should have happened. 200 150 110 100 85 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 The Balassa-Samuelson effect offers an explanation in the case Exchange rate yen/US$ (right) Prices in Japan (left) of the Japanese yen. The rise in prices in Japan came mainly Prices in the United States (left) Sources: Statistics Bureau of Ministry of Internal Affairs and Communications, Bureau of Labor Statistics, Bank of England from the increase in prices in the non-tradable goods and services and Desjardins, Economic Studies sector. Productivity grew stronger in the tradable goods and services sector, exerting upward pressure on salaries and prices in the non-tradable goods and services sector. Therefore, the yen was able to appreciate in spite of a more rapid increase in Japan’s general price level.
Fair Trade
Definition Fair trade is a production-distribution-consumption network that sees itself as a replacement solution to traditional international trade. It is oriented toward supported, sustainable development that greatly benefits the producers who are traditionally located in developing countries. Fair trade is practised mainly in the agricultural goods sector.
For a producer, fair trade makes it possible to have decent working conditions and a decent salary. It also emphasizes a means of production that is respectful of the environment and conforms to the principle of sustainable development9. On the consumer’s side, fair trade guarantees a supply of quality products produced with respect for workers and the environment. Some fair trade agricultural products also receive organic certification. Consumer prices for fair trade products can be higher, but in principle these products should not necessarily cost more than conventional trade products. Fundamentally, it is the sharing of costs and benefits among the various intermediaries in the chain of production and marketing of these products that differentiates fair trade from traditional trade. ______9 See Sustainable Development at page 55.
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ECONOMIC INTEGRATION, GLOBALIZATION, INTERNATIONAL DEVELOPMENT
Economic Integration
Definition Economic integration is a process through which several separate economies come to form a single economic area. According to the typology developed by Hungarian economist Bela Balassa, there are five levels of integration: the free-trade area, the customs union, the common market, economic union, and economic and monetary union.
A free-trade area involves an agreement that eliminates customs duties and trade restrictions among the countries that belong to the zone. The North American Free Trade Agreement (NAFTA) covers Canada, the United States and Mexico. Canada has also signed free trade agreements with Chile, Israel, Costa Rica and the European Free Trade Association, which includes Iceland, Norway, Switzerland and Liechtenstein.
A customs union is similar to a free-trade area, but also has a trade policy that is shared by member nations. In the case of NAFTA, Canada, the United States and Mexico can each unilaterally opt to apply trade restrictions to other countries, which is not the case with a customs union.
A common market is a customs union that involves not only the free movement of the goods and services produced by member nations, but also the free movement of production factors such as labour and capital. The Southern Common Market (MERCOSUR), which contains Argentina, Brazil, Uruguay and Paraguay, is an example of this, but there are still restrictions that have to be lifted before it can be seen as a true common market.
Economic union takes the common market one step closer to economic integration; countries that form such a union aim to harmonize their economic policies. The European Union is an economic union whose member nations agree to hand some decisions over to supranational bodies. A draft common constitution is also on the table.
Economic and monetary union is an economic union in which the nations share the same currency. The euro zone, which many European Union member nations belong to, is a recent economic and monetary union. This zone will also be expanding as the new countries admitted to the European Union become candidates for a broader euro zone.
Optimal Currency Area
Definition An optimal currency area is a zone in which it is better for economies to use the same currency (or to connect their currencies using a fixed exchange rate system). In general, as economies become more connected via trade in goods and services and the more production factors flow freely among them, the benefits of a common monetary area increase.
Belonging to a monetary zone generates both gains and losses for a country. The gains correspond to the savings achieved by avoiding uncertainty, confusion and the calculation and transaction costs that result from floating exchange rates. Clearly, the more an economy trades within this zone, the more it gains. Gains are even higher if production factors within the zone are
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mobile. Investors and workers are better able to predict the return on their investment and work performed elsewhere in the common currency area.
The costs, on the other hand, stem from the loss of an independent monetary policy1. There can be only one policy for the zone as a whole. Monetary policy can be very useful in coping with economic shocks. To minimize the costs of the economy’s loss of independence, economies that decide to have a common currency must be affected by economic shocks in the same manner. This means that monetary policy decisions can solve problems that are common to the entire zone. If a shock causes inflation in one part of the zone and unemployment in another part, it will be hard to make monetary policy decisions that will please everybody. The existence of mechanisms for transferring funds to areas that are doing the worst under the conditions (like Canada’s equalization system2) makes it possible to compensate for the loss of independent monetary policy and thus increase the net benefits of currency integration. ______1 See Monetary Policy at page 72. 2 See Equalization at page 130.
Globalization
Definition Globalization can be defined as intensifying economic interdependence among nations due to the increase in the volume and range of trade, the free international flow of capital and faster dissemination of new technologies.
The definition can be expanded beyond economics by adding political, social and cultural aspects to it.
Alterglobalization
Definition Alterglobalization is a movement that contests globalization3 that emerged at the end of the ‘90s; it does not protest globalization itself but rather the manner in which it is occurring.
The proponents of alterglobalization claim that globalization as it is emerging is completely dominated by a logic of commerce that serves multinationals with the complicity of states and international organizations (like, for example, the WTO4 and IMF5); consequences include increased inequality, environmental degradation, cultural uniformization, challenges to public services and the political marginalization of citizens.
In exchange, proponents of alterglobalization put forward a series of measures to change how globalization is currently unfolding. For example, they support ideas that favour the regulation of financial markets, such as the implementation of a tax on financial transactions6. They are also in favour of cancelling the debt of poor countries, either because they have already repaid their debts via high interest rates, or based on the argument of ecological or colonial debt. The fight against tax havens, the exclusion of sectors like health and education from WTO negotiations, and economic assistance to non-democratic countries that is conditional on democratic progress are other proposals made by the alterglobalization movement. ______3 See Globalization at page 114. 4 See World Trade Organization at page 115. 5 See International Monetary Fund at page 94. 6 See Tobin Tax at page 116.
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Economy in Transition
Definition The expression “economy in transition” is used to describe an economy that is moving from a planned economy to a market economy.
This expression is a good description of the situation that prevails in Russia and other former Soviet block countries, as well as other socialist economies that have decided to abandon their planned economies in favour of a free-market economy. The transition from one system to another is a process that takes a long time. Unlike developing nations, economies in transition frequently have an educated population, infrastructures and a developed manufacturing sector. However, they are not very productive, often have high debt levels and have no institutions to ensure that the market economy operates smoothly. Their financial markets are also very underdeveloped.
Emerging Economy
Definition Emerging economies form a category of economies that is characterized by rapidly growing output and financial markets as well as by integration with international financial and commercial flows.
The concept of “emerging countries” appeared in the ‘80s and became widespread through the ‘90s. China, India, Brazil and South Africa are considered to be emerging countries.
World Trade Organization – WTO
Definition This multilateral trade organization replaced the General Agreement on Tariffs and Trade (GATT) in 1995. The aim of the WTO is to promote trade, make optimal use of global resources and make it possible for developing countries to participate in international trade. The organization has 149 member countries.
The WTO is the only organization that deals with the rules governing trade between nations. To achieve its goals, the WTO:
• Administers trade agreements • Provides a framework for trade negotiations • Settles trade disputes • Examines national trade policies • Helps developing countries in the area of trade policies through technical assistance and training programs • Cooperates with other international organizations.
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Tobin Tax
Definition The Tobin tax is an international tax proposed in 1972 by economist James Tobin on international market operations of a speculative nature. This tax could “moralize” speculation on the financial markets and create an international intervention fund with the revenues it generates.
Originally, the idea of this kind of tax was intended to restore some independence to monetary policy in a situation in which there is a fixed exchange rate system and capital moves freely. Following that, the target objective was then to combat exchange rate volatility and the destabilizing effects of speculation. One more argument to justify this type of tax is the existence of multiple equilibria in the expectations of financial market operators. The tax would stabilize speculation and prevent self- fulfilling crises. A low tax is therefore desirable during lulls, and a higher tax becomes more appropriate during periods of market upheaval.
Proponents of alterglobalization7 have picked up the idea of a Tobin tax; they denounce destabilizing speculation and see the tax as a chance to implement a global tax to finance developing countries and international organizations. Financial stability can be considered a global public good8. On one hand, it makes it possible to expand decision makers’ temporal horizons. It also makes it possible to avoid the volatility that creates inefficiencies in capital allocation and can cause conditions to reverse and threaten systemic crises by contagion (e.g., the Asian crises of 1997, Russia’s in 1999 and Argentina’s in 2002, all related to short-term capital volatility). ______7 See Alterglobalization at page 114. 8 See Public Goods and Private Goods at page 126.
Factor-Price Equalization
Definition Equalization of the relative costs of factors among countries is derived from the Heckscher-Ohlin model9. When two countries open up to mutual trade, the relative prices of the goods and services traded converge; this convergence in turn triggers convergence by the relative prices of production factors.
The explanation lies in the fact that countries involved in trade are exchanging more than simply goods and services: in fact, they are also indirectly trading production factors. The Heckscher-Ohlin theorem demonstrates that it is in the interest of countries participating in international trade to specialize in production that makes more intensive use of the production factor each one has more of. Given that, when a country trades a good, it is indirectly trading the production factor it has more of. This production factor is incorporated into the good traded, making the price for this production factor go up in relation to the other factors. The opposite occurs in the country that imports the good. Also according to the Heckscher-Ohlin theorem, a country imports the goods and services that make the most intensive use of the production factors it has less of. If it has less of certain production factors, at the outset, their relative cost will be higher. However, by importing goods and services that incorporate these rarer factors, their relative prices decrease. Theoretically, the exporting and importing nations’ relative prices for production factors will continue to converge until the factors’ relative prices are the same for all countries involved. ______9 See Heckscher-Ohlin Theorem at page 106.
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In practice, some economists use this concept to explain, among other things, why the wage gap between skilled and unskilled workers has deepened in the United States since the late ‘70s. As the U.S. has relatively more skilled workers, its exports are concentrated in goods and services that require skilled labour, which has the effect of driving wages for these workers up. On the other hand, by importing goods requiring unskilled labour, unskilled American workers have seen their wages lose ground against the wages of more highly skilled fellow Americans.
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Additional references:
BALANCE OF PAYMENTS Exchange Rate Overshooting Balance of Payments Paul R. Krugman. 2001, p. 444. Paul R. Krugman. 2001, p. 345-371. Josette and Max Peyrard. November 2001, p. 25. Theory of the International Fisher Effect IMF. 1993, p. 37-114. Josette and Max Peyrard. 2001, p. 101. Graham Bannock et al. 1998, p. 16-19. Paul R. Krugman. 2001, p. 457-461.
Link Between Savings and the Current Account Dollarization Paul R. Krugman. 2001, p. 353-360. Josette and Max Peyrard. 2001, p. 94.
Domestic Absorption Sterilization Graham Bannock et al. 1998 p. 1. Paul R. Krugman. 2001, p. 555-556. [www.economist.com/research/Economics/alphabetic.cfm]. Capital Flow Graham Bannock et al. 1998, p. 106. Mundell’s Triangle of Incompatibility Josette and Max Peyrard. 2001, p. 126 and 146-147. Claude-Danièle Echaudemaison. 2003, p. 338-339. Alain Beitone et al. 2001, p. 264. Paul R. Krugman. 2001, p. 795-797
Official International Reserves Paul R. Krugman. 2001, p. 368-371. INTERNATIONAL TRADE Graham Bannock et al. 1998, p. 177 and 357. Theory of Comparative Advantage Paul A. Samuelson and William D. Nordhaus. 2005, p. 755. Paul R. Krugman. 2001, p. 4-5 and 13-41. Graham Bannock et al. 1998, p. 68. Wikipedia. [http://en.wikipedia.org/wiki/Comparative_advantage]. INTERNATIONAL MONETARY SYSTEM International Monetary Fund Heckscher-Ohlin Theorem Josette and Max Peyrard. 2001, p. 122-123. Alain Beitone et al. 2001, p. 410-411. Graham Bannock et al. 1998, p. 217-218. Paul R. Krugman. 2001, p. 77-99. IMF. What is the IMF, 2006. [www.imf.org/external/pubs/ft/exrp/ [http://en.wikipedia.org/wiki/Heckscher-Ohlin_theorem]. what.htm]. New Trade Theory World Bank [http://www.economist.com/research/Economics/alphabetic.cfm]. Josette and Max Peyrard. 2001, p. 29 and 132. Denis Delgay-Troïse. [http://perso.univ-rennes1.fr/denis.delgay- [http://www.worldbank.org/]. troise/CI/ciplan.htm].
Exchange Rate Systems Degree of Openness of an Economy Paul R. Krugman. 2001, chapters 17-19. Graham Bannock et al. 1998, p. 304. Graham Bannock et al. 1998, p. 142-144. Terms of Trade Exchange Rate Movements Claude-Danièle Echaudemaison. 2003, p. 489-490. Josette and Max Peyrard. 2001, p. 16, 88, 90 and 214. Josette and Max Peyrard. 2001, p. 246.
Nominal and Real Exchange Rate Prebisch-Singer Thesis Gregory N. Mankiw. 2003, p. 155-158. Wikipedia. [http://en.wikipedia.org/wiki/Singer-Prebisch_thesis]. Paul R. Krugman. 2001, p. 379-384. Marshall-Lerner Criterion Effective Exchange Rate Graham Bannock et al. 1998, p. 266. Josette and Max Peyrard. 2001, p. 71 and 241. C. Paul Hallwood and Ronald MacDonald. 2000, p. 28-29.
Interest Rate Parity Condition J-Curve Carl Schweser and Andrew Temte. 2002, p. 239-241. C. Paul Hallwood and Ronald MacDonald. 2000, p. 29-31. Paul R. Krugman. 2001, p. 395-399 and 412-413. Graham Bannock et al. 1998, p. 226. Wikipedia. [http://en.wikipedia.org/wiki/Interest_Rate_Parity]. Dutch Disease Currency Arbitrage Wikipedia. [http://en.wikipedia.org/wiki/Dutch_disease]. Carl Schweser and Andrew Temte. 2002, p. 233-235. Commercial Policy Purchasing-Power Parity Paul R. Krugman. 2001, p. 213-239. Gregory N. Mankiw. 2003, p. 166-169. Alain Beitone et al. 2001, p. 129 and 327. Paul R. Krugman. 2001, p. 450-454. Graham Bannock et al. 1998, p. 340-341. Dumping Yves Bernard and Jean-Claude Colli. 1996, p. 1050 and 1098. Douglas Greenwald. 1984, p. 246-249. Paul R. Krugman. 2001, p. 163-167.
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Balassa-Samuelson Effect Paul R. Krugman. 2001, p. 471-473 and 480-483. C. Paul Hallwood and Ronald MacDonald. 2000, p. 130-133 and 145-147.
Fair Trade Jean-Louis Laville and Antonio David Cattani. 2006, p. 106-125. Alain Bruno et al. 2005, p. 91.
ECONOMIC INTEGRATION, GLOBALIZATION, INTERNATIONAL DEVELOPMENT Economic Integration Alain Beitone et al. 2001, p. 251-257 and 275. Claude-Danièle Echaudemaison. 2003, p. 271-272. Foreign Affairs and International Trade Canada. [http://www.dfait- maeci.gc.ca/tna-nac/reg-en.asp].
Optimal Currency Area Paul R. Krugman. 2001, p. 699-707. Vincent Trémolet. 2004. p. 144-145. [http://www.economist.com/research/Economics/alphabetic.cfm].
Globalization Josette and Max Peyrard. 2001, p. 130. Wikipedia. [http://en.wikipedia.org/wiki/Globalization].
Alterglobalization Jean-Louis Laville and Antonio David Cattani. 2006, p. 28-36. Alain Bruno et al. 2005, p. 26.
Economy in Transition Graham Bannock et al. 1998, p. 414.
Emerging Economy Alain Beitone et al. 2001, p. 322.
World Trade Organization Josette and Max Peyrard. 2001, p. 189. WTO. [http://www.wto.org/english/thewto_e/whatis_e/whatis_e.htm].
Tobin Tax Olivier Coispeau. 1999, p. 412. Graham Bannock et al. 1998, p. 410. Gilbert Abraham-Frois et al. 2002, p. 377-380.
Factor-Price Equalization Paul R. Krugman. 2001, p. 88-93. Graham Bannock et al. 1998, p. 149 and 368-369. Wikipedia. [http://en.wikipedia.org/wiki/Factor_price_equalization].
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GOVERNMENT AND ECONOMY
Economic Role of State
Definition The state plays a number of roles in modern economies: it improves economic efficiency, reduces inequality, stabilizes the economy and manages international economic policy.
IMPROVING ECONOMIC EFFICIENCY A number of market deficiencies, such as the lack of perfect competition1, the presence of externalities2, public goods3 and incomplete information harm the economy’s efficiency and justify some state intervention.
With respect to competition, the state can, among other things, regulate to keep companies from colluding and to keep some companies from impeding new competitors’ entry into their market. The existence of externalities also justifies state intervention. An unregulated market can generate too much pollution or too little R&D investment; to reduce pollution, the state can force companies to adjust their production methods and, to increase research and development, the state can legislate to protect intellectual property rights over discoveries or subsidize research and development activities. Also, as the market has trouble producing public goods, the state’s intervention is sometimes justified in producing this type of good. Lastly, unregulated markets tend not to produce enough information to allow consumers to make fully enlightened decisions. The state can, among other things, intervene in the area of price posting, advertising and the content and certification of some products, such as medicines. The state can also publish information on certain products, like cars’ safety ratings and average fuel consumption.
REDUCING INEQUALITIES In developed economies, the state acts in various ways and to various extents to reduce the gap between rich and poor. Progressive tax4, certain tax breaks, universal free education and health care and other social programs help reduce inequality. Note that the state is not only concerned about inequalities between the rich and the poor, but also inequalities between men and women and ethnic inequalities, etc.
STABILIZING THE ECONOMY The state tries to smooth out the fluctuations inherent in business cycles by using monetary and fiscal policy5. While stabilizing the economy cannot keep recessions from occurring, monetary and fiscal policy interventions can reduce their scope and duration, which limits increases in unemployment levels. Also, stabilization helps keep economic growth from exceeding potential6 by too much, which keeps goods and services prices from going up too quickly.
CONDUCTING INTERNATIONAL ECONOMIC POLICY The state is also responsible for holding the reins of international economic policy; instituting or reducing tariff barriers and negotiating free trade agreements are arenas in which the state intervenes in international trade7. However, international economic policy does not only deal with trade. Some states also finance assistance programs for countries that need it. States are also responsible for the preservation of the planet. In this case, as in others, economic policies must be coordinated among various States. It is not up to just one country to combat the ozone layer’s deterioration, the extinction of animal and plant species, greenhouse gases and other threats to the environment. ______1 See Perfect Competition at page 16, Monopolistic Competition at page 17 and Oligopoly at page 17. 2 See Externalities at page 21. 3 See Public Goods and Private Goods at page 126. 4 See Progressive and Regressive Tax at page 139. 5 See Monetary Policy at page 72 and Fiscal Policy at page 78. 6 See Output Gap at page 33. 7 See Commercial Policy at page 110 and Economic Integration at page 113.
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Public Choice Theory
Definition Public choice theory gets economic observers to focus on how a society makes and should make public decisions. According to public choice theory, the state does not intervene in the general interest of the community, but rather in the interests of the political class, civil servants or lobby groups that do not represent the interests of the entire population. In this context, state intervention is not desired, even if there are market deficiencies (externalities8, monopolies9, public goods10, etc.).
Public choice theory refutes the hypothesis that the state acts in the interest of everyone: it instead claims that decisions are made on the basis of private interests. For example, it asserts that politicians maximize their own interests by acting on the basis of their chances of getting re-elected in the near future. As for civil servants, public choice theory claims that they try to maximize their income and power, which would lead to an unjustified increase in public expenditure. As for the electorate, lobby groups can influence state intervention to maximize their private interests by demanding services, assistance and social programs that would benefit them personally, while trying to pass the bill along to all taxpayers. ______8 See Externalities at page 21. 9 See Monopoly at page 17. 10 See Public Goods and Private Goods at page 126.
Adam Smith’s Invisible Hand
Definition The invisible hand is a metaphor coined by Adam Smith, an English economist considered to be the father of modern economics. The message conveyed by this metaphor is that the pursuit by each of us of our own self-interest serves the collective interest. An individual is guided by an invisible hand to fulfill an end (collective interest) that was not part of his intention.
Adam Smith’s expression is often adopted by those who believe that the market must be the unique regulator of all economic activity. According to them, it is the best way to serve the collective interest.
Size of Government
Definition The size of government can differ from one economy to another. The most common measurement is total annual government spending. However, other measurements such as the number of employees that work there can be used.
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Government spending includes purchases and expenditures for Size of government in Canada goods and services, transfers to individuals, companies and other levels of government, as well as interest payments on its In billions of CAN$ In % 575 53 debt. In Canada, the consolidated expenditures of the federal 525 51 government, provincial governments and municipal 475 49 425 administrations totalled $550 billion in 2006. We can compare 47 375 11 45 this amount to the size of the economy by dividing by GDP . 325 43 This spending corresponded to 38% of Canada’s GDP in 2006. 275 41 ______225 175 39 11 See Gross Domestic Product at page 30. 125 37 1982 1985 1988 1991 1994 1997 2000 2003 2006 Consolidated spending of the federal government, provincial governments and municipal administrations (left) Spending as a % of GDP (right)
Sources: Statistics Canada and Desjardins, Economic Studies
Centralization Ratio
Definition In a federal context, the centralization ratio is used to measure the weight of the central (federal) government in relation to other tiers of government. More specifically, the ratio involves dividing the federal government’s portion of spending by total spending by governments. As the ratio increases, so does the federation’s centralization.
The centralization ratio must be interpreted cautiously, however. Centralization ratio: Ratio of the federal government’s expenditure A low ratio does not necessarily mean that the central government to all public spending in Canada, fiscal years ended March 31 has less of a hand in public expenditure and leaves the other In % of total public spending In % of total public spending 46 46 tiers of government with more power. In fact, if the central 45 45 government finances some of the expenses of other tiers of 44 44 12 43 43 government using fund transfers , and the funding is conditional 42 42 on various criteria set out by the central government, the 41 41 centralization ratio underestimates the central government’s 40 40 39 39 power. The reverse can also happen, when the central 38 38 government’s expenditures are dictated by lobbying by other 37 37 36 36 tiers of government. Canada’s centralization ratio has fallen 35 35 sharply since 1997, the year in which the federal government cut 34 34 spending to deal with its recurring deficit13 problem. Since then, 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 the ratio has been around 36%. Sources: Statistics Canada and Desjardins, Economic Studies ______12 See Transfer Payments at page 130. 13 See Deficit at page 132.
Wagner’s Law
Definition This is a law formulated by the German economist Adolph Wagner, often used to explain the increase in the relative size of the state. The growing demand for the goods and services produced by the state are the cause of increases in the size of the state in developed countries.
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More precisely, Adolph Wagner put forward three explanations for the fact that the size of the state tends to increase as an economy develops. Firstly, economic development makes it necessary to increase public services such as the conveyance and purification of water, road infrastructure, public transportation, lighting of streets and roads and security. Secondly, a country whose level of development is high must make considerable expenditures in order to meet the needs of education, health and culture. Thirdly, economic growth entails the creation, in certain sectors, of oligopolies14 and monopolies15, which justifies regulation or control of these enterprises by the state. ______14 See Oligopoly at page 17. 15 See Monopoly at page 17.
Parable of the Broken Window – The Economic Benefit Myth
Definition The parable of the broken window is a fictitious example of a situation that illustrates that the economic benefit of a project or an event can be easily overestimated if we neglect to calculate certain costs that are not directly observable.
The author of this parable is the French economist Frédéric Bastiat (1801-1850) who wished to illustrate the notion of hidden costs. The parable tells the story of a kindly retailer who has his shop window broken by a little boy. A priori the witnesses on the scene sympathize with the retailer who is the victim of this act of vandalism, but they quickly change their minds and consider the act of the little boy as beneficial for society. By breaking the window, the little boy created work for the glazier, who, with the money received for the repairs, created work for other inhabitants of the neighbourhood. If this “logic” were pushed to the extreme, a public official could encourage vandalism in order to generate economic benefits.
As the author of the parable explains, the expressed economic benefits don’t take into account the costs associated with the broken window. Even though the glazier receives an amount for the repairs, the retailer loses the same amount. Moreover, the economic activity initiated by the glazier who spent his earnings could just as well have been initiated by the retailer who, instead of changing his window, could have bought something else from someone else. Taking these costs into account, there is no economic benefit.
Similar reasoning is at the base of debates between individuals who advocate state intervention and those who don’t. By taxing the population for a certain project, the state causes both a loss and a gain for the economy. The loss corresponds to what will not be consumed or saved from the taxes collected. This reasoning can also be extended to the so-called economic fallout of a war or a hurricane for which we must also take into account the costs associated with the destruction of infrastructure and personal property.
Public Goods and Private Goods
Definition The difference between a public good and a private good is determined by two criteria: rivalry and excludability. A good is said to be rival if the act of consuming it limits its consumption by another individual, and it is said to be excludable if it is possible to restrict the consumption of that good to a certain number of individuals. By definition, a private good is a rival and excludable good, whereas a public good is non-rival and non-excludable.
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From the rivalry and excludability criteria, two other types of goods can be defined: common-pool resources and club goods. A common-pool resource is rival but not excludable. Consuming a unit of this type of resource will limit the consumption by another individual, but it is impossible to control the number of consumers of this resource. On the other hand, a club good is excludable but not rival. Consuming a club good does not prevent another individual from consuming this same good, and it is possible to restrict the number of consumers.
The diagram opposite synthesizes these types of goods according to their rivalry and excludability criteria. In practice, goods are Classification of goods often more or less rival or more or less excludable. When a good is strictly non-rival or strictly excludable, or some other Rival Non-rival combination of these criteria, it is sometimes said to be a pure good (e.g., a pure public good or a pure club good). Excludable Private goods Club goods There are numerous examples of private goods in everyday life. A meal in a restaurant, an automobile or a hotel room are goods Non- Common-pool whose consumption is rival and excludable. Public goods excludable resources goods Examples of public goods—especially pure public goods—are more rare. A lighthouse is sometimes considered to be a pure public good. A ship cannot be excluded from benefiting from Source: Desjardins, Economic Studies its warning light (non-excludable), and the arrival of another ship does not reduce the usefulness of the light for other ships (non-rival). Street lighting is another example of a public good. It is difficult to prevent an individual from benefiting from the light, and the consumption of the light by the individual doesn’t reduce it for others.
In the club goods category, we find examples such as golf, tennis and ski clubs. Up to a certain point, the addition of one more skier, golfer or tennis player does not deny the use of the club by others (non-rival), but to be able to consume this good, they must all pay their dues (excludable).
Finally, in the case of common-pool resources, we have examples such as deep-sea fishing, national parks and public forests. These goods are non-excludable since it is rather difficult to control international fishing, comings and goings in parks or the cutting of trees. However, they are rival since the fish caught by one fisherman cannot be caught by another, the campsite used by one hiker cannot be used by another and a tree already cut cannot be cut again.
THE NATURE OF GOODS AND STATE INTERVENTION Depending on the type of good, state intervention may be necessary either in the production of the good or in matters of legislation. In the case of private goods, the open market ensures the production of the optimal quantity of these goods. State intervention is not required. In the case of club goods, the private sector also manages to supply goods without the help of the state.
For common-pool resources and public goods, the situation gets a little more complicated. Their consumption is non-excludable since the open market cannot impose a price on the consumer. Whether they pay or they do not pay, consumers have access to common-pool resources and public goods. Where common-pool resources are concerned, the solution lies mainly with legislation. For example, a system of quotas can be imposed on fishing, and stumpage fees can be allocated to lumbering. In the case of public goods, it is generally more economically efficient that they be produced by the state. Otherwise, too few are produced, even though the population gets great satisfaction from them.
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Cost-Benefit Analysis
Definition Cost-benefit analysis is a method used to choose one project among several, in which all costs and benefits of the projects are calculated. The net benefit (benefits minus costs) is a measure of the well-being resulting from the implementation of a project. The higher this measure, the more the project is a benefit to society. This analytical tool can be used by governments to evaluate their large projects.
Cost-benefit analysis is composed of five important elements:
• Preparing an inventory of costs and benefits • Identifying the economic agents involved • Evaluating the monetary costs and benefits • Discounting the costs and benefits • Maximizing well-being through the choice of projects.
One of the key elements of the analysis is the inventory of costs and benefits. The benefits can be defined by the degree of satisfaction that the project brings to its beneficiaries. The costs correspond to the total of direct monetary expenses and non- monetary elements required to implement the project.
To correctly determine the costs and benefits associated with a project, it is necessary to identify the economic agents involved in the project and the impacts of the project on their well-being. For example, a project that results in a decrease in the price of a product increases the consumer surplus16 of those who use this product. The increase in the consumer surplus constitutes the impact of the project on this group of individuals.
The third element of a cost-benefit analysis is the evaluation of costs and benefits using a common base. In concrete terms, it is a question of expressing all the costs and benefits in terms of monetary value. For costs and benefits already stated in monetary terms, this statement in common terms is done automatically. However, for non-monetary costs and benefits (cost of pollution, increase in the risk of death, etc.), the economic literature suggests different approaches to monetizing them.
The fourth element of a cost-benefit analysis is the evaluation of the costs and benefits taking into account that they do not all happen at the same time. The simplest way is to state all the costs and benefits in terms of their present value17 (or discounted value). To do this, it is necessary to actualize the costs and benefits using a selected discount rate. The higher the chosen discount rate, the lower the present value equivalents of the future values will be. The following formula is used to discount a future value (FV) using a discount rate (r) where n corresponds to the number of periods that separate the future and present values. Each period is discounted at the rate (r).
FV PV (1 r)n
Finally, the cost-benefit analysis determines whether or not a project improves the well-being of society. The decision criterion is the net present value (NPV) of the project determined by the present value of the benefits minus the present value of the cost. For society to benefit from the project, the NPV must be positive (benefits greater than costs). If the project is to be selected from among many, the one with the highest positive NPV should be chosen. ______16 See Consumer Surplus at page 15. 17 See Present Value at page 177.
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BUDGET AND GOVERNMENT INDEBTEDNESS
Government Budget
Definition The government’s budget presents the state’s expected expenditures and revenues for a given period (usually one year). It also reports on the government’s priorities for public spending. Also, to estimate public revenues and expenditures, the budget includes projections as to how the economy could evolve.
The government’s main revenue sources are usually personal The primary revenue and expenditure of Canada’s federal income taxes, corporate income taxes and consumption taxes. government, fiscal years ended March 31 Personal income tax is the tax that individuals pay on the income 1990 1995 2000 2005 they declare for a year. Personal income tax represents about Total revenues (in millions of CAN$) 122,828 139,255 184,018 216,443 Personal income tax 55,042 61,658 85,437 98,340 45% of the revenue of Canada’s federal government, which means In % total revenue 44.8 44.3 46.4 45.4 Corporate income tax 13,021 12,432 23,997 30,087 it is the government’s largest revenue stream. Corporate income In % total revenue 10.6 8.9 13.0 13.9 Consumption tax 28,803 30,554 36,011 47,312 tax is the tax that companies pay on their profits. Consumption In % total revenue 23.4 21.9 19.6 21.9 Total expenditures (in millions of CAN$) 150,851 175,991 177,019 211,324 taxes come from the various taxes on goods and services that Health and social services 59,245 76,170 68,399 101,019 In % total revenue 39.3 43.3 38.6 47.8 Protection of people and property 15,890 17,433 18,448 23,928 are consumed. In Canada, this includes the Goods and Services In % total revenue 10.5 9.9 10.4 11.3 General purpose transfers to other levels 9,711 10,408 24,797 20,971 Tax (GST), customs duties and taxes on gas, alcohol and some of government In % total revenue 6.4 5.9 14.0 9.9 other items. Consumption taxes are the Canadian federal Debt charges 32,390 32,221 31,539 22,051 In % total revenue 21.5 18.3 17.8 10.4 government’s second biggest source of income, accounting for Surplus(+)/deficit(-) -28,023 -36,736 6,999 5,119 about 22% of its revenue in 2005. Other revenue comes from contributions to social security plans (like employment Sources: Statistics Canada and Desjardins, Economic Studies insurance), the sale of goods and services (like passports) and investments.
Government spending varies from country to country. Countries can, to different extents, spend on national security, transportation, education, health, culture, etc. In Canada, almost half of the budget went to health and social services in 2005; a major share of the health and social services budget is transferred to the provinces, however, going to finance their health care system and social programs. Protection of life and property, including military spending, takes up from 10% to 11% of total expenditures each year. General purpose transfers to other levels of government also constitute a sizeable expense for Canada’s government. These transfers are another source of financing for the provinces and municipalities. They include equalization1 payments. These expenses have fluctuated substantially over time and, in 2005, represented just under 10% of federal spending. Lastly, the Government of Canada must pay interest on its debt, an expense that comes under the heading of debt charges2; in 2005, it represented just over 10% of its total expenditure. ______1 See Equalization at page 130. 2 See Debt Service at page 134.
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Transfer Payments
Definition In a federal system, transfer payments are the financing that a level of government gives to other levels of the public administration that belong to the federation.
In Canada, the federal government primarily finances the Main federal government of Canada transfer payments provinces and territories through four major programs: to the provinces and territories
• The Canada Health Transfer 2004- 2005- 2006- 2007- • The Canada Social Transfer 2005 2006 2007 2008 3 • Equalization Canada Health Transfer1 28,591 32,865 34,057 35,821
• Territorial Formula Financing. Canada Social Transfer 15,142 15,727 16,294 17,622
Equalization 10,774 10,900 11,536 12,925 There may or may not be conditions on fund transfers to other Territorial Formula Financing 1,900 2,000 2,072 2,221 tiers of government. Transfers are said to be unconditional when Total of the main transfers2 55,055 60,119 62,548 67,010 the government receiving the financing can use it as it sees fit. Conversely, transfers are said to be conditional when the
government receiving the funds must spend the money based 1 The Canada Health Transfer includes transfers for health care reform and transfers to reduce wait times. 2 The totals are adjusted to prevent double counting of the associated equalization payment. on rules or priorities set by the central government. Sources: Department of Finance Canada and Desjardins, Economic Studies
Canadian Health and Social Transfers are federal transfers that are to be used to support specific areas like health care, post- secondary education, social assistance and social services, early childhood development and child care. Equalization and the Territorial Formula Financing are unconditional transfers to provinces and territories. ______3 See Equalization at page 130.
Equalization
Definition In a federal context, equalization is a program used to redistribute tax revenue among the member regions of the federation. Part of the revenue of the wealthy states is redistributed to the less prosperous areas.
In Canada, the equalization program allows the provinces, no matter what their capacity to generate tax receipts, to offer their populations services comparable to those offered the inhabitants of the more wealthy provinces. The calculations of the amounts to be paid by province are based on the ability of that province to produce tax revenue. Supposing that each province applied the same tax rate, the ones whose tax revenue per inhabitant was below the country’s average would benefit from equalization. Except for Ontario and Alberta, all the provinces have benefited from equalization in past years. British Columbia is sometimes among the beneficiaries and sometimes not. Over all, Québec captures the largest share of equalization payments. However, when the data is compared as a function of the number of inhabitants per province, it is Prince Edward Island that is the largest beneficiary and Québec comes in sixth.
It should be noted that the equalization amounts shown in the table above also include an adjustment used to balance the value of tax points transfers. Transfer payments4 for health and social programs are made in cash and tax points. However, since tax ______4 See Transfer Payments at page 130.
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points transfers have a greater value in certain provinces (i.e., Equalization paid to the Canadian provinces for the budget they make it possible to get more revenue), the federal year 2006-2007 government permanently equalizes tax points transfers using an adjustment called “associated equalization”. In 2006-2007, about In millions of $ $ per inhabitant $1.4 billion was distributed to balance tax points transfers. Newfoundland and Labrador 632 1,238 Prince Edward Island 291 2,103 Nova Scotia 1,386 1,483 New Brunswick 1,451 1,936 Québec 5,539 725 Ontario 0 0 Manitoba 1,709 1,452 Saskatchewan 13 13 Alberta 0 0 British Columbia 260 60
Sources: Department of Finance Canada, Statistics Canada and Desjardins, Economic Studies
Tax Base
Definition The tax base refers to that which is taxed: income, consumption, profits, etc.
For example, for personal income tax, the tax base is taxpayers’ income and taxable benefits. For consumption taxes, the tax base is the value of the goods and services that are subject to tax. Municipally, the property tax base is the value of municipal assessments. The size of the tax base depends on how many items it includes, as well as on their value. For example, if we stop taxing foodstuffs, we reduce the tax base for sales taxes; when property values go up, the tax base for property tax expands.
Value-Added Tax
Definition This is a tax on the value that is added5 to the goods and service that are produced. In practice, a good or service’s value added is the difference between its sale price and the prices of the goods and services used in producing it. The amount of the tax that returns to the public coffers is thus the difference between the tax collected when a good or service is sold minus the taxes the company paid to buy other goods and services.
Many countries use this type of taxation, though it is called different things from country to country. Canada’s Goods and Services Tax (GST) is a value-added tax.
One of its benefits is that it is a neutral tax, in that it hits all types of industries equally. In the case of a flat tax that is applied to the sale price, without taking input prices into consideration, an industry in which creating a good requires a number of exchanges (several input sales and purchases) would pay more taxes than an industry requiring fewer exchanges, even if the value added to the goods produced by the two industries was the same. Another benefit of the tax is that it creates its own discipline: in fact, it is in the interest of each successive buyer to have the seller accurately report all of the tax owing, so that the buyer can maximize his refund and minimize the net amount owed to the government. ______5 See Value Added at page 32.
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Direct and Indirect Tax
Definition This is the distinction that is made between a tax that is collected directly from the person who carries the tax burden (direct tax) and a tax that is collected by a third party who is not responsible for the tax burden (indirect tax).
Personal income tax is a direct tax. The people who pay these taxes must also make sure that the tax authorities receive what is owed to them. Consumption taxes, on the other hand, are indirect taxes because retailers, among others, are responsible for paying the amounts owed to taxation authorities, while it is consumers who in fact carry the tax burden by paying taxes on their purchases.
Public Debt
Definition Public debt is the amount that public administrations owe. It comes from loans obtained on financial markets and internal debt that is primarily contracted with public employees’ pension fund accounts.
Public debt can be expressed in either gross or net terms. Gross Federal government of Canada’s public debt, debt is the total of all amounts owed, while net debt is gross fiscal years ended March 31 debt minus financial assets. In analyzing government In billions of CAN$ In billions of CAN$ 700 700 indebtedness, whether in Canada or abroad, net debt is the 650 650 reference that is used most frequently. 600 600 550 550 500 500 The graph shows how the Canadian government’s gross debt 450 450 400 400 and net debt have evolved. Until the mid-90s, public debt rose 350 350 300 300 continuously, peaking at $609 billion in net terms in the 250 250 1996-1997 fiscal year. 200 200 150 150 100 100 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Gross debt Net debt
Sources: Department of Finance Canada and Desjardins, Economic Studies
Deficit
Definition A public deficit (budget deficit) occurs when a government’s expenditures exceed its tax revenues for a given period which is normaly one year.
A deficit can be financed by public borrowing, by issuing savings bonds, among other things, or by the central bank. When a deficit is financed by the public, it increases the government’s public debt, and the government must pay interest to those who hold its debt securities. However, when the central bank finances a deficit, it buys the government’s debt securities and pays for them out of the newly created monetary base6. The government pays the central bank interest; however, as it owns the ______6 See Monetary Base at page 64.
132 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Public Economics / Budget and Government Indebtedness central bank, this amounts to not paying any interest. The cost of this type of financing is instead felt by the public at large, as the resulting increase in the money supply generates inflationary pressure.7
A public deficit is said to be cyclical if it is associated with fluctuations in the economic situation. When the economy is in Budget balances of Canada’s federal government a recession, the government is more vulnerable to a deficit given In billions of CAN$ In % of GDP 30 4 that its revenues tend to drop and its expenses tend to climb. A 3 20 public deficit is said to be structural if it is associated with 2 10 Surplus 1 economic policy decisions such as a cut to the tax rate or a 0 0 public infrastructure investment policy. When a primary deficit -10 Deficit -1 -2 is involved, this means that neither interest charges associated -20 -3 with paying back the public debt nor income from assets are -30 -4 -5 -40 being considered. -6 -50 -7 -60 -8 8 To measure a deficit’s size, we can compare it to GDP or to 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 government expenditures. In the European Union, a consolidated Budget balance (left) Budget balance/GDP (right) deficit (i.e., the total of all deficits of all public administrations in Sources: Statistics Canada and Desjardins, Economic Studies a given economy) that is greater than 3% of GDP is considered to be excessive. In 1997, the Canadian government ended a long history of deficits by finishing the year with a $6.3 billion surplus. Many of the federal government’s previous deficits had been greater than 3% of Canada’s nominal GDP. ______7 See Inflation at page 57 and Seigniorage at page 70. 8 See Gross Domestic Product at page 30.
Foreign Debt
Definition Foreign debt is the debt of a country owed to foreign lenders. This debt is incurred by the various levels of government and by the private sector.
The greater the foreign debt, the more important the interest and Canada’s foreign debt repayments are that must be paid to foreign lenders. These payments eat away part of the national income of residents. In billions of CAN$ In % of GDP 350 50 330 However, foreign debt is beneficial when it is used to finance 45 310 investment, since it leads to growth in the production potential 290 40 of the economy and, consequently, in national income. 270 35 250 230 30 210 25 In Canada, foreign debt amounted to more than $330 billion in 190 the mid-90s, which represented at that time about 40% of GDP9. 170 20 150 15 130 A decade later, it foreign debt was less than $200 billion and, at 10 110 the beginning of 2007, represented only 7% of Canadian GDP. 90 5 ______1991 1993 1995 1997 1999 2001 2003 2005 2007 Foreign debt (left) Foreign debt/GDP (right) 9 See Gross Domestic Product at page 30. Sources: Statistics Canada and Desjardins, Economic Studies
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Twin Deficits
Definition It is said that an economy has a twin deficit when it shows a budget deficit and a current account10 deficit at the same time.
11 The current account (CA) balance can be expressed as a function of private savings (Sp), public savings (Sg) and investment (I).
CA = Sp + Sg – 1
In the context of an economy that is open to international trade, when the government’s need for financing increases and private savings do not meet this need, the country must borrow on foreign markets. As we see from the equation above, assuming private savings and investment are constants, a cutback in public savings (reduction of the state’s surplus, creation or increase in the budget deficit) will have a negative influence on the current account balance, and vice versa.
During the ‘80s, the United States experienced a twin deficit situation, attributable to the expansionist fiscal policy12 of Budget balance and current account balance in the United States
President Reagan. During the ‘90s, the Bush (senior) and Clinton In billions of US$ In billions of US$ administrations reversed the American budgetary situation. In 200 200 100 100 spite of this, the current account did not improve because 0 0 investment in information technology and a reduction in the -100 -100 -200 -200 savings rate of American households each did their part in -300 -300 pushing the current account into the red. After the events of -400 -400 -500 -500 September 11, 2001, the struggle against terrorism and the war in -600 -600 Iraq again created a budget deficit in the U.S. At the same time, -700 -700 we see the continued deterioration of the American current -800 -800 -900 -900 account balance. 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 ______Budget balance Current account balance (annualized) 10 See Balance of Payments at page 89. Sources: Bureau of Economic Analysis and Desjardins, Economic Studies 11 See Link Between Savings and the Current Account at page 90. 12 See Fiscal Policy at page 78.
Debt Service
Definition Debt service, or debt charge, represents the total amount paid each year by the public administration in order to reimburse their debt. This includes the payment of interest on the debt and the part of the capital that is reimbursed.
In Canada and in other countries, the notion of debt service refers mainly to the payment of interest on the debt. Different ratios can be used to determine the extent of debt service. We can determine its weight based on the value of goods and services produced or exported. The ratio of debt charges to the value of exports is used less frequently in the case of industrialized countries. This ratio determines to what extent the exports of a country will cover the payment of interest on the public debt. We can also compare the weight of debt charges to government expenses or revenues, which allows us to determine the proportion of expenses which must be used to service the debt or the capacity of the government to pay in relation to its revenue.
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The graph opposite shows the ratios of debt charges of the Government of Canada debt charges, fiscal years ended March 31 Canadian government as a function of GDP, of total budget expenses and of revenue. Since the middle of the ‘90s, a series of In billions of CAN$ In % 39 28 surplus budgets have reduced the total debt and, consequently, 37 25 interest payments. Lower interest rates have also contributed to 35 22 33 19 the reduction of debt charges. Moreover, if debt charges remain 31 16 constant, an increase in wealth reduces the burden of the debt 29 13 27 10 on the population. 25 7 23 4 21 1 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Debt charges (left) Debt charges/Budgetary expenses (right) Debt charges/GDP (right) Debt charges/Budgetary revenues (right)
Sources: Statistics Canada and Desjardins, Economic Studies
Ricardian Equivalence
Definition According to the concept of Ricardian equivalence, government deficits don’t cause any problems since supposedly rational individuals save more when governments run deficits in order to be able to pay the eventual increase in taxes that will serve to absorb the accumulated debt.
The concept of Ricardian equivalence is not received with unanimity by economists. The traditional approach to the state’s indebtedness suggests that when a government runs a deficit by insufficiently taxing the population, consumption is stimulated. Not being taxed as heavily as they should, the people have more disposable revenue and can consume more. However, financing the deficit drains part of savings, increases interest rates, slows investment and appreciates the domestic currency.13 In the longer term, a lower level of investment reduces the supply of capital and potential GDP.14 In short, according to the traditional approach, when the state incurs debt, its citizens enjoy increased prosperity. However, in the long run, their potential revenue could be affected and their consumption reduced by the need to reimburse the accumulated debt.
The proponents of Ricardian equivalence see quite a different story. They suppose a priori that people are rational regarding the future, and that their current consumption is not only based on their current income but also on their anticipated income. If people believe that the state will settle the deficit by a future increase in taxes, they will then expect a reduction in their future disposable revenue and will not increase their consumption. Instead, the increase in their current income is dedicated entirely to saving in anticipation of a future reduction in their income due to the repayment of the public debt. This growth in savings allows the state to borrow without affecting the level of interest rates or investment. In short, according to Ricardian equivalence, apart from the rate of savings, no economic variables are affected by the state incurring debt.
Even though the Ricardian equivalence theory makes a certain amount of sense, the fact remains that the expected result changes when we consider, among other things, that people have a limited life expectancy and that governments don’t signal their intentions to increase taxes at a later date. In fact, if people believe that they are going to die before their taxes are raised, they could see an opportunity to increase their consumption and leave the payment of the accumulated public debt to future generations. Moreover, a government that reduces taxes and creates a deficit could very well promise to reduce the deficit by slashing expenses rather than by future tax increases. Here again, this could persuade rational individuals to increase their current consumption, given that they have no fear of a future decrease in their disposable income. ______13 See Fiscal Policy at page 78. 14 See Golden Rule of Capital Stock at page 48 and Potential GDP at page 32.
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ECONOMY AND TAXATION
Fiscal Neutrality
Definition Fiscal neutrality is when a tax does not cause any change in the assignment of productive resources.
When a government collects taxes, it must make sure that this does not affect consumption and production in the economy. In practice, fiscal neutrality is very hard to achieve because the means proposed for achieving it can create social equity problems. An “efficient” tax is a neutral tax. However, an efficient tax is, in practice, frequently not equitable, and thus difficult to apply.1 ______1 See Efficiency vs. Equity of Taxation at page 137.
Laffer Curve
Definition The Laffer curve is an illustration of the theory that there is an optimal tax rate (below 100%) at which a government’s tax revenue is maximized. When the tax rate is low, raising it helps increase the state’s revenues. When it is high, raising it no longer helps increase the state’s revenues; in fact, revenues can even decline.
Some economists use the Laffer curve to argue in favour of Theoretical illustration of the Laffer curve reducing taxes to stimulate the economy without worrying about decreasing the state’s revenues and excessive debt. Since taxes have a negative impact on business and worker activity, a substitution effect can prod workers to reduce work time; an income effect can make them work more to offset the income losses associated with the tax increases. An overly heavy tax burden can also promote the black market. According to the State’s tax revenues tax State’s Laffer curve, when the tax rate becomes too high, the substitution Area in which increasing Area in which increasing the tax rate makes the the tax rate makes the effect wins out over the income effect: workers cut back on state’s revenues go up state’s revenues go down their work hours and companies reduce production, with the end result that the entire economy’s taxable income declines, 0 100 as do the state’s revenues. Where a state is overtaxing its Tax rate in % population, a decrease in the tax rate could cause output, taxable Source: Desjardins, Economic Studies income and tax revenues to go up. In the ‘80s, U.S. President Ronald Reagan used a policy based on this principle.
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Fiscal Drag
Definition Fiscal drag refers to the phenomenon in which progressive tax2 interferes with growth by real income.
In a progressive tax system, an increase in personal income means that people are taxed more from year to year which, in real terms3, curbs growth by their disposable income or even makes it decline. To prevent fiscal drag, governments must index tax tables and prevent too much tax progressiveness. Also, even if tax tables are indexed to the cost of living, this may not completely prevent fiscal drag as an increase in workers’ productivity means that their income may increase more quickly than the inflation rate. Thus, even if the government indexes the tax tables at the same rate as inflation, real tax revenues may increase, and taxpayers’ real income growth may be limited accordingly. This could result in curbing economic growth.
Fiscal drag may also support taxation policy4 in order to smooth economic cycles. In fact, when an economy is growing faster than its capacity5, the real increase in tax income results in putting the brakes on the economy so that it returns to a more sustainable pace and prevents overly high inflation. ______2 See Progressive and Regressive Tax at page 139. 3 See Nominal and Real Value at page 176. 4 See Fiscal Policy at page 78. 5 See Potential GDP at page 32.
Efficiency vs. Equity of Taxation
Definition In public economics, the introduction of fiscal measures creates interest as far as efficiency and equity are concerned. Efficient taxation causes few economic distortions, and equitable taxation is considered to be socially acceptable. The ideal system is one which is efficient and equitable, but, as a general rule, one of these objectives is attained to the detriment of the other.
A tax is said to be inefficient if it modifies the behaviour of consumers or companies (unless the objective was not exactly to change this behaviour). For example, income tax reduces the attraction of work, capital tax reduces savings and investment, and the act of taxing one good more than another reduces its consumption compared to other goods. These inefficiencies can be measured in terms of society’s loss of welfare.6 According to economic literature, a lump-sum tax (i.e., a fixed amount that has to be paid by everyone) is a tax that does not cause any economic inefficiencies. A little less efficient than a lump-sum tax, taxing goods according to their price elasticity7 minimizes loss of welfare. It is preferable to put a higher tax on goods whose demand is inelastic rather than those whose demand is more elastic. Although they are efficient, these last two forms of taxation would not seem very equitable in the eyes of society. In the case of the lump-sum tax, it would be a very regressive tax8, whereas taxing goods that are the most inelastic, like water or food, could irritate a number of people.
When we talk of equity in taxation, it is a question of either horizontal or vertical equity. Horizontal equity stipulates that equal people should be treated equally, while vertical equity states that individuals not benefiting from the same conditions should ______6 See Excess Burden at page 142. 7 See Concept of Elasticity and Inelasticity at page 12. 8 See Progressive and Regressive Tax at page 139.
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be treated in a different and just manner. There is consensus around the principle of horizontal equity, but there is none when it comes to vertical equity. One of the main factors used in taxation to distinguish an individual’s situation is his level of revenue. According to the principle of vertical equity, a wealthier individual may be required to pay more in income tax than a poorer individual. The progressive nature of taxes agrees with the vertical equity principle. For similar reasons, we understand better why a lump-sum tax or taxes on goods with an inelastic demand, such as food products, are rarely applied in our societies. The poor are greatly disadvantaged by such measures.
Tax Credit
Definition A tax credit is an amount that is deducted from the income tax payable. In principle, the amount is the same for all taxpayers, as it does not depend on their income, unlike tax deductions9. However, some credits can be earmarked only for low-income earners or seniors.
There are various tax credits in Canada. One feature that differentiates them is that some are refundable, and others are not. A refundable tax credit means that, even if the amount of tax payable is less than the amount of the credit, the government refunds the difference to the taxpayer. For non-refundable tax credits, if the tax payable is less than the amount of the credit, the difference is not refunded to the taxpayer. For instance, in Canada, the Goods and Services Tax credit is refundable, while the tuition credit is not. ______9 See Deductions at page 138.
Deductions
Definition A tax deduction is an amount that is deducted from taxable income. It reduces the tax payment by an amount equivalent to the deduction times the marginal tax rate10.
For example, someone with a marginal tax rate of 50% who declares an income of $60,000 and deducts $5,000 saves $2,500 in tax. However, if, on an income of $58,000 or less, the marginal tax rate came down to 40%, someone earning $60,000 would instead save $2,200 (i.e., $2,000 X 50% + $3,000 X 40%). In Canada, registered retirement savings plan contributions are tax deductible within permitted limits. ______10 See Marginal Tax Rate at page 139.
Marginal Tax Rate
Definition The tax rate that applies to a taxpayer’s highest portion of taxable income. In a progressive rate tax system, the marginal tax rate is higher for people with higher incomes; in a regressive tax rate system, the marginal tax rate is higher for people with lower incomes.11
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In Canada, the income tax rate goes up with each additional income bracket. In 2007, the federal government taxed the first income bracket, whose ceiling is $37,178, at a rate of 15.5%; it taxed the portion between $37,178 and $74,357 at a rate of 22%; between $74,357 and $120,887, the rate was 26%; for the portion of income over $120,887, the rate was 29%. This means that if someone earned $37,178 or less, the federal marginal tax rate was 15.5%; the rate went up to 29% for someone earning over $120,887. ______11 See Progressive and Regressive Tax at page 139.
Progressive and Regressive Tax
Definition A “progressive” tax is a tax whose rate increases more quickly than the income of the person or company. A “regressive” tax, on the other hand, is a tax whose rate increases at a slower pace than income. A tax can be neither progressive nor regressive: a proportional tax is a tax whose rate increases at the same pace as income.
The variation in the average tax rate shows how a tax is graduated. The average rate corresponds to the amount of tax divided by income. For someone who has to pay $10,000 in tax and has an income of $40,000, the average tax rate is 25%. If someone has to pay $20,000 in tax on an income of $60,000, his average tax rate is 33.3%. In this example, the average tax rate increases with income, so this is a progressive tax. If the second person’s average rate was the same as the first person’s, it would be a proportional tax; if it was lower than the first person’s, it would be a regressive tax. Note that we should avoid defining tax progressiveness based only on the fact that the marginal tax rate12 increases according to income. A flat tax system (constant marginal rate) with a guaranteed minimum income can also be progressive.13
In Canada, personal income tax is a progressive tax. Because low-income earners are given a tax credit and higher income brackets are taxed at a higher rate, the average tax rate increases as income goes up. The degree of progressiveness is not as easy to see in consumption taxes. Fundamentally, it is a regressive tax, because people with higher incomes tend to use up less of their income (they save more), which means that they pay less consumption tax in proportion to their income. However, a tax credit can be given to low-income earners to compensate them for their tax burden, making the tax more progressive. Also, some essential consumer goods, like foodstuffs, can be tax-exempt, which also reduces the consumption tax burden on the poorest people. These two measures are applied in Canada and help to make consumption tax more progressive. ______12 See Marginal Tax Rate at page 139. 13 See Flat Tax at page 140.
Flat Tax
Definition In a flat tax rate (single tax rate) taxation system, all people are taxed at the same rate, regardless of how much taxable income they have. The concept of a flat tax can be extended to the entire tax base, i.e., all types of income (wages, dividends, etc.) are taxed at the same rate.
Worldwide, a flat tax is not used widely. In Alberta, a flat 10% rate is in effect on personal income tax, but taxpayers still get a basic exemption. As the figure shows, a conventional progressive tax system in which the marginal tax rate varies based on taxable income is better for the poorest people than a flat tax rate with no basic exemption. Applied to business tax, a flat tax limits
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 139 Public Economics / Economy and Taxation
what the government can do to encourage business start-ups or Comparison of a flat tax system and a multiple rate tax system favour one industry over another. Nevertheless, a flat tax system can streamline the tax system and cut its costs. Also, given that, In fictional $ In fictional $ 20,000 20,000 Tax paid with a fixed tax rate under a progressive tax system, it could be to the benefit of 18,000 18,000 Tax paid with multiple tax rates wealthier people to find ways to pay less tax, those who are in 16,000 16,000 14,000 14,000 favour of a flat tax argue that it would, among other things, Flat taxation rate 14 12,000 of 30% 12,000 reduce tax evasion and increase government tax revenues . After $45,000, the 10,000 marginal tax rate 10,000 goes up to 50%. 8,000 Starting at $9,000, the 8,000 marginal tax rate goes 6,000 from 0 to 30%. 6,000
4,000 After $20,000, the 4,000 marginal tax rate goes 2,000 up to 40% 2,000 0 0 0 10,000 20,000 30,000 40,000 50,000 Taxable income in $
Source: Desjardins, Economic Studies
FLAT TAX RATE AND NEGATIVE INCOME TAX When combined with a negative income tax, the features of a flat rate taxation system change somewhat. A negative tax means that, instead of paying tax, some taxpayers end up receiving an amount from the government. Under this type of system, the government pays a guaranteed minimum income to everyone, and the remainder of their income is taxed at a flat rate.
The following example uses a guaranteed minimum Net tax owing with a guaranteed minimum income of $10,000 income of $10,000 and a flat tax rate of 50%. and a flat tax rate of 50%
Someone with no other income would therefore In fictional $ In % 20,000 have $10,000 to live on. Someone receiving other 18,000 25 16,000 0 income would also get the $10,000, but pay tax on 14,000 12,000 -25 10,000 the other earned income. That means that someone -50 8,000 who earned $20,000 would pay $10,000 in tax but, 6,000 Flat tax rate of 50% -75 4,000 as he receives a guaranteed minimum income of 2,000 -100 0 -125 $10,000, he would not owe the tax authorities -2,000 -150 -4,000 Guaranteed minimum anything in the end. He would only really pay tax -6,000 income of $10,000 -175 -8,000 when his additional earnings exceed $20,000. This -10,000 -200 15 0 10,000 20,000 30,000 40,000 50,000 is thus a progressive tax system , since the Taxable income in $ average tax rate increases along with income Net tax paid – or received when negative (left) Average tax rate (right)
(excluding the guaranteed minimum income). Source: Desjardins, Economic Studies Someone with a taxable income of $50,000 would pay a net amount of $15,000 into the public coffers, about 30% of his earnings.
______14 See Laffer Curve at page 136. 15 See Progressive and Regressive Tax at page 139.
Green Tax
Definition A green tax is a tax system that is designed to tax the harmful features rather than the beneficial features of economic activity.
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Governments tend to tax personal and business income, as well as consumption. However, work, investment, business development and consumption are beneficial to the economy and taxing them can only discourage them. A new approach to taxation emerged with emission taxes and the other taxes on undesirable externalities16 (smoking, alcoholism, etc.). These taxes make it possible to reduce the amount of pollution generated or other negative externalities, as well as yielding major revenues for governments. These additional revenues can allow the government to reduce personal or business income tax, as well as consumption taxes. This way, taxation penalizes desirable activities less and harmful activities more. ______16 See Externalities at page 21.
Pigouvian Tax
Definition The Pigouvian tax is a solution to problems with negative externalities17. When the amount of a good that is produced and its market price do not take into account the costs associated with negative externalities, it is theoretically possible to levy a tax to help the market reach an equilibrium that considers these costs.
Picture a market in which someone produces a good and pollutes. Illustration of a Pigouvian tax The market’s supply curve corresponds to the marginal cost18 of Price Supply = marginal cost + marginal each unit produced but does not consider the damage done to damage to the environment the environment, however. As, in this market, production costs Supply + Pigouvian tax are underestimated, the quantity Q0 that is produced is greater than it would be if negative externalities were weighed. In that Supply = marginal cost a d case, Q* would be produced, i.e., the quantity produced when PQ* market demand intersects with the supply of a market that PQ considers environmental costs (in other words, the marginal 0 b c cost curve plus the marginal damage to the environment). If we opt to institute a Pigouvian tax on this market, it must be equivalent to the marginal damage when the market is at Q* Demand Q* Q equilibrium. In the illustration, this tax corresponds to the distance 0 Quantity between points c and d. By adding the tax to the supply curve, Source: Desjardins, Economic Studies the market’s equilibrium moves from Q0 to Q*. Also, the tax revenues collected by the government correspond to the area bounded by rectangle abcd, i.e., the quantity Q* multiplied by the tax cd.
In practice, the difficulty of assessing the value of externalities limits the application of this type of tax. Looking at the illustration, to reach Q* equilibrium, we have to know the exact cost of negative externalities. If these costs are overestimated, an overly high tax would lead to an equilibrium amount that is less than Q*; if the costs are underestimated, an overly low tax would not generate enough of a reduction in what the market is producing.
This type of taxation can be applied to areas other than polluting markets. For example, in Canada and elsewhere, governments collect various taxes on tobacco and alcohol products to take into account the social costs of consuming these products and reduce overall consumption; in addition to discouraging harmful behaviour, governments can use revenues from such taxes to finance social programs or reduce the tax burden on workers and businesses.19 ______17 See Externalities at page 21. 18 See Marginal Analysis at page 11 and Perfect Competition at page 16. 19 See Green Tax at page 141.
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Excess Burden
Definition The excess burden is a non-recoverable loss of welfare. The loss can, among other things, be caused by instituting a tax or subsidy. It can also be defined as a loss of economic efficiency.
In an efficient market that does not have any externalities20, a Welfare derived from consuming and producing producer delivers goods until his marginal production cost a given good or service equals the market price; goods are consumed until the marginal Price 21 utility of consumption is equal to the market price. The welfare Supply a society gets from producing a good or service thus boils down to the consumer surplus and the producer surplus22. Consumer surplus P0
Interventions that change a market’s equilibrium amount or price Producer also change the society’s economic welfare. This is what happens surplus when a sales tax is implemented, among other things. The graph on the left depicts the state of a market and the welfare the society derives from it. In the second graph, a sales tax has Demand Q been added, changing how welfare is distributed. Firstly, the 0 Quantity consumer surplus decreases, as the increase in the sale price Source: Desjardins, Economic Studies caused by introducing a tax reduces the amount of goods consumed. Secondly, the producer surplus also declines, given Adding a tax causes an excess burden that the quantity required decreases. Thirdly, the government Price recovers some of the consumer and producer losses due to tax Supply + tax revenue. However, the government’s gain does not fully offset Supply the losses incurred by the consumer and producer. This difference Consumer is called the excess burden. In the second graph, the tax revenue surplus P d with tax a corresponds to the area of rectangle abcd, and the excess burden Tax revenue = abcd P0 e bc Excess burden = cde is defined by triangle cde. Pproduction
The magnitude of the excess burden depends on the elasticity23 Producer of supply and demand. The more elastic supply and demand are surplus in response to price changes, the greater the market’s net loss of Demand Q Q welfare will be. with tax 0 Quantity ______Source: Desjardins, Economic Studies 20 See Externalities at page 21. 21 See Marginal Analysis at page 11. 22 See Consumer Surplus at page 15 and Producer Surplus at page 22. 23 See Concept of Elasticity and Inelasticity at page 12.
Fiscal Competition
Definition Fiscal competition is a government strategy which consists of decreasing the level of taxation in order to attract more foreign investment and specialized labour.
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In the past, governments could choose their level of taxation with more liberty given the existence of more rigid barriers to capital investment and labour mobility. The reduction of these barriers has increased the flow of workers and the movement of labour. A low level of taxation is an advantage for attracting capital investment and specialized workers, who generally have higher taxable revenue. Countries with a heavy fiscal burden have more difficulty in attracting investment by large multinationals or professionals and researchers of international renown.
As an example, by imposing few taxes on companies, Ireland has succeeded in attracting considerable foreign investment. Within the European Union, few barriers now limit the circulation of workers and capital. Consequently, countries of the European Union must harmonize their taxation policies since, if they don’t, they could become non-competitive in these areas and could lose capital and specialized workers to other more attractive countries. Tax havens also intensify fiscal competition.
Fiscal Imbalance
Definition Fiscal imbalance is an expression used in Canada and in other federations to describe a situation where one government does not have the capacity to collect the revenue necessary to meet its obligations, while at the same time, other governments at the same or at a different level have more than enough capacity to collect the revenue needed to meet their responsibilities.
In practice, it can be a question of vertical or horizontal fiscal imbalance. There is vertical imbalance when the revenues of the different levels of government do not meet their respective obligations in terms of governmental expenditures. One level of government could be in a constant surplus situation, while another is continually in a deficit situation. This type of imbalance can be resolved through a better sharing of revenues and responsibilities between the different levels of government. There is horizontal imbalance when different regions of a country cannot generate enough revenue to be able to offer equivalent services. In this type of situation, the imbalance could be resolved through a transfer formula that would distribute part of the revenue of the wealthier regions to the less wealthy regions, as is the case of the Canadian equalization program24.
Debates on the subject of fiscal imbalance take place in various federations. In Canada, a report published in 2002 assessed the differences between the enviable situation of the federal government and the precarious situations of the provinces, whose expenses are expected to grow faster than their revenues.25 In Iraq, when drawing up the new constitution, fiscal imbalance was at the heart of the discussions between the high income oil producing regions and the other regions of the country. Finally, in Nigeria, the central government can count on significant oil revenue, whereas the other levels of government can scarcely find the sources of revenue needed to meet their expenses. ______24 See Equalization at page 130. 25 Yves SÉGUIN et al. A New Division of Canada’s Financial Resources – Final report, Commission on Fiscal Imbalance, Québec, 2002, 214 pages.
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Additional references:
GOVERNMENT AND ECONOMY Direct and Indirect Tax Economic Role of State Alain Beitone et al. 2001, p. 239-240. Paul A. Samuelson and William D. Nordhaus. 2005, p. 324-327. Yves Bernard and Jean-Claude Colli. 1996, p. 801-802. Gilbert Abraham-Frois et al. 2002, p. 182-187. Public Debt Public Choice Theory Department of Finance Canada. [http://www.fin.gc.ca/gloss/gloss- Alain Beitone et al. 2001, p. 141. g_e.html#gorssfeddebt]. Graham Bannock et al. 1998, p. 337-338. Alain Bruno et al. 2005, p. 151.
Adam Smith’s Invisible Hand Deficit Claude-Danièle Echaudemaison. 2003, p. 303. Michael Parkin et al. 2000, p.113, 212-217, 223-225, 311-312 Bernard Guerrien. 2002, p. 312-314. and 562. Wikipedia. [http://en.wikipedia.org/wiki/Budget_deficit]. Size of Government Alain Bruno et al. 2005, p. 138. Harvey S. Rosen et al. 2003, p. 8-12. Foreign Debt Centralization Ratio Department of Finance Canada. [http://www.fin.gc.ca/gloss/gloss- Harvey S. Rosen et al. 2003, p. 156-158. d_f.html#dette_ex]. Wikipedia. [http://en.wikipedia.org/wiki/External_debt]. Wagner’s Law Alain Beitone et al. 2001, p. 271. Twin Deficits Harvey S. Rosen et al. 2003, p. 149-152. Gregory N. Mankiw. 2003, p. 148-151. Joseph E. Stiglitz. 2000, p. 540-542. Parable of the Broken Window Wikipedia. [http://en.wikipedia.org/wiki/Double_deficit_ [http://bastiat.org/]. %28economics%29]. Wikipedia. [http://en.wikipedia.org/wiki/Parable_of_the_broken_ window]. Debt Service Alain Bruno et al. 2005, p.424 Public Goods and Private Goods Graham Bannock et al. 1998, p. 339. Ricardian Equivalence Harvey S. Rosen et al. Public, p. 52-54. Graham Bannock et al. 1998, p. 360-361. Alain Beitone et al. 2001, p. 31-32. David Glasner et al. 1997, p. 577-580. Gregory N. Mankiw. 2003, p.491-498 Cost-Benefit Analysis Gilbert Abraham-Frois et al. 2002, p. 4-8. ECONOMY AND TAXATION Fiscal Neutrality BUDGET AND GOVERNMENT INDEBTEDNESS Graham Bannock et al. 1998, p. 157. Government Budget Alain Beitone et al. 2001, p. 307. Michael Parkin et al. 2000, p. 212-217. Government of Canada. [http://www.canadianeconomy.gc.ca/english/ Laffer Curve economy/fedbudget.html]. Graham Bannock et al. 1998, p. 238. Bernard Guerrien. 2002, p. 389. Transfer Payments Wikipedia. [http://en.wikipedia.org/wiki/Laffer_curve]. Harvey S. Rosen et al. 2003, p. 170-178. Department of Finance Canada. [http://www.fin.gc.ca/gloss/http:// Fiscal Drag www.fin.gc.ca/access/fedprove.html]. Graham Bannock et al. 1998, p. 156-157.
Equalization Efficiency vs. Equity of Taxation Harvey S. Rosen et al. 2003, p. 176-181. Paul A. Samuelson and William D. Nordhaus. 2005, p. 331-332 Department of Finance Canada. [http://www.fin.gc.ca/FEDPROV/ and 337-338. eqpe.html]. Harvey S. Rosen et al. 2003, p. 45-48 and 336-359.
Tax Base Tax Credit Department of Finance Canada. [http://www.fin.gc.ca/gloss/gloss- Harvey S. Rosen et al. 2003, p. 372-380. t_e.html#TaxBase]. [www.economist.com/research/Economics/alphabetic.cfm]. Deductions Harvey S. Rosen et al. 2003, p. 372-380. Value-Added Tax Canada Revenue Agency. RRSPs and Other Registered Plans for Graham Bannock et al. 1998, p. 426. Retirement 2006, [http://www.cra-arc.gc.ca/E/pub/tg/t4040/ Douglas Greenwald. 1984, p. 418. t4040-e.html]. Wikipedia. [http://en.wikipedia.org/wiki/Value-added_tax].
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Marginal Tax Rate Graham Bannock et al. 1998, p. 261. Canada Revenue Agency. [http://www.cra-arc.gc.ca/tax/individuals/ faq/taxrates-e.html].
Progressive and Regressive Tax Harvey S. Rosen et al. 2003, p. 45-48 and 291. Graham Bannock et al. 1998, p. 336 and 353.
Flat Tax Harvey S. Rosen et al. 2003, p. 345-347. H. Richard Hird. 2002, p. 130. Douglas Greenwald. 1984, p. 478-480. Wikipedia. [http://en.wikipedia.org/wiki/Flat_tax].
Green Tax Wikipedia. [http://en.wikipedia.org/wiki/Green_tax_shift]. Paul A. Samuelson and William D. Nordhaus. 2005, p. 339.
Pigouvian Tax Harvey S. Rosen et al. 2003, p. 76. Wikipedia. [http://en.wikipedia.org/wiki/Pigovian_tax].
Excess Burden Harvey S. Rosen et al. 2003, p. 320-332 and 515.
Fiscal Competition Economist.com. [www.economist.com/research/Economics/ alphabetic.cfm]. Wikipedia. [http://en.wikipedia.org/wiki/Tax_competition]. Benoît Delage et al. 2000, p. 67-93.
Fiscal Imbalance Wikipedia. [http://en.wikipedia.org/wiki/Fiscal_imbalance].
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PORTFOLIO MANAGEMENT
Return
Definition A variety of terms are used to refer to what an asset earns or how it performs, such as return, yield or performance. In general, in finance, return is defined as the gain (or loss, in the event of a negative return) derived from an asset. The rate of return expresses that difference as a percentage. The yield is what that asset earns. In practice, the word “yield” often refers directly to “yield rate”.
For example, if someone has a share that is worth $15, and the share earns an annual dividend of 75¢, the share yields 5%. The concept of return (rate of return) adds the increase in the value of the capital to the yield. In other words, a share that was worth $15 last year, earns a dividend of 75¢ and has appreciated to $17 has an 18.3% rate of return (2.75/15 x 100). In another order of ideas, the stock market’s return or performance refers to the ascent or decline of a stock market index over a specific period. Finally, in the bond market, the return calculated for a bond is based on the coupon (interest paid) and the fluctuations in the bond’s market price.
Some factors, such as the risk and maturity1 involved in some securities, have an influence on the return investors demand. As a general rule, the return usually demanded for a security increases along with the risk it presents and the length of its term (maturity). ______1 See Yield Curve at page 149.
Yield Curve
Definition The yield curve (interest rate curve) shows the relationship between the yield of fixed-income securities and their maturities (terms of three months, one year, five years, etc.). The securities have to be comparable, for example, United States Treasury securities for various maturities.
The yield curve is said to be positive when short-term rates are lower than the rates for longer terms. The curve is “negative” when short-term rates are higher than long-term rates; it is “flat” if short- and long-term rates are at about the same level.
Generally, the yield curve is positive: investors demand higher yields to compensate for the risk associated with holding debt securities with longer terms. However, sometimes, the yield curve does flatten or invert. More specifically, it is primarily the 0- to 10-year section of the curve that will change slope. The yield curve inverts when monetary policy2 is especially restrictive, or when the market is anticipating a recession and eventual easing in short-term rates.
Market segmentation theory suggests another explanation for alternately shaped yield curves (non-positive slopes). According to this theory, there are different markets for each of the maturities (one market for one-year securities, another market for ten- year securities, etc.). The different interest rates would then depend on supply and demand in the respective market. It would thus be possible to see lower long-term interest rates (e.g., demand that exceeds the supply of long-term securities) or higher ______2 See Monetary Policy at page 72.
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short-term interest rates (e.g., a demand that is lower than the Yield curve in the United States (3-month to 10-year securities) supply of short-term securities). However, it is hard to demonstrate that this type of market segmentation exists. In % In % 5.5 5.5
This graph shows a section of the yield curve for United States 5.0 5.0 Treasuries (UST) in December 2004 and in December 2006. Note: 4.5 4.5 the UST yield curve can be extended up to a term of 30 years. In 4.0 4.0 2004, the curb was positive; in 2006, it partially inverted. Among 3.5 3.5 other things, the inversion was triggered by monetary policy 3.0 3.0
firming on the part of the Federal Reserve and by the market’s 2.5 2.5
rate cut expectations. Also, strong demand for medium- and 2.0 2.0 long-term USTs would have kept the yields required for these 3-month 1-year 2-year 3-year 5-year 7-year 10-year securities at lower levels. The savings surplus in Asia and December 2006 December 2004 recycling of petrodollars are behind the growing enthusiasm for Sources: Federal Reserve Board and Desjardins, Economic Studies these U.S. securities.
Nominal and Real Interest Rate
Definition The real interest rate is the difference between the nominal interest rate and the inflation rate. In practice, the nominal interest rate can be associated with various rates, including the interest rate that someone gets on a deposit and the interest rate that applies to a mortgage.
Let us assume that someone invests $10,000 for one year at a rate of 8%. At the end of that year, is that person 8% richer? The deposit is, in fact, worth 8% more but, if prices have gone up, the amount of goods and services that he can now buy has not increased by 8%. If inflation is 2%, the person’s purchasing power has gone up by 6%. Here, the real interest rate is the increase in buying power provided by interest income; in other words, it is the nominal interest rate minus the inflation rate.
FISHER EQUATION The Fisher equation can be defined based on the concept of the real interest rate. According to this equation, the nominal interest rate (i) depends on the real interest rate (r) and the inflation rate ( ).
i r The above equation is used to develop a nominal interest rate theory. The variations in the nominal interest rate depend on variations in the real rate, which adjusts to balance savings and investment and variations in the inflation rate, which is influenced by monetary policy. Assuming that the real interest rate is constant, the Fisher equation demonstrates that there is a proportional relationship between the inflation rate and the nominal interest rate. This relationship is called the Fisher effect. Specifically, as we do not know exactly what future inflation will be, this is a relationship between the nominal interest rate and the expected inflation rate. In practice, it is clear that interest rates go up when inflation goes up.
Bond market players are well aware of the connection between inflation and interest rates. Since bond prices move in the opposite direction to interest rates3, it is possible to achieve gains by accurately predicting how inflation, and thus interest rates, is going to move.
______3 See Link Between Bond Value and Bond Market Interest Rate at page 165.
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Risk
Definition Generally speaking, risk is the probability that a danger, financial loss or another type of unfortunate event will occur. While risk is sometimes linked to uncertainty, in some areas such as finance, a distinction is drawn between risk and uncertainty, given that risk, unlike uncertainty, can be measured.
More specifically, there exist various types of economic and financial risks:
• Foreign exchange risk: Risk of financial losses linked to currency fluctuations.
• Interest rate risk: Risk that the value of a financial asset will diminish or that liabilities will take on value following an interest rate movement.
• Purchasing power risk: Risk that an asset’s purchasing power will decrease in value because of inflation.
• Credit risk: Risk of a loss occurring when a borrower is in default.
• Financial risk: Risk that a company will not be able to meet its financial obligations.
• Sovereign risk: Risk that a state’s debts or related interest will not be paid.
• Political risk: Risk that legislative or regulatory changes will bring about a drop in investors’ anticipated rates of return.
• Reinvestment risk: Risk that an investor’s future proceeds will need to be reinvested at a lower rate because of an interest rate drop.
Portfolio risk, increasingly related to portfolio management, refers to the volatility of portfolio returns.4 This risk, moreover, is actually comprised of two distinct risks: systematic risk and specific risk. Systematic risk is due to general market fluctuations and cannot be limited by the diversification of a portfolio’s securities, while specific risk is unique to each security and can be reduced by proper portfolio diversification. ______4 See Portfolio Theory at page 153.
Risk Aversion
Definition Risk aversion is a notion explaining the behaviour of people in situations of uncertainty. It can notably push someone to prefer a less profitable but safer option over a scenario with the potential for greater returns but with a higher degree of risk. Hence, a person with an aversion to risk (dubbed risk averse) is one who dislikes risk and seeks to avoid it.
The notion of risk aversion is well exemplified by the scenario of an individual who must choose between a guaranteed amount and a lottery. Let us suppose that an individual is offered the choice between an amount of $80 and a chance to win $200. If the probability of winning $200 is 50% (which also implies a 50% chance of winning nothing), the earnings expectation is $100 (i.e., 0.5 x 0 + 0.5 x 200), which is greater than the amount the individual will obtain if he opts to forego the lottery. If he accepts the sure amount rather than the lottery, we say he has a risk aversion. He prefers to be certain of receiving $80 than to
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bet on a 50% chance of walking away with $200. Inversely, if he refused the guaranteed amount to try his luck at the lottery, we would say he is indifferent or tolerant with regard to risk (possibly even a risk lover).
Risk aversion has a number of economic and financial impacts. It notably has a significant influence on portfolio theory5. People less willing to accept risk will prefer a portfolio with a lower expected return if the associated risk is that much less. Aversion to risk also explains why people turn to insurance. They prefer to pay a set amount each year in insurance premiums than to risk having to incur the potentially high costs related to a fire, car accident, theft, etc. Extended warranties offered by retailers are also a response to individuals’ needs to avoid risk. People pay more for their goods to avoid the risk of costly breakdowns in the future. ______5 See Portfolio Theory at page 153.
Value at Risk – VaR
Definition VaR is an estimate of the maximum loss that can occur over a given period at a given confidence level. For example, a financial institution could estimate that, at a confidence level of 95%, its loss should not exceed five million dollars in one day.
Commercial banks, investment banks, insurance companies and other institutions hold asset portfolios that may include loans, bonds, equity, currencies and derivatives. They therefore need to know how much they could potentially lose in a given period.
The concept of VaR is built on the idea that fluctuations in the value of an asset or portfolio follow a probability distribution, for example, a normal6 or other distribution. Using the historical data for financial assets, it is possible to calculate a portfolio’s volatility and thus estimate its probability distribution. This figure depicts a simple example using a normal distribution in which a VaR is calculated for an equity portfolio with variance7 2 for which the average daily return is assumed to be zero. Assuming a zero average is common practice. Here, the VaR is calculated to be 5%, in other words, the maximum loss for a confidence level of 95%, or a VaR for which there is a 5% chance that the loss will be greater than this value. For a standardized normal distribution (i.e., with a zero average and variance of one), the critical value for this confidence interval is -1.645. Multiplying this coefficient by the portfolio’s standard deviation yields the critical value for the distribution associated with portfolio returns. It is a negative return for which there is a 5% chance of obtaining a result that is worse. Multiplying this return by the portfolio’s value gives the cash value of the risk. For a portfolio of $100 million and a standard deviation of 1.5%, the VaR here would be $2.47 million.
Other distribution laws can be used, particularly distributions VaR of 5% for a portfolio whose daily returns follow a normal distribution with a variance of σ2 that award a greater probability to extreme results, like the Cauchy distribution8. In comparison with the normal distribution shown above, these distributions have thicker tails (the ends of the VaR of 5% = value of the “bell” are thicker). For the same confidence interval, therefore, portfolio multiplied by -1.645σ There is 95% probability of doing the VaR estimated with these distributions is higher. Another better than the VaR. important factor that can vary from one method of calculation to another is volatility determination. In the above example, There is 5% probability of a loss volatility is assumed to be constant, but a number of approaches that is greater than this VaR ______6 See Normal Distribution at page 178. 7 See Variance and Standard Deviation at page 173. (0 - 1.645σ)% 0% 8 See L-Stable Distributions at page 178. Source: Desjardins, Economic Studies
152 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Market Finance / Portfolio Management assume a volatility that can fluctuate. Graphically, this involves adjusting the probability distribution according to the estimated variance for the given period. The quality of the results obtained using the various calculation methods suggested by the literature differ depending on the type of portfolio analyzed. For example, as stock market volatility is known to vary over time, it is important to look for the best approach based on the type of asset being analyzed.
Portfolio Theory
Definition Portfolio theory is based on the relationship between risk and return and the assumption that investors want a better return when they take more risks. Portfolio theory shows that diversifying a portfolio helps to reduce risk while retaining a sizeable return.
Risk averse9 investors simultaneously weigh return and risk in selecting investments. Since securities that provide higher returns are often more risky, investors do not systematically rush to them. It is still possible to earn an attractive return with less risk. The solution involves selecting a portfolio that includes a number of securities whose risks cancel each other out, partially or completely.
10 2 A security’s risk is measured based on its variance . To calculate a portfolio’s risk ( p ), we add the variances and covariances of all securities, considering their respective weights (w) in the portfolio. Covariance is the measure of two securities’ common variance; it is equal to the product of the standard deviations ( ) multiplied by the correlation coefficient11 ( ).
2 p wi w j ij wi w j i j ij ij ij
2 2 2 2 2 For example, the risk for a portfolio that contains only two securities (A and B) is: p wA A wB B 2wAwB A B AB. Clearly, the complexity of the math increases with the portfolio’s size. Even with just three securities, the formula is already much more complex:
2 2 2 2 2 2 2 p wA A wB B wC C 2wA wB A B AB 2wA wC A C AC 2wB wC B C BC
For portfolio risk to decline when a new security is added, that security’s correlation with the other securities must be less than 1. Calculating a portfolio’s rate of return is simpler than the risk calculation. It is the weighted average12 of the returns expected for the securities in the portfolio.
There are numerous possibilities for portfolios that provide different combinations of risk and return. In theory, all portfolio Portfolio theory – The efficient frontier choices can be plotted on a graph in which the axes represent Optimal the expected risk and return for each of the portfolios. Moreover, portfolios for any specific level of risk, it is then possible to identify the Efficient portfolio with the highest return. Portfolios that maximize return frontier for each degree of risk are efficient portfolios; they mark the Suboptimal efficient frontier. All portfolios that are located on the efficient portfolios frontier offer higher return than the other existing portfolios return Expected with an equal risk. ______9 See Risk Aversion at page 151. 10 See Variance and Standard Deviation at page 173. Risk 11 See Correlation at page 181. Source: Desjardins, Economic Studies 12 See Average at page 173.
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A priori, the efficient frontier contains investors’ portfolio selections based on the level of risk they are prepared to accept. However, assuming that a risk-free security exists means that the concept of an efficient frontier must be enhanced. Treasury securities, some government bonds and guaranteed investment certificates are deemed to be risk-free assets. It is possible to put all of one’s wealth into this type of security, but the return will be lower than it would with a diversified portfolio. Still, investors can opt for a compromise between a diversified portfolio and risk-free securities by allocating a portion of their wealth to each of these investment vehicles. Graphically, the possible allocations among a risk-free security and a risk portfolio are represented by the straight line connecting the two options. All portfolios that are located below this line offer returns that pay less for risk than do the allocation options located on the line.
On the graph, an allocation line is drawn between the risk-free security with the lower return and portfolio A. While the Portfolio theory – Optimal allocations with risk-free security
allocations located on the line are better than any of the options Portfolio A located below the line, the fact remains that more attractive options are above the line. However, there is an allocation line, Market portfolio Efficient called the market line, that connects with a portfolio called the frontier Market market portfolio for which it is impossible to identify investment line options that are better than those along the line. Mathematically, Expected return Wealth allocation line between the risk- the market line is tangent to the point associated with the market free security and portfolio A portfolio.
Risk-free security The market portfolio has the property of being the portfolio
that provides the most return for an increase in risk. The Sharpe Risk
ratio (S), defined by the equation below, measures this feature Source: Desjardins, Economic Studies of portfolios.
ER R S f
The Sharpe ratio is the ratio between the additional return expected from a portfolio and that portfolio’s risk ( ). The additional
return expected from a portfolio is the difference between the expected portfolio return (R) and the risk-free return (Rf).
All points on the market line have the same Sharpe ratio as the market portfolio. This means that an investor who is concerned about risk finds the most advantageous investments along this line. However, the portion invested in the risk-free security will depend on the total level of risk the investor wants to deal with. The remainder of the investor’s wealth must be allocated in the market portfolio to secure the best premium in terms of return for the additional risks being taken. Also, here, the rule of thumb suggests that, as people age, increasingly, they will want to have a large proportion of their assets in risk-free securities. When they are on the point of retiring, people will be less and less inclined to take risks.
Buying on Margin/Short Selling
Definition These are risky stock market transactions executed when someone anticipates a future hike or drop in stock prices. Buying on margin involves purchasing securities without paying for them immediately, while short selling consists of selling securities that are not yet in one’s possession at a predetermined date and for a set price.
Buying on margin can be advantageous if the stock market price of the securities purchased increases, as one can then sell these securities at a profit without having ever actually paid for them. Short selling can generate profits when the price of securities drops, making it possible to buy securities that were sold on a given date at a lower price than the agreed-upon selling price. Should prices fluctuate in a manner other than that expected, buying on margin and short selling are both practices that can prove very costly.
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Hedging
Definition In finance, hedging involves taking a position that is specifically designed to eliminate or reduce the risk associated with another position. Hedge transactions are done on organized futures markets or over-the-counter markets, or with specialized bodies.
The situations that can be shielded from risk exposure, and the means used for doing so, are myriad. For example, a person who owns shares in company XYZ is worried that stock prices are going to drop; he can cover himself by purchasing a put option (sale option) that, for a limited period, gives him the option of selling his shares at a price set in advance. Hedge transactions are often done in order to limit exchange rate risks. For example, an importer who is expecting a major transaction next month can cover the exchange rate risk by buying a future that provides a given exchange rate for the expected value of the transaction.
Short Position/Long Position
Definition In general, someone taking a long position wants to be a buyer of a particular security or in a particular market. Taking a short position, on the other hand, means being a seller of a security or in a market.
More specifically, the expressions “short position” and “long position” can be respectively associated with short selling and buying on margin13. In the exchange market, a long position means that an investor’s currency buys for a given date are greater than his currency sales for the same currency and date. Conversely, a “short” exchange rate position means that his currency sales exceed his purchases for the same currency and date. Finally, a short position can also refer to the position of a company whose currency debts for a given date are greater than its claims in the same currency for the same date. In this context, a long position refers to the position of a company whose currency claims for a given date are greater than its debts in the same currency for the same date. ______13 See Buying on Margin/Short Selling at page 154.
Interest Rate Position
Definition An interest rate position refers to the spread between the maturities of interest-bearing assets and liabilities, or the difference between the interest rate benchmarks for assets and liabilities.
This expression is used most frequently at financial institutions which have to manage interest-bearing assets and liabilities. In a market in which interest rates are expected to go up, it is more profitable to hold assets (loans) with short terms and liabilities (deposits) with long terms. Revenue from the interest charged on loans tends to go up, while expenses, which consist of paying interest on deposits, tend to remain constant. Conversely, in a market in which interest rates are expected to fall, it is better to hold assets with longer maturities to keep revenues high for as long as possible and hold liabilities with short maturities to reduce expenses associated with paying interest on deposits.
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What’s more, a financial institution that does not want its revenue to fluctuate in tandem with interest rates must strive to minimize the gap between asset and liability maturities. Interest rate risk is the risk that revenue will decline because of interest rate movement. Financial instruments like interest rate swaps help reduce interest rate risk.
Leverage Effect
Definition Leveraging is increasing return on investment by increasing debt. To have a leverage effect, the rate of return on the assets must be greater than the interest rate charged for financing.
For example, suppose a company has a debt/equity ratio of 1. Example: Leverage effect This means that 50% of its assets are financed from equity and the other half is financed by debt. Equity is the portion of capital that is held by the owner(s). Suppose the company has assets Before After
of $1 million, revenues of $75,000 and an interest rate on debt of Equity: $500,000 Equity: $250,000 6%. In this example, the return on assets is 7.5% ($75,000/$1 Debt: $500,000 Debt: $750,000 million), which is higher than the interest rate on the debt (6%). Revenue = $75,000 Revenue = $75,000
The company can thus benefit from the leverage effect. Now, Interest = 6% X $500,000 Interest = 6% X $750,000 suppose that the owner decides to finance the company through = $30,000 = $45,000
debt rather than use his own money, so that the debt/equity Revenue – interest = $45,000 Revenue – interest = $30,000 ratio rises to 3. As the table shows, this makes the interest expense Return on equity Return on equity go up and causes revenue net of interest to decline. However, = $45,000 / $500,000 = 9% = $30,000 / $250,000 = 12% since the share of the capital provided by the owner has fallen sharply, the return on his investment goes from 9% to 12%. Source: Desjardins, Economic Studies What’s more, the $250,000 that the owner is now not investing in the business can very well be reinvested elsewhere and provide additional income.
The leverage effect can also be applied to financial markets. It can, for example, consist of selling or buying short14. What’s more, while the leverage effect can increase the return substantially, it also increases the risk. Buying or selling short involves risks of financial losses if securities prices do not behave as expected. For a company that takes on more debt, the financial risk increases in tandem with the debt level, since interest on debt is a relatively stable expense over time and revenue can fluctuate.
The leverage effect we have been discussing to date refers specifically to the effect of financial leverage. Occasionally, the literature refers to the operating leverage effect: this is a company’s ability to increase its revenues by selling more. In practice, the operating leverage effect is greater at companies with a higher proportion of fixed costs. This has the effect of reducing their marginal production costs15 and procuring a larger marginal profit on the additional units produced. With this type of cost structure, operating leverage is thus higher than it is for companies with lower fixed costs and therefore higher marginal costs and lower marginal profits. Once again, the risks are greater for companies with a larger leverage effect, because their profitability fluctuates more with the number of units sold. If sales drop too much, the company can lose money very quickly. ______14 See Buying on Margin/Short Selling at page 154. 15 See Marginal Analysis at page 11.
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Venture Capital
Definition Venture capital is capital that is used to finance start-up companies or risky expansion projects. This capital is provided by private investors or from funds managed by institutions that specialize in venture capital.
Venture capital plays a key role in business creation and growth. Given the higher risk when starting up a company or embarking on various expansion projects, traditional financing (e.g., a loan from a financial institution) is often more difficult to secure. Venture capital is thus an important source of funding for such risky investments. Investors are also well served, for despite the risk that a good number of the initiatives funded may fail, those projects that do succeed usually represent very significant rates of return, which compensate for other losses. Moreover, some specialized venture capital institutions also offer their expertise to the businesses they finance, as a means of maximizing the odds that an initiative will succeed.
Hedge Fund
Definition Hedge funds generally deliver a greater return than traditional funds; however, it is also possible to lose more than with traditional funds. The funds make heavy use of leveraging16 to take positions in situations that are in the process of reversing and to speculate on various assets including corporate shares, bonds, currencies and commodities.
Hedge funds are less regulated than traditional funds, allowing their managers to make greater use of derivatives and leveraging. However, a strategy that is based on a leverage effect implies increased debt and, by implication, losses can be huge if the unexpected happens. Hedge funds usually do a good job of managing small risks, but not large ones, i.e., the risks associated with a small probability of losing a great deal. On September 23, 1998, Long-Term Capital Management (LTCM), a prestigious hedge fund, was saved from certain bankruptcy by the U.S. Federal Reserve. This hedge fund had taken sizeable short positions in favour of the convergence of the bond markets; in the fallout of the Russian financial crisis and Asian crisis, these positions put the fund’s survival in jeopardy and threatened to send shock waves through the international financial system.
Hedge funds can move billions of dollars from market to market very quickly. They can thus have a major influence on the daily movements of stock markets, bond markets and derivatives markets. Hedge funds are not just for any investor. In general, they are for the wealthiest investors, because the initial capital outlay is very high. Lastly, hedge funds appear attractive for diversifying portfolio risk17. The correlation between the returns on these funds and the returns on a portfolio’s securities is fairly low, helping to improve the risk/return ratio. When the economy or financial markets are changing directions, in principle, hedge funds are able to do well by taking positions that are tailored to these situations, which explains the weak correlation between their returns and the returns of other investment products. ______16 See Leverage Effect at page 156. 17 See Portfolio Theory at page 153.
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FINANCIAL MARKETS
Financial Markets
Definition Broadly, a financial market is a mechanism that makes it easy for people to trade in financial securities, commodities and other items of value at a fair price and low transaction costs.
Basically, the financial markets act as intermediaries, making it easy for those who want to buy or sell financial securities and other items to find each other. If there were no financial markets, someone who wanted to sell shares in a given company would probably have a lot more trouble finding a buyer for his shares. Also, even if he did find a buyer, that would not mean the selling price would be appropriate. Efficient financial markets, i.e., markets that contain many buyers and sellers and in which all available information is reflected in the price, make it possible to buy and sell at the best price.
Financial markets include a variety of market types:
• Capital markets: Include stock markets and bond markets on which shares and bonds are issued (primary markets) and subsequently traded among individuals (secondary markets).
• Money markets: Involve trading in short-term financial securities, i.e., highly liquid securities.
• Foreign exchange markets: Facilitate trade by enabling the investors and actors involved in international trade to trade currencies quickly.
• Derivatives markets: Provide financial instruments that are used to manage risk, such as futures, swaps and call and put options (purchase and sale options).
• Commodity markets: Facilitate trading in commodities such as oil, metals and agricultural products.
• Insurance markets (or reinsurance): Facilitate the redistribution of risk.
All in all, in addition to making it easier to trade financial securities, commodities and other items of value, among other things, financial markets help to efficiently distribute capital thanks to capital markets, decrease risks through the derivatives markets and facilitate trade via the foreign exchange markets.
Lastly, financial markets can exist as organized, regulated bodies, as is the case with many stock markets found worldwide. They can also be more informal, i.e., they can exist outside a set regulatory framework as is the case, for example, of the interbank market within which financial institutions lend each other money in order to make their daily transactions balance.
Market Efficiency Theory
Definition Market efficiency theory is a hypothesis whereby the market price reflects the expectations of all investors. If this assumption were confirmed, it would be impossible to find undervalued stock on the market or to predict market movements, for the market price of shares would already reflect all of the elements making it possible to predict and fix share price, except for pure strokes of luck.
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In practice, the market efficiency hypothesis is defined in three fashions, each of a varying degree. A market is said to have weak-form efficiency (i.e., there are the fewest restrictions) when there is no relationship between the past and future price of securities; if weak-form efficiency were to be confirmed, technical analyses1, which are based on historical relationships, would be relatively inefficient. A market is said to have semi-strong form efficiency, and is even more limiting, if public information is already incorporated into the value of securities, such that a basic analysis of public data cannot allow for determining whether securities are undervalued or overvalued. Lastly, a market is said to have strong-form efficiency if all private and public information is incorporated in securities, meaning that no individual has access to privileged information that could impact the stock prices. ______1 See Technical and Fundamental Analyses at page 161.
Stock Market Indexes
Definition A stock market index is a measure of the stock market value of several companies and serves to measure the performance of a market or stock exchange. Certain major stock market indexes reflect changes in economic activity and are used as future2 economic indicators.
The various stock market indexes are distinctly calculated and comprised of a varying numbers of companies. At times, a series of secondary indexes will be derived from a main index; these may either represent different activity sectors or a specific group of companies (example: major companies, small companies, etc.).
The main Canadian stock market index, the S&P/TSX, and the main U.S. stock market index, the S&P 500, are illustrated in the Stock market indexes graph to the right. The S&P/TSX measures the performance of Index Index the Toronto Stock Exchange and is calculated by adding the 14,000 1,600 13,000 1,500 1,400 floating supply (float) of a large number of companies. In early 12,000 1,300 3 11,000 2007, these companies numbered 276. Market capitalization 1,200 equals the price of company stock multiplied by the number of 10,000 1,100 9,000 1,000 shares in circulation for each company. The floating supply 8,000 900 800 corresponds to those shares likely to be traded on the stock 7,000 700 6,000 market on any given day and notably excludes large blocks of 600 stock held by certain shareholders for non-speculative purposes. 5,000 500 4,000 400 The S&P 500, in turn, is a stock market index based on the floating 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 stock of the 500 major companies listed on U.S. exchanges. Canadian S&P/TSX index (left) U.S. S&P 500 index (right)
Sources: Toronto Stock Exchange, Standard and Poor’s and Desjardins, Economic Studies The calculation methods for the S&P/TSX and S&P 500 indexes are thus very similar, both of them being based on the floating supply. Other indexes are based on the comprehensive stock value, with no distinction allowed for float. Lastly, some stock market indexes, like the Dow Jones in New York, are calculated on the basis of the average stock value of a sampling of companies. Index values are normally expressed in thousands or tens of thousands (1,000 or 10,000), by applying an appropriate factor to total market capitalization or a calculated average. ______2 See Economic Indicators at page 53. 3 [http://www.tsx.com/HttpController?GetPage = MDFIndicesView&SelectedTab = ConstituentCompanies&Exchange =
T&IndexID = 0000&Page = 1&SelectedIndex = 0000&OpenIndex = &Market = T&Language = en].
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 159 Market Finance / Financial Markets
Tobin’s Q
Definition Tobin’s Q is the ratio between the stock market value of capital and the capital replacement cost. Developed by James Tobin, the Nobel Prize Laureate for Economics in 1981, the theory states that companies base their investment decisions on this ratio. When the stock market value is greater than the replacement value (Q > 1), companies are favourable toward investment. Conversely, when the stock market value is lower than the replacement value (Q < 1), companies prefer to divest.
Stock market value of capital Q Replacement value of capital
A company’s stock market capital value equals its present and expected profits. When a company’s stock market value is greater than its capital replacement cost, it is in the company’s interest to invest more since the expected value of its profits is greater than the value of the new investments. On the other hand, if a company’s stock market value is less than its capital replacement cost, this means that the expected value of its profits is lower than the value of new investments, meaning it is not in the company’s interest to invest. Moreover, in this situation, it is in the company’s interest to sell a part of its assets (divest). Evolution of Tobin’s Q in the United States
Since capital’s marginal productivity usually declines, adding Tobin’s Q Tobin’s Q capital tends to reduce the value of Tobin’s Q, whereas reducing 2.00 2.00 capital tends to increase it. At equilibrium, the marginal 1.75 1.75 productivity of capital equals the marginal cost of capital, for a 1.50 1.50 Tobin’s Q that is equal to 1. 1.25 1.25
1.00 1.00
The graph shows how Tobin’s Q has evolved in the United States 0.75 0.75
since 1965. From 1974 to 1990, Tobin’s Q remained well below 0.50 0.50
1. It then shot up until the beginning of 2000, when the 0.25 0.25
speculative bubble was overestimating the stock market value 0.00 0.00 of capital. Since then, Tobin’s Q has oscillated between 0.75 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
and 1. Sources: Federal Reserve Board and Desjardins, Economic Studies
Price/Earnings Ratio
Definition The price/earnings ratio corresponds to the price of a firm’s common share divided by what that company earns per share.
For example, a company whose profits per share are $0.75 and whose common share price is $12 has a price/earnings ratio of 16 (i.e., 12/0.75). This means that the company’s stock market valuation is 16 times its profits. A low ratio may mean that the share is undervalued, while an overly high ratio may be the sign of a speculative bubble. Expectations of declining profits that translate into a decline in a share’s price may be behind a lower ratio. On the other hand, companies whose revenues are expected to increase usually have a higher price/earnings ratio. Between 1900 and 2005, the price/earnings ratio of market- listed U.S. corporations oscillated around 15, on average.
The graph on page 161 shows the price/earnings ratio of the U.S. S&P 500 stock market index. The global ratio is calculated based on a weighted average of the price/earnings ratios of the companies in the index. The weight corresponds to the size of each company’s market capitalization.
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Companies that are included in a popular stock market index U.S. S&P 500 stock market index price/earnings ratio usually have an above-average price/earnings ratio given that there is stronger demand for these securities. In fact, the Price/earnings ratio Price/earnings ratio 50 50 popularity of indexed investment funds drives demand for the 46 46 companies in those indexes up, which makes the value of their 42 42 shares go up, giving them a higher price/earnings ratio. 38 38 34 34
30 30
26 26
22 22
18 18
14 14
10 10 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Sources: Standard and Poor’s and Desjardins, Economic Studies
PRICE/EARNINGS RATIO AND THE BOND MARKET Connection between the inverted price/earnings ratio The reverse of the price/earnings ratio is the and the 10-year bond rate in the United States corporate rate of return based on market value. As In % In % 11 11 the graph shows, in the United States, this rate of 10 10 return moved on a path similar to that of the U.S. 9 9 bond market’s 10-year rate until the end of 1999. 8 8
During the tech bubble, this relationship was 7 7
disrupted by the stock market’s inflated price and 6 6
thus by a corporate rate of a return that was 5 5
unusually low. Moreover, since 2003, there has 4 4
been a constant spread between the two variables. 3 3 The Chinese savings surplus and recycling of 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 petrodollars could be responsible for a bond rate Inverted price/earnings ratio 10-year bond rate that is abnormally low compared to the corporate Sources: Standard and Poor’s, Federal Reserve and Desjardins, Economic Studies rate of return.
Technical and Fundamental Analyses
Definition Technical analysis is the analysis of the past evolution of the price of a security or index; among other things, it is based on the study of graphs and recognition of patterns that tend to repeat over time. Fundamental analysis, on the other hand, is based on the analysis of economic variables and financial data. Fundamental analysis ends in the evaluation of the companies studied and a buy or sell recommendation, depending on the results.
TECHNICAL ANALYSIS Technical analysis does not consider economic and financial data. Based on how the market itself evolves, a technical analysis tries to identify trends, cycles and various patterns that repeat over time. The graph on page 162 depicts one of the many figures that can be detected using technical analysis. At the peak of a shoulder or head, the analyst will expect a share price to decline, whereas an increase can be expected in the troughs that occur after a shoulder or head has been reached.
Technical analysis is based on some theoretical principles. Among other things, it looks at crowd psychology: a market, like a crowd, can get caught up in a dynamic of optimism (even euphoria), a dynamic of pessimism (or despair) or a phase of hesitancy.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 161 Market Finance / Financial Markets
This is reflected in a stock’s price, through periods of ascent, Technical analysis pattern: head and shoulders descent or stagnation. Crowd psychology also explains why events repeat. While an individual can learn from the past (and Fictional share price Fictional share price
keep events from repeating), a crowd, on the other hand, learns Head nothing and often acts in the same way in identical situations. This phenomenon may explain crashes and speculative bubbles.
Shoulders Shoulders FUNDAMENTAL ANALYSIS Fundamental analysis, on the other hand, is based on economic and financial data. In terms of economic data, interest rate levels and national and global growth are some of the factors that can provide clues to stock prices. Corporate financial data also helps predict prices. Data on corporate assets, earnings and sales, or management methods and the state of the market in which Source: Desjardins, Economic Studies corporations operate provides indications as to the value of companies and the direction their stock prices should take.
In short, these are two very different approaches. Fundamental analysis tries to quantify the impact that economic variables and other corporate data have on how market prices behave, while technical analysis, though it does not deny the influence that the economy’s theoretical underpinnings have on the markets, puts its focus on past price behaviour and market psychology to predict where prices will go. There is debate about the use of technical analysis, which is far from being accepted as an exact science; rather, it is an additional tool for market operators. Moreover, technical analysis contradicts the hypothesis that markets move randomly4 (i.e., the hypothesis that they are not predictable). ______4 See Market Efficiency Theory at page 158.
Calendar Effect
Definition A calendar effect is any observed stock market trend that is regularly repeated over time and which is associated with a particular day of the week, a specific month of the year, etc.
One of the best-known calendar effects is the January effect. Historically, certain stock prices tend to rise markedly during this month, in comparison to the levels recorded at the end of December. For various reasons, numerous investors wish to sell stocks at the end of the year, which has the effect of depressing stock prices below their true value. As of early January, bargain hunters attempt to purchase these undervalued stocks, causing a rapid rally in stock market values. With the January effect becoming better known over the past few years, its impact has become less marked and has shifted somewhat to the month of December.
Announcement Effect
Definition An announcement effect is an abrupt market response to the disclosure of unexpected information regarding the economy, a specific industry or a particular company.
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A central bank announcement regarding its key money rate, for Announcement effect subsequent to a surprise move example, can evoke a significant market reaction if unexpected. by the U.S. Federal Reserve on January 3, 2001 In a case in point, a surprise decision by the U.S. Federal Reserve In % In % 7.00 6.25 (Fed) on January 3, 2001 caused an abrupt market adjustment. Given the surprise nature of the 6.75 Fed’s announcement, interest rates 6.00 underwent a sharp adjustment. As indicated by the graph below, the unexpected 50-point drop 6.50 5.75 in the Fed’s central rate was followed by a quick correction of 6.25 5.50 short- and mid-term interest rates. A month later, the Fed 6.00 5.25 announced another rate drop, but because this one was expected 5.75 5.00 by the markets, few movements ensued. 5.50 5.25 4.75 On a smaller scale, announcement effects are observed when 5.00 4.50 December January Febuary economic data with results differing from those generally 2000 2001 expected are published, or whenever good or bad news regarding Fed funds rate (left) 3-month rate (right) 2-year rate (right) a company is communicated. The stock price for the company in Sources: Datastream and Desjardins, Economic Studies question then undergoes swift movements. Some announcements can rapidly influence one or more entire economic sectors.
Overshooting
Definition Overshooting is the magnification of price movements due to exaggerated expectations.
On the financial markets, securities prices can go up or down to a greater extent than needed to adjust to new market or economic conditions. A lack of perfect information is one reason for this phenomenon. As they do not have enough information, some investors jump on the bandwagon in response to rumours that circulate in the markets, which makes the prices for the securities involved go up and down. As investors become better informed, the prices return to values that are more representative of the theoretical foundations of economics and finance.
Speculative Bubble
Definition A speculative financial bubble is a sustained rise in share prices that has nothing to do with the actual state of the economy or other economic and financial indicators. Speculative bubbles are bandwagon phenomena in which rationality is abandoned in favour of “irrational exuberance”, in the words of former U.S. Federal Reserve Chairman Alan Greenspan, on December 5, 1996. During a speculative bubble, the perception of a financial asset’s potential gain is no longer connected with the potential of the underlying physical asset, but rather with the hoped-for resale value of the financial asset.
History has seen a number of speculative bubbles occur in the financial markets. The most famous is probably the one that led to the crash of 1929. At the time, a number of new inventions had come onto the market quickly, particularly the car and the radio. These industries appeared to have unlimited profit outlooks and speculation was rampant. In the 18 months before the crash, the Dow Jones index went up 77% then, on October 29, 1929, plummeted by 11.7%.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 163 Market Finance / Financial Markets
More recently, in 2000, it was the tech bubble that shook financial Speculative bubble in the tech sector, as indicated markets. Once again, many investors were speculating about by the NASDAQ the opportunities and profits to be delivered by the emergence Index Index of new technologies. A bubble is especially clear when we look 4,750 4,750 at how the NASDAQ stock market index evolved. In early 2007, 4,250 4,250 we were still well below the levels reached at the end of 1999 and 3,750 3,750 early 2000. 3,250 3,250 2,750 2,750
2,250 2,250
1,750 1,750
1,250 1,250
750 750
250 250 1991 1993 1995 1997 1999 2001 2003 2005 2007
Sources: Global Financial Data and Desjardins, Economic Studies
Panurge’s Law
Definition Panurge’s law refers to the existence of unconsidered movements of an entire market in a same direction, which can at times bring about a speculative bubble5 or a stock market panic leading to a crash.
Panurge is the name of a literary character, created by the French writer François Rabelais, who threw a sheep he had bought from a merchant out to sea. Once this first sheep was in the ocean, it took little time for the remainder of the flock to blindly follow it to a certain death. The tale of Panurge’s sheep is a critique of the stupidity of the species’ herding instinct and illustrates the danger of following a group of people without taking the time to reflect on one’s actions. The renowned tulip mania that occurred in Holland between 1633 and 1637 is a good example. The price of tulip bulbs skyrocketed in that part of the world, without any logical explanation. At the top of the bubble, a tulip bulb could be sold for an amount that was approximately 20 times what a carpenter would earn per year. In February 1637, the euphoria ended and tulip bulb prices plummeted. ______5 See Speculative Bubble at page 163.
Real Estate Bubble
Definition A real estate bubble is a market condition where prices are clearly overvalued in comparison to real estate prices suggested by an analysis of fundamental market factors. According to 2001 U.S. Nobel Prize in Economics laureate Joseph Stiglitz, a speculative bullet is a state where market prices are high only because investors believe that selling prices will be even higher in the future.
Real estate market fluctuations are mainly based on interest rates, available household income and demographics. Low mortgage rates, high income and a growing population all contribute to a growing market demand and higher real estate prices. The opposite is also true. The real estate market generally follows a 15- to 20-year cycle, also called a Kuznets cycle6. When a bubble is being created, real estate prices reach an absurd level where growth can no longer be justified by an analysis of fundamental ______6 See Business Cycles at page 47.
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Real estate bubble in Japan in the 1980s-1990s, Desjardins Affordability Index – Canadian real estate market as depicted by the land price index
Index Index Index Index 150 150 160 160
130 130 150 150
140 140 110 110 130 130 90 90 120 120 70 70 110 110
50 50 100 100
30 30 90 90 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 1989 1992 1995 1998 2001 2004 2007
Sources: Japan Real Estate Institute, Thomson and Desjardins, Economic Studies Source: Desjardins, Economic Studies factors. Such a bubble expansion phase is generally followed by a sudden, sharp drop in prices. In the least severe cases, strong price hikes can be followed by a long ‘flat’ period where prices are constantly decreasing in real terms.
Real estate bubbles are fairly common. The graph above illustrates the increase in land prices in Japan in the 1980s, followed by a constant drop lasting from the early ’90s to the mid-2000s. Recently, real estate bubbles have burst in a number of other countries. Between 2004 and 2005, the price of homes dropped, among others, in certain regions of the United Kingdom, Australia and Spain. In 2006, a period characterized by rising prices came to a sudden halt in the United States.
A series of indicators exist that make it possible to monitor the real estate market’s evolution and detect signs of imminent bubbles. Desjardins notably publishes the Desjardins Affordability Index.7 This index is the ratio between available household income and the income necessary to obtain a residential mortgage for an average-priced home (qualifying income). Qualifying income is calculated on the basis of the costs of owning a home (mortgage costs, municipal taxes and public utilities). The real estate market is considered more affordable when the available household income increases or the qualifying income decreases and vice versa. Other indexes of this type rely on median data rather than averages, comparing available revenue to real estate prices.
Still other indicators are based on the debt level incurred by a home purchase, such as the mortgage debt to income ratio or the mortgage debt to assets ratio. Increasing debt levels are obviously a sign that households are having more difficulty purchasing a home at current market prices. A last category of indicators is used to measure household interest in becoming homeowners. It includes ratios such as the number of owners vs. the number of people who rent, the rental unit occupancy rate and profitability measures for a homeowner who rents a dwelling. ______7 [http://www.desjardins.com/en/a_propos/etudes_economiques/conjoncture_quebec /indice_abordabilite/].
Link Between Bond Value and Bond Market Interest Rate
Definition Bond values adjust according to fluctuations in bond market interest rates. When interest rates increase, bond prices drop, and these conversely increase when interest rates decrease.
One way of considering this is to think of the present value8 (PV) of a bond, which corresponds to its market value. A bond is in fact a sequence of income flows spread out over time; the holder receives at each period a fixed payment called a coupon (C). For ______8 See Present Value at page 177.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 165 Market Finance / Financial Markets
the last period, he receives the last coupon and the payment of the bond’s nominal or face value (F). The face value of a bond never changes. The discount rate (r) corresponds to the bond market interest rate, which itself corresponds to the rate of return obtained on similar new bonds (same risk and term). An increase in interest rates will thus lead to a drop in the actual value of a bond and vice versa. This sensitivity to interest rates also depends on the bond’s term: the longer the term, the more sensitive to interest rate movements the bond value will be.
1 1 C C C C F (1 r) n F PV 2 3 ... n C n (1 r) (1 r) (1 r) (1 r) r (1 r)
Let us consider the example of a 10-year bond of $100 with an annual coupon of $4.25, recently purchased at the price of $100. The bond market interest at the time of purchase was thus 4.25% for this bond type.
1 1 (1 0.0425)10 $100 Bond value at the time of purchase = $4.25 10 $100 0.0425 (1 0.0425)
Shortly thereafter, if we assume an increase of ten basis points in the bond market interest rates, the resale value of the recently purchased bond will have decreased.
1 1 (1 0.0435)10 $100 Resale value of the bond = $4.25 10 $99.20 0.0435 (1 0.0435)
At $99.20, a future buyer of this bond would have a return of 4.35%, which corresponds to the new interest rate in force for the bond market. If there are no adjustments to the bond price, it will be of no interest to buyers, seeing as the rate of return would be less than the market rate.
Eurodollars
Definition Eurodollars are deposits in a given currency made at financial institutions outside of the country of the currency involved. More specifically, eurodollars are deposits in U.S dollars at banks outside of the United States. These deposits are not subject to U.S. banking regulations.
The eurodollar market was created in the 1950s, during the Cold War. At the time, the Soviet Union had enormous amounts in U.S. dollars deposited in American banks. Fearful that these would be frozen in retaliation, it moved its dollar deposits to European banks. Today, it is no longer only United States dollars that are exchanged on European markets (from where the original expression “eurodollars”), for we also see different currencies exchanged in various countries and continents (euroyen and eurosterling). Several factors have contributed to the growth of the eurodollar market, among them international trade, government financial regulations and political decisions.
Trade creates a need for deposits in various currencies by companies; for example, a British company that imports American products needs U.S. dollars, which the eurodollar market enables it to either borrow or deposit elsewhere than in the United States. Another factor favouring the eurodollar market involves financial regulations. For example, while a country can require mandatory reserves on deposits at financial institutions located within its territory, foreign institutions are outside of its control.
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Because mandatory reserves and other regulations represent additional costs to national financial institutions, those institutions located outside of the country, by virtue of being sheltered from such regulations, are more competitive and attract clients by offering, among others, a higher rate of return on currency deposits. A last factor, this one political, promotes eurodollars. As was the case for the Soviets during the Cold War, countries, organizations or individuals may wish to hold deposits in a given currency outside of the country of the currency in question. Numerous oil-exporting Arab countries notably placed important amounts in U.S. dollars outside of the United States subsequent to the oil shocks of 1973-1974 and 1979-1980.
The eurodollar market is not without its share of criticism. The primary censure involves risks of international inflation9 due to an uncontrollable increase in the money supply ensuing from eurodollars. Central banks can control their respective monetary bases10, but they cannot control the multiplication of eurodollar deposits and loans11, which promote an increase in the international money supply. ______9 See Inflation at page 57. 10 See Monetary Base at page 64. 11 See Money Creation Process at page 65.
Disintermediation
Definition Disintermediation is the movement of traditional savings accounts, with their lower rate of return, to other investment vehicles with higher returns, such as savings bonds.
To counter this phenomenon, financial institutions must provide higher returns on the deposits of savers, yet this implies that they consequently need to charge higher interest rates to borrowers. Disintermediation is not as much of a concern as it once was, specifically in light of the deregulation of the banking system.
Chaos Theory
Definition According to chaos theory, a system of deterministic equations (that do not contain any random factors) may not lead to deterministic predictions, regardless of how precisely the equation system’s initial conditions are measured. In other words, indeterminacy is introduced into deterministic systems.
This observation specifically applies to non-linear equation systems. The slightest change in the equation systems’ initial conditions (system parameters, value of system variables, etc.) leads to results that can diverge sharply (chaotic paths). Moreover, in economics and finance, it is usually hard to pinpoint a system’s initial conditions. The sensitivity to initial conditions combined with a problem in identifying them makes it impossible to make predictions based on this type of model. Note that chaotic evolution can be seen even in very simple non-linear systems.
In economics and finance, chaos theory is used in the study of statistical series where we want to show that it is impossible to detect cycles, regardless of how complex they are, as is the case with stock market series.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 167 Market Finance / Financial Markets
Internal Rate of Return – IRR
Definition The IRR is used to determine the viability of investment plans and corresponds to the discount rate that is used to make net present value equal zero12 (i.e., discounted revenues less discounted costs = 0).
If the IRR is greater than the cost of financing the project Example: Calculating the IRR and NPV (financing interest rate), the project is viable. The IRR can also to compare a short project with a long project be compared to the rate of return an investor would get if he
opted to put his money into savings vehicles like bonds or Project 1: Project 2: securities. However, calculating the IRR can be complicated for Initial cost: $5 million Initial cost: $5 million
projects whose costs and revenues are spread over several Revenue: $8 million the next year Revenue: $0.8 million a year forever
periods, as the solution to the calculation involves the roots of Discount rate: 8% Discount rate: 8%
a polynomial whose degree corresponds to the number of periods NPV = - 5 + 8 / (1.08) NPV = -5 + 0.8 / 0.08 discounted. Today’s computing tools do make these calculations = $2.407 million = $5 million easier. Depending on the circumstances, the IRR solution may IRR = r: IRR = r: NPV = 0 = - 5 + 8 / (1 + r) NPV = 0 = -5 + 0,8 / r not be unique, making it harder to interpret. r = 60% r = 16%
The IRR is sometimes used as the criterion for deciding on a project. Where a business person is hesitating among several Source: Desjardins, Economic Studies projects, he may opt to choose the one with the highest IRR. As a decision-making criterion, however, the IRR is not considered Example: Calculating the IRR and NPV to be as powerful as net present value (NPV) and may lead to to compare a small project with a big project less than optimal results. Compared with NPV, the IRR privileges
short projects with greater revenues in the short term and Small project: Big project: penalizes large-scale projects. Initial cost: $10 million Initial cost: $100 million
Revenue: $1 million per year forever Revenue: $9 million per year forever
Here are two examples of how IRR causes us to choose a project Discount rate: 8% Discount rate: 8%
that is less attractive, economically speaking. The first example NPV = -10 + 1 / 0.08 NPV = -100 + 9 / 0.08 compares two $5-million projects. In project 1, all of the revenues = $2.5 million = $12.5 million are earned the next year, whereas project 2 generates annual IRR = r: IRR = r: NPV = 0 = -10 + 1 / r NPV = 0 = -100 + 9 / r revenues forever. The NPV calculated for project 2 is twice as r = 10% r = 9% much as the NPV for project 1, but its IRR is almost four times smaller than project 1’s. The second example compares the set- up of a $10-million project with the set-up of a $100-million project. Source: Desjardins, Economic Studies The two projects provide perpetual annual revenues of $1 and $9 million respectively; the NPV calculation shows greater net economic benefits for the larger project, while the IRR is higher with the smaller project. In fact, the small project would be a more attractive proposition only if it could be repeated several times, which is impossible in the case of mutually exclusive projects like a dam or road. At a single location, it is possible to build either a big road or a small road; it is not possible to build ten small roads that will deliver more benefits than one big road. ______12 See Present Value at page 177.
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Additional references:
PORTFOLIO MANAGEMENT Hedge Fund Return John Downes and Jordan Elliot Goodman. 2003, p. 469-470. John Downes and Jordan Elliot Goodman. 2003, p. 960-962. Olivier Coispeau. 1999, p. 201. Graham Bannock et al. 1998, p. 438. Michel Fleuriet. 2003, p. 255-259. Josette and Max Peyrard. 2001, p. 216. Bancware Erisk. [http://www.erisk.com/Learning/CaseStudies/ Yves Bernard and Jean-Claude Colli. 1996, p. 1197-1198. Long-TermCapitalManagemen.asp].
Yield Curve John Downes and Jordan Elliot Goodman. 2003, p. 961. FINANCIAL MARKETS Douglas Greenwald. 1984, p. 170-172. Financial Markets Wikipedia. [http://en.wikipedia.org/wiki/Yield_curve]. John Downes and Jordan Elliot Goodman. 2003, p 260, 415, 588-589 and 844. Nominal and Real Interest Rate Josette and Max Peyrard. 2001, p. 158-163. Gregory N. Mankiw. 2003, p. 109-112. Wikipedia. [http://en.wikipedia.org/wiki/Financial_market].
Risk Market Efficiency Theory Olivier Coispeau. 1999, p. 372-373. Josette and Max Peyrard. 2001, p. 101 and 246. Josette and Max Peyrard. 2001, p. 221-223. Wikipedia. [http://en.wikipedia.org/wiki/Efficient_market_hypothesis]. Carl Schweser and Andrew Temte. 2002, p. 230-236. Stock Market Indexes Risk Aversion John Downes and Jordan Elliot Goodman. 2003, p. 426 Graham Bannock et al. 1998, p. 364. and 837-843. Josette and Max Peyrard. 2001, p. 22. TSX Group. 2006, p. 10-11 and 21-22. Hal R. Varian. 2000, p. 237-239. Olivier Coispeau. 1999, p. 238. Wikipedia. [http://en.wikipedia.org/wiki/stock_index]. Value at Risk Gregory P. Hopper. 1996. [www.phil.frb.org/files/br/brja96gh.html]. Tobin’s Q The University of Chicago Graduate School of Business et al. 1998, Gregory N. Mankiw. 2003, p. 559-560. p. 272-281. Graham Bannock et al. 1998, p. 342. [http://www.economist.com/research/Economics/]. Price/Earnings Ratio Portfolio Theory Douglas Greenwald. 1984, p. 961-963. Douglas Greenwald. 1984, p. 1066-1070. Graham Bannock et al. 1998, p. 326-327. Wikipedia. [http://en.wikipedia.org/wiki/Modern_portfolio_theory]. Wikipedia. [http://en.wikipedia.org/wiki/PE_ratio]. Wikipedia. [http://en.wikipedia.org/wiki/Sharpe_ratio]. Carl Schweser and Andrew Temte. 2002, p. 190-194 and 208-236. Technical and Fundamental Analyses Josette and Max Peyrard. 2001, p. 126, 183 and 247. Olivier Coispeau. 1999, p. 43-44. John Downes and Jordan Elliot Goodman. 2003, p. 440, 467-468 Buying on Margin/Short Selling and 887. Josette and Max Peyrard. 2001, p. 3 and 260. Wikipedia. [http://en.wikipedia.org/wiki/Technical_analysis].
Hedging Calendar Effect Josette and Max Peyrard. 2001, p. 75-76. John Downes and Jordan Elliot Goodman. 2003, p. 252, 466 John Downes and Jordan Elliot Goodman. 2003, p. 468-469. and 523. Wikipedia. [http://en.wikipedia.org/wiki/Hedge_(finance)]. Wikipedia. [http://en.wikipedia.org/wiki/Calendar_effect].
Short Position/Long Position Announcement Effect Olivier Coispeau. 1999, p. 138, 262 and 336-337. Josette and Max Peyrard. 2001, p. 100 and 228. John Downes and Jordan Elliot Goodman. 2003, p. 557 and 806. Olivier Coispeau. 1999, p. 178. Josette and Max Peyrard. 2001, p. 200. Thomas P. Fitch. 2000, p. 20.
Interest Rate Position Overshooting Thomas P. Fitch. 2000, p. 241-243 and 291. Josette and Max Peyrard. 2001, p. 235. Josette and Max Peyrard. 2001, p. 200. Economist.com. [http://www.economist.com/research/Economics/].
Leverage Effect Speculative Bubble Josette and Max Peyrard. 2001, p. 100-101. Desjardins, Economic Studies. Special report on financial crises, John Downes and Jordan Elliot Goodman. 2003, p. 542-543. September 2001, 47 pages. Olivier Coispeau. 1999, p. 86-87. Venture Capital Graham Bannock et al. 1998, p. 365. Panurge’s Law John Downes and Jordan Elliot Goodman. 2003, p. 936-937. Olivier Coispeau. 1999, p. 262. Wikipedia. [http://en.wikipedia.org/wiki/Venture_capital]. Wikipedia. [http://en.wikipedia.org/wiki/Mouton_de_Panurge]. Mike Dash. 1999, 297 pages.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 169 Market Finance
Real Estate Bubble [http://www.histo-immo.info/bulle-immobiliere/definition.php]. Wikipedia. [http://en.wikipedia.org/wiki/Housing_bubble]. Jean-Michel Pouré. [http://www.bulle-immobiliere.org/].
Link Between Bond Value and Bond Market Interest Rate Hal R. Varian. 2000, p. 208-210. Claude-Danièle Echaudemaison. 2003, p. 173. The Canadian Securities Institute. 1998, chapter 5, p. 30-35.
Eurodollars Paul R. Krugman. 2001, p. 729-739. Douglas Greenwald. 1984, p. 582-585. Olivier Coispeau. 1999, p. 186. Wikipedia. [http://en.wikipedia.org/wiki/Eurodollar].
Disintermediation John Downes and Jordan Elliot Goodman. 2003, p. 346.
Chaos Theory Graham Bannock et al. 1998, p. 57. Bernard Guerrien. 2002, p. 56-58.
Internal Rate of Return Bernard Guerrien. 2002, p. 511. Graham Bannock et al. 1998, p. 214. Peter G. C. Townley. 1998, p. 40-43.
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PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 171 172 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Statistical Concepts / Descriptive Statistics
DESCRIPTIVE STATISTICS
Average
Definition The average is commonly defined as the sum of a variable’s values divided by the number of observations of the variable. This type of average is also called the arithmetic mean. There are other types of averages: weighted mean, geometric mean, harmonic mean and quadratic mean.
x The arithmetic mean ( ) of a given variable “x” made up of “n” observations of the value xi is equal to the following expression:
1 n x xi where is the sum symbol. n i1
A simple arithmetic mean assumes that each instance is of equal weight. In various situations, each instance of xi can be assigned a different weight: this is a weighted mean. Based on the expression for the arithmetic mean, we can write the expression for the following weighted mean ( xw ), in which fi is the weight of value xi.
n f i xi i1 xw n f i i1
Other types of means exist, including the harmonic mean ( x H ), geometric mean ( xG ) and quadratic mean ( xQ ).
1 n n 1 f x 2 f i xi i i i1 n i1 f x x H n i Q n i 1 f1i f 2 f3 f n xG x1 x2 x3 ...xn f f i i i1 i1
Among other things, the harmonic mean is used to calculate an average of ratios. The geometric mean can, for its part, be used to calculate an average of rates of return while, lastly, the quadratic mean is primarily used to calculate standard deviation1 (also sometimes called root-mean-square deviation). ______1 See Variance and Standard Deviation at page 173.
Variance and Standard Deviation
Definition Variance is a measure of the dispersion of a variable’s values around its mean. The more a variable’s values are dispersed around its mean, the greater its variance. The square root of variance is called “standard deviation”.
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The variance V(x) of a given variable “x” is calculated as follows:
N 2 (xi x) i1 x V , where N is the number of observations and is the average of the xi. (x) N
The symbol 2 may be used to designate a variable’s variance, while refers to its standard deviation. More specifically, the standard deviation of a given variable “x” is calculated as follows:
N 2 (xi x) i1 V x N ( x)
Trend
Definition A trend is a long-lasting movement that influences how a phenomenon evolves that can be identified independent of the phenomenon’s seasonal, cyclical or irregular fluctuations.
Let’s use Canada’s real GDP2 to illustrate the concept of a trend. A country’s output can, in the short term, increase, stagnate or decrease. These variations can be caused by random, seasonal, cyclical or other kinds of factors. However, overall, we can see that, over a long period, real GDP tends to increase from year to year.
A trend can take on different forms: it can be a constantly ascending curve, constantly declining curve or constantly stagnant curve. A trend can be linear or non-linear. A linear trend can be easily estimated using a linear line; this is not true for non- linear trends. To estimate the latter, we can use non-linear functional forms (e.g., logarithmic forms, exponential forms and second-degree polynomial forms and higher), but we can also use smoothing techniques that estimate a series’ trend component.
A popular method for smoothing series is to use the Hodrick- Canada’s real GDP and trend real GDP Prescott filter (HP filter). The HP filter strives to calculate the smoothed series “s” of a series “y” by minimizing the variance of In billions of CAN$ In billions of CAN$ 1,400 1,400 “y” around “s” and by limiting the acceleration by “s” (e.g., the 1,300 1,300 double difference of variable “s”). Parameter measures the 1,200 1,200 1,100 1,100 weight given to the second constraint. The larger is, the more 1,000 1,000 900 900 the smoothed series “s” will look like a straight line. Usually, the 800 800 recommendation is to take = 100 for annual data, 1,600 for 700 700 600 600 quarterly data and 14,400 for monthly data. 500 500 400 400 300 300 T T 1 200 200 2 2 (yt st ) ((st 1 st ) (st st1 )) 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 thp = t1 t2 Real GDP Trend GDP (HP filter) The graph shows Canada’s real GDP and its long-term trend Sources: Statistics Canada and Desjardins, Economic Studies estimated using an HP filter. ______2 See Gross Domestic Product at page 30.
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Seasonality
Definition Several economic series contain seasonality. Seasonality involves regular, periodic movements that recur at the same time year after year.
Canadian retail sales illustrate the phenomenon of seasonality Total value of Canadian retail sales well. When we analyze this series, it is clear that sales tend to be stronger in December (holiday season sales) and weaker in In billions of CAN$ In billions of CAN$ 40.0 40.0 January and February. 37.5 37.5 35.0 35.0 It is frequently useful to remove seasonal fluctuations to get a 32.5 32.5 30.0 30.0 better view of how the series looks. There are several ways to 27.5 27.5 seasonally adjust the data series. The moving average method 25.0 25.0 is one of them. For each observation, this involves calculating 22.5 22.5 an average based on that observation and prior and future 20.0 20.0 17.5 17.5 observations. The order of the moving average affects the 15.0 15.0 number of past and future observed values to be included in the 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 calculation. For example, a third order moving average involves Non-seasonally adjusted series Seasonally adjusted series calculating the mean of the values n-1, n and n+1 for all observed Sources: Statistics Canada and Desjardins, Economic Studies “n” values in the sample.
The simple moving average method isolates a series’ trend-cycle component by removing the seasonal component as well as the “irregular” or residual component of a series. More complex methods are available for removing on the series’ seasonal component. The X-11 and X-12 methods developed by the U.S. Census Bureau pick up the idea of seasonal adjustment using the moving average method. Once the irregular-seasonal component has been isolated, these approaches use other moving averages to isolate the seasonal component. The seasonal weights obtained are normalized so that their total over a full year is approximately zero. Once these steps have provided an estimation of a first seasonally adjusted series, the process is repeated with other types of moving averages. This filters a series’ seasonal fluctuation out even further. Also, these methods contain tools for detecting outliers (erratic values) as well as handling fluctuations associated with the number of business days, at Easter, for example. Moving averages respond poorly to the presence of outliers, so processing for them improves the quality of the seasonally adjusted series.
The X-11 and X-12 approaches differ by how the latest values in a series are processed. The use of moving averages delays the last useable observation. For example, with a series that ends in December 2006, a moving average of order 12 could only be computed until June 2006. To deal with this issue, the X-11 method uses seasonal variations in prior years, giving greater weight to the fluctuations of the most recent years. The X-12 approach generates the missing values using a regression model that is estimated automatically based on the dynamic of the series that is to be adjusted. This method is similar to the X-11-ARIMA method that Statistics Canada has been using since the ‘80s. Using the estimated values, it is possible to calculate moving averages up to the final data point observed.
It is important to be cautious in processing seasonality because, although the phenomenon appears to repeat continually in the same way, some changes can be noted over a long period. For example, technological innovations and climate changes allow contractors to build more and more homes during the winter than they could previously, which decreases seasonal fluctuation in the construction industry. Another example we can point to is the growing vogue for giving gift cards at Christmas. For several years now, a proportion of pre-Christmas sales have been postponed until after the holidays, when gift card recipients use their cards.
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Absolute and Relative Variation
Definition Simply, a variation can be defined as a measure of the change in a variable between two dates. Variation is sometimes said to be absolute when the measure is just the difference in a variable’s value between two periods; the variation is said to be relative if the difference is divided based on the value noted prior to the change.
In practice, these expressions are not used very often. Depending on the situation, the word “variation” can refer to either a relative variation or an absolute variation: a variation of $100 million (absolute), a 5% variation in national income (relative), etc. Other terms can be used as well. Annual variation refers to the rate of growth for a variable’s value at a given date and its value on the same date the year before, for example, the annual change in the price of oil between June 1, 2006 and June 1, 2007. The monthly variation refers to a variable’s rate of growth between two consecutive months, while quarterly variation refers to a variable’s growth rate between two consecutive quarters. Finally, an absolute variation between two values that are expressed as percentages, such as interest rates and economic growth, is called a percentage point change.
Annualizing
Definition Annualizing involves converting a datum or variation that covers a period of less than one year into a datum or variation that covers a full year.
Different kinds of data can be annualized. For example, a weekly salary is converted to an annual salary by multiplying by 52, the number of weeks in the year. For some data, we need to take seasonal adjustment3 into account. For example, we cannot simply annualize July’s non-seasonaly adjusted ice cream sales by multiplying by 12: July’s tend to be much higher than sales in other months.
Yield rates and growth rates are often annualized. A monthly growth rate of 1% can quickly be annualized by multiplying by 12, the number of months, giving an annualized rate of 12%. However, if we want to take the cumulative effects of growth (or compounding of yields) into account, it is better to use the following annualization formula:
n rannualized = (1 + rperiod) – 1
where n is the number of periods per year. With this formula, a monthly growth rate of 1% is equal to an annualized growth rate of 12.68% (calculation: (1 + 0.01)12 – 1). In a second example, a quarterly growth rate of 3% is equal to an annualized growth rate of 12.55% (calculation: (1 + 0.03)4 – 1). ______3 See Seasonality at page 175.
Nominal and Real Value
Definition A variable is said to be expressed as a nominal value when it is not adjusted for inflation4. On the other hand, we say that a variable is expressed as a real value (in real terms) when it is adjusted for inflation.
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For monetary values, “current dollars” is a synonym for Canada’s nominal GDP and real GDP “nominal value”, and “constant dollars” is a synonym for “real value”. The graph depicts Canada’s GDP5 in current dollars and In billions of CAN$ In billions of CAN$ 1,500 1,500 constant dollars. Specifically, the real GDP values are expressed 1,400 1,400 as 2002 constant dollars. Real GDP thus helps to better monitor 1,300 1,300 1,200 1,200 growth in output volume. We can observe the growth in nominal 1,100 1,100 1,000 1,000 GDP as well, but its monetary value is magnified by the impact of 900 900 inflation. 800 800 700 700 600 600 The concepts of real value and nominal value apply to several 500 500 400 400 economic variables: nominal wages vs. real wages, nominal 300 300 interest rate vs. real interest rate6, nominal house prices vs. real 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 house prices, nominal exchange rate vs. real exchange rate7, Nominal GDP Real GDP ($ in 2002) etc. The idea is the same in all of these cases, i.e., in real terms, Sources: Statistics Canada and Desjardins, Economic Studies we neutralize (or remove) the effect of inflation. ______4 See Inflation at page 57. 5 See Gross Domestic Product at page 30. 6 See Nominal and Real Interest Rate at page 150. 7 See Nominal and Real Exchange Rate at page 97.
Present Value
Definition The present value of a future value is the future value that is adjusted using a discount rate that takes into account loss of value over time. People are generally inclined to take a smaller amount now rather than a bigger amount later. The present value is therefore always smaller than the future value. As the discount rate increases, the present value decreases.
Present value is used in a variety of circumstances. Governments and companies can use it to calculate the present value of the costs and benefits associated with a planned investment.8
The following mathematical formula can be used to calculate the present value (PV) of a future value (FV) based on a discount rate (r) applied to each period; “n” represents the number of periods separating the present value from the future value. For example, an amount of $1,000 ten years in the future discounted at a rate of 10% is currently worth $386. 1 1 PVFV n FV Example: 386 1000 (1 r) (1 0.1)10
The following formula is used to discount a recurring future value (RFV), i.e., an amount that is received every period. The present value thus corresponds to the discounted total of all these amounts. For example, the present value of an amount of $40,000 collected every year for thirty years is $496,362 when it is discounted at an annual rate of 7%.
n (1 r) 1 (1 0.07)30 1 PVRFV n RFV Example: 496 362 40 000 r(1 r) 30 0.07(1 0.07) ______8 See Cost-Benefit Analysis at page 128.
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Also, when the recurrent value is collected for an undetermined period, we are calculating the present value of a perpetual annuity.
1 1 PVRFV , n RFV Example: 571 429 40 000 r 0.07 In practice we could also have to calculate net present value (NPV). This means, for a given project, calculating the discounted total profits minus the discounted total costs.
Normal Distribution
Definition Normal distribution is a probability distribution. A probability distribution shows the distribution of the frequency at which the results of a random phenomenon occur. Normal distribution is frequently used, because the probability of occurrence of many random phenomena presents a distribution that is close to normal distribution.
The most well-known example of normal distribution is a Probability density function of a standard normal distribution distribution centred on 0 with a variance9 that is equal to 1; this is called “standard normal distribution”. Graphically, its f(z) 0.4 probability density function looks like a symmetrical bell that is centred on 0. 0.3
The algebraic expression for the probability density function 2 0.2 of a standard normal distribution f(z) is: f (z) (2 ) 1/ 2 e (1/ 2)z .
The total area below the function’s curve (shaded section) is 0.1 equal to 1. This is a characteristic that is common to all
probability laws (the sum of the probabilities must be equal 0.0 to 1). -4 -3 -2 -1 0 1 2 3 4 Z ______Source: Desjardins, Economic Studies 9 See Variance and Standard Deviation at page 173.
L-Stable Distributions
Definition L-stable distributions, also called -stable distributions, are “stable” distributions that can be used to illustrate random variables whose extreme events are more prevalent or random variables with asymmetrical distributions, as is often the case with financial variables. These distributions have also been called “Pareto-Lévy distributions” and “Pareto-stable distributions”.
A probability distribution with a cumulative distribution function F(x) is said to be stable if for any n there are constants an and
bn which make the following equality of distribution hold true:
d an X 1 X 2 ... X n bn X
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In this equality, X, X1, X2, …, Xn are identically independently distributed according to distribution function F(x). Assuming that random variable X corresponds to financial returns, we could say, taking into account location parameters and scale parameters an and bn, that the sum of daily returns follows a distribution that is equivalent to the monthly or annual returns.
The following equation is a characteristic equation of L-stable distributions, which is in fact the equivalent of a probability density function. The literature mentions other formulations for the characteristic equation of L-stable distributions.
exp t 1 isign(t) tan it, if 1 itx 2 e dF(x) 2 exp t 1 i sign(t) ln t it , if 1
This equation is not very useful analytically. It is not possible to calculate a stable distribution based on this type of equation; however, remember that a stable distribution’s density function is determined by four parameters:
• : Is used to determine the thickness of the distribution’s tails (the weight given to extreme events), also called kurtosis, and 0 < 2. • : Is used to determine the distribution’s symmetry, also called skewness; the distribution is symmetrical around μ if = 0, completely asymmetrical to the left if = -1 and completely asymmetrical to the right if = 1. • : Is used to determine the distribution’s scale. • μ : Is used to determine the distribution’s location.
The parameter is also called the stability index. When random variables are added following the same stable distribution, the resulting random variable retains the same parameter.
It is still possible to isolate three specific analytical patterns based on the characteristic equation shown above and thus directly estimate three stable distribution probability density functions. To estimate other stable distributions than those estimated by these three specific cases, more complex computerized methods must be used.
Where = 2 and = 0, we get a standard normal distribution10 density function. Normal distribution is thus a specific case of L-stable distributions.
( x)2 1 2 f , (x) e 2
Where = 1 and = 0, we get the Cauchy distribution density function, which has thicker tails than standard distribution does.
2 1 1 x f (x) 1 u,
Where = 0.5 and = 1, we get a Lévy distribution density function. This density function has the feature of being focused to the right of μ , given that the parameter = 1 shows complete asymmetry to the right.
1 2 1 2(x) f u, (x) e , x 2 x 3 2
______10 See Normal Distribution at page 178.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 179 Statistical Concepts / Descriptive Statistics
In principle, a fourth specific analytical pattern could be added, Probability density functions for normal, the Lévy inverse distribution for which = -1. Cauchy and Lévy distributions f (x) f (x) 0.5 0.5 The graph shows the probability density functions for normal, Normal Cauchy Cauchy and Lévy distributions. These are all stable distributions, 0.4 Lévy 0.4 so the sum of normally distributed variables yields a normally distributed variable, and so on. Stable distributions are very 0.3 0.3
useful in economics and finance when adding returns, for 0.2 0.2 example. Normal distribution is frequently used in theoretical and applied works, but there is also interest in other stable 0.1 0.1 distributions, particularly for describing random variables whose 0.0 0.0 extreme events are more prevalent or more asymmetrical than -5 -4 -3 -2 -1 0 1 2 3 4 5 normal distribution suggests. Take the distribution of stock X market returns for example: crashes or severe corrections are Source: Desjardins, Economic Studies better illustrated by asymmetrical distributions and distributions with thicker tails. For example, the following graph shows the Cauchy distribution which, with its thicker tails, gives more weight to extreme events. The Lévy distribution, for its part, is an example of an asymmetrical distribution. In practice, to model the randomness of financial variables, it is possible to estimate a multitude of stable distributions by changing the thickness of the tails and the degree of asymmetry.
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ECONOMETRICS
Correlation
Definition Correlation is the degree of similarity between one variable’s variations and another’s. In some cases, the similarity can be quantified by a linear correlation coefficient.
The linear correlation coefficient rx,y calculated for variables x and y is the covariance of the two variables divided by their respective standard deviations1.
n (x x)(y y) Cov(x, y) i i r i1 x, y n n x y 2 2 (xi x) (yi y) i1 i1
The correlation coefficient can have a value of -1 to 1. The closer the coefficient is to -1 or 1, the stronger the correlation is. If the correlation coefficient is positive, we say there is a positive correlation between the two variables. In other words, the variables are moving in the same direction. If, on the contrary, the correlation coefficient is negative, we say there is a negative correlation between the two variables. In other words, when one variable moves in one direction, the other variable moves in the opposite direction.
The correlation may be linear or non-linear. A linear correlation is when all of the points for the values of x and y appear to be aligned on a line; a non-linear correlation is when the points for the values of x and y appear to be aligned along some type of curve. It is not possible to use a linear correlation coefficient to measure a non-linear correlation.
Example: Positive non-linear correlation Example: Negative linear correlation Y values Y values Y
X values X values
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
Note that having a correlation between two variables does not mean there is a causal relationship between them. Two variables can seem to be strongly correlated without having a real connection to each other. Two variables can trend in the same direction without being dependent on each other. ______1 See Variance and Standard Deviation at page 173.
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Linear Regression
Definition A linear regression is an estimation of a linear equation that combines a dependent variable with one or more independent variables (explanatory variables) whose coefficients are usually estimated using the ordinary least squares method.
A linear regression is said to be “simple” when only one explanatory variable is involved. A simple regression between two variables x and y, where x is an independent variable and y is the variable to be explained (the dependent variable), is written y x , where is a constant, is the coefficient associated with x and ε is a random error term. If x and y are time
series, then the simple regression equation is written yt xt t , where “t” indicates time. According to this expression, at time “t”, variable y would be equal to a constant plus x at time “t” plus an error term (ε ).
To estimate the coefficients of a simple linear regression using the ordinary least squares (OLS) method, we must find the values of and that minimize the error sum of squares, also known as the sum of squared residuals (SSR).
n n 2 2 Min SSR Min t Min (yt xt ) t11t n 2 2 2 Min(yt 2yt 2xt yt 2xt (xt ) ) t1
n n n SSR 2 xt yt xt xt 0 t1 t1 t1 SSR n n yt n xt 0 t1 t1
By manipulating the first-order conditions of the minimization problem, we find the equations for estimating the simple linear regression’s coefficients and .
Simple linear regression between the savings rate and interest rate n xt yt nxy t1 , y x 24 n 22 2 2 xt nx 20 t1 18 16 see footnote no. 2 14 12 10 It is easy to illustrate a regression with a single independent 8 variable using a graph. This graph shows the result obtained 6 4 when we try to explain Canada’s savings rate based on a constant 2 Savings rate = 0.53 + 1.22 X (interest rate) Savings rate (In % of disposable income) % (In of disposable Savings rate and the interest rate using a linear regression. 0 1 3 5 7 9 11 13 15 17 19 Interest rate (1-year Treasury bills)
Usually, linear regression models contain more than one Sources: Statistics Canada and Desjardins, Economic Studies independent variable. The coefficients of a linear regression with several independent variables can also be estimated using ordinary least squares. Because there are more variables, the algebraic calculations used to isolate the values of the coefficients are riskier. It is best to use matrix algebra to estimate the vector of coefficients. ______2 y and x are the arithmetic means of x and y.
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Let Y X be a linear regression equation where Y is a vector that contains n observations of the dependent variable (variable to be explained), X is a matrix that contains n observations of k independent variables, is a vector of k coefficients ˆ and ε is a vector of n error terms. Using the OLS method, we find the estimator OLS which minimizes the sum of squared residuals.
n 2 T T T T T T T Min SSR Min t Min Min (Y X ) (Y X ) Min Y Y 2 X Y X X t1
SSR 2X T Y 2X T Xˆ 0 OLS
ˆ T 1 T OLS (X X ) X Y
If there is perfect collinearity3 between two variables, the matrix (XTX) cannot be inverted, and it is impossible to estimate the coefficients.
In general, linear regressions estimated using OLS with large samples are limited by the following hypotheses:
• The dependent variable’s relationship with the independent variables must be linear. • Matrix X of the independent variables must be of full rank (i.e., the number of linearly independent columns must be equal to the number of columns in the matrix). • X variables must be exogenous4. The processes that determine the values of X variables must be external to the model.5 • The error term must not be correlated with independent variables. • The error term must not be auto-correlated6 or heteroscedastic7. • The error term must have a zero mean and finite variance and must be independently, identically distributed.
If any of these hypotheses are not fulfilled, this can bias the results or prevent estimation of the equation. The literature on econometrics suggests a number of tests for verifying these hypotheses; where some hypotheses are violated, there are ways to estimate models that ensure valid results. ______3 See Multicollinearity at page 186. 4 See Exogenous and Endogenous Variables at page 184. 5 See Endogeneity at page 186. 6 See Auto-correlation at page 185. 7 See Heteroscedasticity at page 185.
Coefficient of Determination
Definition The coefficient of determination, also called R-squared (R2), is a measure of the correspondence between a dependent variable and one or more independent variables. The coefficient’s value can range between 0 and 1: 0 means there is no correspondence, and 1 means there is perfect correspondence.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 183 Statistical Concepts / Econometrics
In general, the coefficient of determination R2 can be calculated in two ways. On one hand, it can be obtained from the ratio of the explained sum of squares (ESS) to the total sum of squares (TSS); on the other, it can be obtained by calculating 1 minus the ratio of the sum of squared residuals (SSR) over the total sum of squares.
n n (yˆ y) 2 ESS i SSR i 1) R 2 i1 2) R 2 1 1 i1 n n TSS 2 TSS 2 (yi y) (yi y) i1 i1
Here, “ yˆ ” corresponds to the variable y estimated by a linear regression8 model, and ε corresponds to the residual of the same regression. The closer the values estimated by a regression model are to the true values in the series to be explained, or the lower the sum of squared residuals is, the higher R2 will be. ______8 See Linear Regression at page 182.
Exogenous and Endogenous Variables
Definition An econometrician would describe a variable as exogenous if its values are not determined by his econometric model; a variable would be endogenous if its values are induced by his model.
In economics, a broader definition that differentiates between the two types of variables involves describing exogenous variables as variables whose values are determined outside of the economy (outside of its workings), whereas endogenous variables are variables whose values depend on the economy’s internal workings. For example, variations in weather are exogenous, while variations in consumption are often caused by income fluctuations and are thus endogenous.
The term “exogenous variable” is sometimes used instead of “explanatory variable” and “independent variable”, while the term “endogenous variable” substitutes for the expressions “variable to explain” and “dependent variable”. However, in theory, an explanatory variable is not necessarily exogenous, because, in some types of models, endogenous variables can be explanatory.
Dummy Variable
Definition A dummy variable is a variable that takes the values 0 or 1 depending on a very specific characteristic. In the literature and in practice, it can be called an indicator or binary variable.
For example, an econometric model may require a variable indicating people’s genders to be used, i.e., 1 = male and 0 = female. A dummy variable can also be used to take a structural change into account. The typical case is an analysis that is done over a period that includes a war, in which 1 = wartime and 0 = period of peace. A binary variable can also be used to remove the effect of an observation. The variable would then take the value “1” for the observation and “0” for the others.
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Auto-Correlation
Definition Auto-correlation does not refer to the correlation between two variables but rather to the correlation between successive values for a single variable. In econometrics, the concept of auto-correlation is primarily used to describe a situation in which the serial values of a regression’s error term (residual) are correlated with each other. This type of situation compromises the hypothesis that a regression’s error term is random9.
Error auto-correlation can be noted for a variety of reasons, such as:
• Lack of an important explanatory variable whose residual explanation would make the error term random • Model misspecification, i.e., the relations between the variable to explain and explanatory variables are not linear and expressed in a form other than the estimated model (logarithms, first differences, etc.) • Smoothing using a moving average or interpolation of data creating artificial auto-correlation among the errors due to the use of these two operators.
Auto-correlation can be detected visually, but it is best to use the statistical tests developed for detecting it. Graphically, if we look at the residual of a regression that features auto-correlation, there are two types of patterns:
• The sign of the errors is either positive or negative for several periods (positive auto-correlation) • The sign of the errors alternates every period (negative auto-correlation).
As with the presence of heteroscedasticity10, the presence of auto-correlation leads to a poor estimation of coefficient variance. If the problem is not handled properly, it makes some statistical tests invalid, including those used to establish the significance of estimated coefficients. Also, if auto-correlation is caused by the omission of important variables, and these variables are even minutely linked with other explanatory variables, we can expect the estimated coefficients to be biased. ______9 See Linear Regression at page 182. 10 See Heteroscedasticity at page 185.
Heteroscedasticity
Definition Heteroscedasticity is a problem seen in econometrics when the residual error term (residual) does not have a constant variance11. Where the residual’s variance is constant, the errors are said to be homoscedastic. Error homoscedasticity is a basic hypothesis of econometric models.12
The graph on page 186 shows a series of random errors whose variance is not stable over time: at some points, the errors are more dispersed around the average. In practice, heteroscedasticity is not always as visible as it is in this illustration, and it can look quite different. The literature on econometrics suggests various tests for detecting heteroscedasticity and a variety of ______11 See Variance and Standard Deviation at page 173. 12 See Linear Regression at page 182.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 185 Statistical Concepts / Econometrics
methods for dealing with the problem’s consequences for Example of a heteroscedastic residual interpreting the results of econometric analysis. Heteroscedasticity leads to a poor estimation of coefficient variance. If heteroscedasticity is present, and the problem is not handled properly, it makes some statistical tests invalid, including those used to establish the significance of estimated coefficients.
Source: Desjardins, Economic Studies
Endogeneity
Definition Endogeneity refers to a problem seen in econometrics when there is a correlation between a model’s error term and explanatory variables. Endogeneity biases the ordinary least squares estimator13 and makes it non-convergent.
There is a correlation between the error and the explanatory variables when the values of the explanatory variables are observed with error, or when the explanatory variables’ values are determined by the model.
The first refers to a situation in which the explanatory variables’ values come from surveys or sample-based estimations. These values do not correspond to the exact values of the variables. It is then possible to show analytically that the error of a model with explanatory variables will be correlated with the explanatory variables. The second situation refers to a model with simultaneous equations in which a variable can be used as an explanatory variable in one equation and a variable to explain in another equation (model with several endogenous variables). In this type of situation, it can be shown analytically that the endogenous variables (which act as explanatory variables) are correlated with the error terms of the model’s equations.
The problem of endogeneity biases the ordinary least squares estimator (i.e., the estimated coefficients) and makes it non- convergent. This means that the problem does not resolve as the sample size is increased. However, with another type of estimator, the instrumental variables estimator, it is possible to get around the problem of endogeneity. ______13 See Linear Regression at page 182.
Multicollinearity
Definition Multicollinearity exists when a regression model’s explanatory variables are inter-correlated14.
______14 See Correlation at page 181.
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In practice, a model’s explanatory variables are frequently inter-correlated. This can lead to problems if there is a high degree of correlation. At the extreme, where two explanatory variables are perfectly correlated, it is impossible to estimate a regression model’s coefficients. Where there is a strong but not perfect correlation, the main consequences are an increase in the estimated variance of some coefficients and instability in estimating some coefficients.
There is no method for resolving multicollinearity that does not create other problems. One solution that is often used is to sort the inter-correlated variables and keep only the ones that are mostly enhancing the model’s explanatory power.
T-Stat
Definition Also known as the Student statistic or Student’s ratio, this statistic is calculated to verify such things as the significance of a coefficient estimated using a linear regression.
It is important to check the significance of coefficients estimated using a regression model. Based on the standard errors15 estimated for each coefficient, we can calculate the Student’s ratio. If we want to see whether a coefficient is significantly different from 0, the statistic is calculated as follows:
ˆ 0 ˆ T-Stat s s where ˆ corresponds to the estimated coefficient being tested and s is its estimated standard error.
The test’s null hypothesis (H0) is the hypothesis that the tested coefficient will be equal to 0, while the test’s alternative hypothesis (H1) is the hypothesis that the tested coefficient will be other than 0. The null hypothesis’ rejection threshold is up to the statistician but, in econometrics, a confidence interval of 95% is usually used. A higher required confidence interval means that the value of the T-Stat must be higher to reject the Student’s ratio test null hypothesis. The critical values are the values the Student statistic must cross to dismiss the null hypothesis at the selected confidence level. We must refer to a probability distribution table to determine these values. Specifically, we use a Student distribution with n-k degrees of freedom, where “n” is the sample Confidence interval of size and “k” is the number of estimated coefficients. As n-k 95% Critical Critical increases, the Student distribution seems more and more like a value value standard normal distribution16. Looking at the figure, a coefficient is considered significant if the Student statistic T-Stat calculated is within the zone for the alternative hypothesis, H1. H1 H1
For a large estimation sample and a confidence interval of 95%, H0 the critical values are respectively about -1.96 and 1.96. Source: Desjardins, Economic Studies ______15 See Variance and Standard Deviation at page 173. 16 See Normal Distribution at page 178.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 187 Statistical Concepts / Econometrics
P-Value
Definition P-value is the probability of being wrong if we reject a statistical test’s null hypothesis. As the probability gets smaller, it is easier to reject the null hypothesis.
Rather than basing ourselves on a statistical test’s numerical Example: P-value calculated for a Student’s ratio test value, it is often more convenient to calculate the probability of being wrong by rejecting the tested null hypothesis. In econometrics, null hypotheses are usually rejected as soon as the P-value is lower than 10% or 5%.
The figure shows a P-value calculated from a Student’s ratio P-value = 13.4% test17. For a Student’s statistics equal to 1.5, we get a P-value of 13.4%. This means that there is a 13.4% chance we will be wrong in rejecting the test’s null hypothesis. As the illustration shows, the P-value for a Student’s statistic equal to 1.5 -1.5 0 corresponds to the shaded area below the curve of the Student Student probability density function: the total area is 100%. As this is a statistic = 1.5 symmetrical test, we also take into account the area below the Source: Desjardins, Economic Studies curve, up to -1.5. For other types of tests, the P-value may correspond to the area below a single side of the probability density function. ______17 See T-Stat at page 187.
Cointegration
Definition Cointegration theory was introduced to take into account the fact that some non-stationary variables can be bound by a long-term stable relation and yet still diverge from each other in the short term. When cointegration is detected, error correction models should be used. This type of model takes into account the long-term relationship between the variables and enables a valid statistical inference on the estimated coefficients.
Formally, cointegration can be defined as follows. Let X and Y be two integrated series of order “d”. These variables are cointegrated if there is a linear combination Z whose order of integration is less than that of X and Y. The order of integration corresponds to the number of times a series must be differentiated to become stationary. In general, a time series is said to be stationary if it has a constant average and variance18. In practice, unit root tests are used to check whether a series is stationary.
A simple instance of cointegration is the case of two integrated series of order 1 for which there is a stationary linear combination Z (i.e., Z is integrated of order 0). In other words, that means that if we regress X and Y, the regression’s residual Z will be stationary. In this situation, we say that there is a stable long-term relationship between X and Y. This relationship is called a
cointegration relation or long-term relation. It is given by Yt X t . Over the long term, the similar movements by X and Y tend to offset each other, but temporary imbalances can occur. The variable Z measures the size of the imbalances; it can be called the equilibrium error. In practice, a number of examples are similar to this situation. They include the relationship between consumption and income and the relationship between short-term and long-term interest rates. ______18 See Variance and Standard Deviation at page 173 and Average at page 173.
188 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Statistical Concepts / Econometrics
When cointegration is detected, it is best to use error correction modelling or ECM (for error correction model). For X and Y, two integrated series of order 1 linked by a cointegration relation, the ECM can look like this:
Y Z Y X t t1 i t i j t j t where Z Y X i j t 1 t 1 t1 This type of equation can be estimated using the ordinary least squares method, as can any linear regression19. In this equation, coefficient is a measure of the speed at which the past imbalances in the long-term relationship between Y and X corrected. The coefficient must be significantly negative to show that imbalances tend to correct. This representation assumes that Y is determined by X. If the causal connection is not clear (i.e., Y influences X and X influences Y), a more complex form is used, but the general intuition is the same. ______19 See Linear Regression at page 182.
Binary Choice Model
Definition A binary choice model is a non-linear regression model whose dependent variable (variable to explain) is a variable that can have only a finite number of values. The binary choice model is a specific instance in which the dependent variable can have only one of two values: 0 or 1.
A binary choice model can be used to estimate the probability that an event will occur or not. The value estimated by such a model is the expected value of the dependent variable. For a binary choice variable, it is the expectation that the variable will be equal to 0 or to 1. Since the first choice is 0, it is a matter of calculating the probability that the dependent variable will equal 1. Below, we show this result assuming that variable Y is associated with the occurrence of events A or B. By making A = 0 and B = 1, it is easy to see that the estimated value is a number that is between 0 and 1, representing the probability that event B will occur. E(Y ) (1 )A B E(Y) (1 α)(0) α(1) E(Y) α , where 0 α 1
For example, we can estimate the risk that a recession will occur Risks of a recession in Canada estimated using in Canada or in the United States using a binary choice model. In a binary choice model this case, the dependent variable Y takes the value “1” when the Probability Probability economy is in a recession and takes the value “0” when it is not 100 100 90 90 in a recession. The value the model estimates is the probability 80 80 that a recession will occur based on the values observed for the 70 70 model’s independent variables. 60 60 50 50 40 40 To estimate a binary choice model, it is usually useful to maximize 30 30 a function (Y, ) , called the loglikelihood function, using 20 20 computer tools. In this function, Y is a binary variable made up 10 10 0 0 of “0” and “1”, is the vector of the coefficients to be estimated, 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 and X is the matrix of explanatory variables. In a specific instance Recession and severe slowdown Estimated probability of a binary model that is known as a probit model, the function Source: Desjardins, Economic Studies
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 189 Statistical Concepts / Econometrics
Risks of a recession in United States estimated using Standard normal cumulative distribution function a binary choice model
Probability Probability F(Xt) 100 100 1.0 Xt 1 90 90 0.9 1 ( (X )2 ) F(X ) e 2 d(X) 80 80 0.8 t 2 70 70 0.7
60 60 0.6
50 50 0.5 40 40 0.4 30 30 0.3 20 20 0.2 10 10 0.1 0 0 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 0.0 -4 -3 -2 -1 0 1 2 3 4 Recession Estimated probability Xt
Source: Desjardins, Economic Studies Source: Desjardins, Economic Studies
20 F(Xt ) is a standard normal cumulative distribution function. The function cannot take values below 0 or greater than 1, and its slope is always positive.
n (Y, ) Yt F(X t ) (1 Yt )1 F(X t ) t1 ______20 See Normal Distribution at page 178.
190 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Statistical Concepts
Additional references:
DESCRIPTIVE STATISTICS Exogenous and Endogenous Variables Average Paul A. Samuelson and William D. Nordhaus. 2005, p. 759. Bernard Delmas. 2000, p. 111-123. Graham Bannock et al. 1998, p. 127-128 and 144-145. Claude-Danièle Echaudemaison. 2003 p. 333-334. Russell Davidson et al. 2004, p. 311-329.
Variance and Standard Deviation Dummy Variable Bernard Delmas. 2000, p. 118 and 128-131. Graham Bannock et al. 1998, p. 113. Wikipedia. [http://en.wikipedia.org/wiki/Indicator_variable]. Trend Yves Bernard and Jean-Claude Colli. 1996, p. 1343-1344. Auto-Correlation Quantitative Micro Software. March 2004, p. 344-345. Graham Bannock et al. 1998, p. 13. Régis Bourbonnais. 2002, p. 119-128. Seasonality Bernard Delmas. 2000, p. 61-83. Heteroscedasticity Dominique Ladiray, Benoît Quenneville. July 1999, p. 0-37. Graham Bannock et al. 1998, p. 187. U.S. Census Bureau. July 2002, 191 pages. Russell Davidson et al. 2004, p. 196-202 Statistics Canada. [http://www.statcan.ca/english/freepub/12-539- and 266-270. XIE/12-539-XIE03001.pdf ], p. 52-56. Endogeneity Absolute and Relative Variation Russell Davidson et al. 2004, p. 311-329. Bernard Delmas. 2000, p. 28 and 184-187. William H. Greene. 2003, p. 378-381. Alain Bruno et al. 2005, p. 481. Multicollinearity Annualizing William H. Greene. 2003, p. 56-59. John Downes and Jordan Elliot Goodman. 2003, p. 193. Graham Bannock et al. 1998, p. 285. Bernard Delmas. 2000, p. 183. Régis Bourbonnais. 2002, p. 99-112. [http://www.answers.com/topic/annualize#after_ad3]. T-Stat Nominal and Real Value Russell Davidson et al. 2004, p. 122-141. John Downes and Jordan Elliot Goodman. 2003, p. 625-626 and 727. P-Value Russell Davidson et al. 2004, p. 122-129. Present Value Alain Beitone et al. 2001, p. 12. Cointegration Graham Bannock et al. 1998, p. 325-326. Sandrine Lardic and Valérie Mignon. 2002, p. 122 and 211-232. Peter G. C. Townley. 1998, p. 32-37. Binary Choice Model Normal Distribution William H. Greene. 2003, p. 663-718. Bernard Delmas. 2000, p. 143-145. Russell Davidson et al. 2004, p. 451-475. Yves Bernard and Jean-Claude Colli. 1996, p. 564. Wikipedia. [http://en.wikipedia.org/wiki/Normal_distribution].
L-Stable Distributions Svetlozar T. Rachev et al. 2005, p. 29-46 and 81-91. John P. Nolan. [http://academic2.american.edu/~jpnolan/stable/ stable.html]. Daniel Zajdenweber. 2000, 218 pages. Benoit Mandelbrot et al. 2004, p. 25-42.
ECONOMETRICS Correlation Régis Bourbonnais. 2002, p. 8-14. Graham Bannock et al. 1998, p. 81.
Linear Regression Régis Bourbonnais. 2002, p. 49-55. William H. Greene. 2003, p. 10-18 and 67-69. Russell Davidson et al. 2004, p. 86-118.
Coefficient of Determination Régis Bourbonnais. 2002, p. 34. Graham Bannock et al. 1998, p. 287.
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 191 192 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Index
INDEX
A Central bank independance, 71 Absolute advantage, 105 Central bank transparency, 71 Absolute purchasing-power parity (PPP), 100 Centralization ratio, 125 Absolute variation, 176 Channels for transmitting monetary policy, 73 Acceleration principle, 50 Chaos theory, 167 Adam Smith’s invisible hand, 124 Club goods, 127 Adaptive expectations, 61 Coase theorem, 21 Administrative barriers, 110 Coefficient of determination, 183 Aggregate demand, 28 Coefficient of sacrifice, 61 Aggregate expenditure, 30 Cointegration, 188 Aggregate income, 30 Commercial policy, 110 Aggregate supply, 28 Commodity markets, 158 Alterglobalization, 114 Common market, 113 Alternative cost, 11 Common-pool resources, 127 Announcement effect, 162 Comparative advantage, 105 Annualizing, 176 Competition policy, 82 Annual variation, 176 Competitive devaluation, 110 Associated equalization, 130 Concept of elasticity and inelasticity, 12 Auto-correlation, 185 Conditional transfers, 130 Average, 173 Constant dollars, 177 Average tax rate, 139, 140 Consumer confidence, 35 Average total cost, 16 Consumer price index – CPI, 57 Average variable cost, 16 Consumer surplus, 15 Consumption, 34 Core CPI, 58 B Corporate income tax, 129 Balance of payments, 89 Correlation, 181 Balassa-Samuelson effect, 111 Cost-benefit analysis, 128 Barrier to entry, 16 Cost-push inflation, 57 Base effect, 55 Covariance, 153, 181 Binary choice model, 189 Creative destruction, 52 Binary variable, 184, 189 Credibility of a central bank, 62 Bond value, 165 Credit risk, 151 Breakeven point, 16 Crowding out effect, 80 Business cycles, 47 Crowd psychology, 161 Buying on margin, 154 Currency arbitrage, 99 Currency board, 96 Currency drain, 65 C Current account, 89 Calendar effect, 162 Current dollars, 177 Capital and financial account, 89 Customs union, 113 Capital flow, 92 Cyclical deficit, 133 Capital-labour substitution, 43 Cyclical unemployment, 40 Capital markets, 158 Capital-output ratio, 50 Carry-over effect, 54 D Cash, 65 Debt/equity ratio, 156 Cauchy distribution, 179 Debt service, 134 Cauchy distribution probability density function, 179 Deductions, 138 Causality, 181 De facto dollarization, 102 Central bank, 71 Deficit, 132 Central bank autonomy, 70, 71 Deflation, 58
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 193 Index
Degree of openness, 107 Exchange rate appreciation, 97 Demand, 27 Exchange rate depreciation, 97 Demand for money, 66 Exchange rate devaluation, 97 Demand-pull inflation, 57 Exchange rate movements, 97 Derivatives markets, 158 Exchange rate overshooting, 101 Desjardins Affordability Index, 165 Exchange rate revaluation, 97 Desjardins Leading Index, 54 Excludable/non-excludable goods, 126 Diamond-water paradox, 12 Exogenous variables, 184 Direct exchange rate, 97 Expansionist policy, 73 Direct foreign investment, 92 Expectations, 61 Direct tax, 132 Explained sum of squares, 184 Discount rate, 71 Explanatory variable, 184 Disinflation, 58, 61 Export subsidies, 110 Disinflationary gap, 33 Externalities, 21 Disintermediation, 167 Disposable income, 34, 49, 78 Division of labour, 43 F Dollarization, 102 Factor-price equalization, 116 Domestic absorption, 91 Fair trade, 112 Dummy variable, 184 Fiat money, 63 Dumping, 111 Fiscal policy, 78 Durable goods, 34 Financial leverage, 156 Dutch disease, 110 Financial markets, 158 Financial risk, 151 Fiscal competition, 143 E Fiscal drag, 137 Earnings expectation, 151 Fiscal imbalance, 143 Economic and monetary union, 113 Fiscal neutrality, 136 Economic depression, 47 Fisher equation, 150 Economic expansion, 47 Fixed exchange rate, 97 Economic indicators, 53 Fixed exchange rate system, 97 Economic integration, 113 Flat tax, 140 Economic role of state, 123 Flight of capital, 92 Economic slowdown, 47 Floating exchange rate, 97 Economic union, 113 Floating exchange rate system, 97 Economies of scale, 20 Floating supply (float), 159 Economies of scope, 20 Foreign debt, 133 Economy in transition, 115 Foreign exchange markets, 158 Education and training policy, 82 Foreign exchange operations, 93 Effective exchange rate, 98 Foreign exchange risk, 96, 151 Efficiency of taxation, 137 Free trade area, 113 Efficiency wage theory, 44 Free-rider, 21 Efficient frontier, 153 Frictional unemployment, 40 Emerging economy, 115 Full employment rate, 41 Employed population, 39 Fundamental analysis, 161 Employment, 39 Employment rate, 39 Endogeneity, 186 G Endogenous variables, 184 Game theory, 22 Engel’s law, 14 GDP at factor cost, 31 Equalization, 130 GDP at market price, 31 Equilibrium of supply and demand, 27 GDP using expenditure method, 30 Equilibrium quantity, 28 GDP using income method, 30 Equity of taxation, 137 GDP per industry, 32 Error correction model – ECM, 188 Geometric mean, 173 Essential good, 14 Gini coefficient, 46 Eurodollars, 166 Globalization, 114 Euroization, 102 Golden rule of capital stock, 48 Excess burden, 142 Gold standard system, 95
194 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Index
Goodhart’s law, 75 Irrational exuberance, 163 Goods and services tax – GST, 129, 131 Government budget, 129 Green tax, 141 J Gresham’s law, 68 January effect, 162 Gross debt, 132 J-Curve, 109 Gross domestic product – GDP, 30 Juglar cycle, 47 Gross national disposable income – GNDI, 31, 89 Gross national product – GNP, 31, 89 Guaranteed minium income, 140 K Kaldor-Verdoorn’s law, 83 Keynes effect, 70 H Key rate, 71 Harmonic mean, 173 Kitchin cycle, 47 Heckscher-Ohlin theorem, 106 Kondratieff cycle, 47 Hedge fund, 157 Kurtosis, 179 Hedging, 155 Kuznets cycle, 47 Herfindahl-Hirschman index, 18 Heteroscedasticity, 185 Hidden cost, 126 L History of the international monetary system, 95 Labour force, 39 Hodrick-Prescott filter, 33, 174 Labour market, 38 Home bias, 52 Labour mobility, 43 Homoscedasticity, 185 Labour productivity, 42 Horizontal equity, 137 Laffer curve, 136 Horizontal fiscal imbalance, 143 Lagging indicator, 53 Horizontal integration, 19 Laspeyres index, 58 Household net worth, 50 Law of diminishing marginal utility, 11 Household wealth, 34, 49 Law of diminishing returns, 19 Human capital, 42 Law of supply and demand, 27 Human capital theory, 42 Leading indicator, 53 Hyperinflation, 56 Lending and deposit facilities, 72 Hysteresis hypothesis, 41 Leverage effect, 156 Lévy distribution, 179 Lévy distribution probability density function, 179 I Lifespan theory, 50 Implicit contract theory, 44 Linear correlation coefficient, 181 Import quotas, 110 Linear regression,182 Income effect, 13 Link between bond value and bond market interest rate, 165 Indicator variable, 132 Link between savings and the current account, 90 Indirect exchange rate, 97 Liquidity trap, 74 Indirect tax, 132 Long position, 155 Inferior goods, 13 Long-term aggregate supply, 27 Inflation, 57 Long-term macroeconomic equilibrium, 29 Inflationary gap, 33 Lorenz curve, 46 Inflation rate, 57 Low income measure, 45 Inflation target, 58 L-stable distributions, 178 Inflation tax, 70 Lump-sum tax, 137 Interest rate parity condition, 99 Interest rate position, 155 Interest rate risk, 151, 156 M Internal rate of return – IRR, 168 M1, 63 International Bank for Reconstruction and Development, 94 M2, 63 International crowding out effect, 80 M2+, 63 International Development Association, 94 Managed floats, 95 International Monetary Fund – IMF, 94 Mandatory reserves, reserve requirements, 72 Inter-temporal substitution in consumption, 49 Marginal analysis, 11 Inventory change, 35 Marginal cost, 11, 16 Investment, 35 Marginal labour productivity, 38, 42
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 195 Index
Marginal propensity to consume, 34 Non-refundable tax credit, 138 Marginal propensity to import, 37 Non-working population, 39 Marginal propensity to save, 49 Normal distribution, 178 Marginal revenue, 11, 17 Normal distribution probability density function, 178, 179 Marginal tax rate, 139 Normal goods, 13 Marginal utility, 11 Market capitalization, 159, 160 Market efficiency theory, 158 O Market line, 154 Official dollarization, 102 Market portfolio, 153 Official international reserves, 92 Market power, 18 Okun’s law, 41 Market price, 27 Oligopoly, 17 Market segmentation theory, 149 Open-market operations, 72 Marshall-Lerner criterion, 108 Operating leverage, 156 Minimum wage, 45 Opportunity cost, 11 Mobility of capital, 52 Optimal currency area, 113 Monetary aggregates, 63 Order of integration, 188 Monetary base, 64 Ordinary least squares – OLS, 182 Monetary conditions, 76 Output gap, 33 Monetary inflation, 57 Overnight rate, 71 Monetary policy, 72 Overnight target rate, 71 Money creation process, 65 Overshooting, 163 Money illusion, 69 Money market, 67 Money multiplier, 64 P Money supply, 63 Paasche index, 58 Monopolistic competition, 17 Panurge’s law, 164 Monopoly, 17 Parable of the broken window, 126 Monthly variation, 176 Paradox of thrift, 50 Moral hazard, 14 Paradox of value, 12 Moving average method, 175 Pareto optimality, 15 Multicollinearity, 186 Participation rate, 39 Multifactor productivity, 53 Percentage point change, 176 Multiplier, 79 Perfect competition, 16 Mundell’s triangle of incompatibility, 103 Perfectly elastic, 12 Perfectly inelastic, 12 Personal income tax, 129 N Phillips curve, 60 Nash equilibrium, 23 Pigou effect, 69 National savings, 90 Pigouvian tax, 141 Natural monopoly, 18 Political risk, 151 Natural unemployment rate, 41 Portfolio investment, 92 Negative correlation, 181 Portfolio theory, 153 Negative externality, 21 Positive correlation, 181 Negative income tax, 140 Positive externality, 21 Net debt, 132 Potential GDP, 32 Net domestic product – NDP, 31 Poverty threshold, 45 Net exports, 36 Prebisch-Singer thesis, 108 Net present value, 128, 178 Present value, 177 Neutral interest rate, 77 Price/earnings ratio, 160 Neutrality of money, 69 Price/earnings ratio and the bond market, 161 New trade theory, 106 Price elasticity, 12 Nominal exchange rate, 97 Price quotation, 97 Nominal interest rate, 150 Price rigidity, 62 Nominal interest rate theory, 150 Primary deficit, 133 Nominal value, 176 Private goods, 126 Nominal wage, 44 Private savings, 90 Non-durable goods, 34 Probit model, 189 Non-recoverable loss of welfare, 142 Producer surplus, 22
196 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES Index
Productivity cycle, 51 Second best, 15 Progressive tax, 139 Sector’s concentration ratio, 18 Public choice theory, 124 Seigniorage, 70 Public debt, 132 Semi-durable goods, 34 Public expenditure, 36 Semi-strong form market efficiency, 158 Public goods, 126 Sensibility of investment demand, 75 Public investment policy, 82 Sharpe ratio, 154 Public savings, 90 Short position, 155 Purchasing power risk, 151 Short selling, 154 Purchasing-power parity – PPP, 100 Short-term aggregate supply, 27 P-value, 188 Short-term macroeconomic equilibrium, 29 Shutdown point, 16 Size of government, 124 Q Skewness, 179 Quadratic mean, 173 Sovereign risk, 151 Quantity quotation, 97 Special drawing rights – SDR, 94 Quantity theory of money – QTM, 68 Specific risk, 151 Quarterly variation, 176 Speculative bubble, 163 Stagflation, 59 Standard deviation, 173 R Standard normal cumulative distribution function, 190 Rational expectations, 61 Stationary, 188 Real balance effect, 69 Sterilization, 102 Real business cycle, 48 Stock market indexes, 159 Real estate bubble, 164 Strong-form market efficiency, 159 Real exchange rate, 97 Structural deficit, 133 Real interest rate, 150 Structural unemployment, 40 Real value, 176 Substitution effect, 13 Real wage, 44 Sum of squared residuals, 182, 183 Recession, 47 Supply, 27 Refundable tax credit, 138 Supply shock, 81 Regressive tax, 139 Supply side policies, 81 Reinvestment risk, 151 Sustainable development, 56 Relative purchasing-power parity (PPP), 100 Systematic risk, 151 Relative variation, 176 Research and development policy, 82 Reservation wage, 44 T Restrictive policy, 73 Tariffs, 110 Return, 149 Taxation policy, 78 Ricardian equivalence, 135 Tax base, 131 Risk, 151 Tax credit, 138 Risk averse, 151 Taylor rule, 76 Risk aversion, 151 Technical analysis, 161 Risk lover, 152 Technical progress, 52 Rival/non-rival goods, 126 Terms of trade, 107 Role of money, 63 Theory of comparative advantage, 105 Theory of contestable markets, 18 Theory of external economies, 20 S Theory of the international Fisher effect, 102 S&P 500, 159 Tobin tax, 116 S&P/TSX, 159 Tobin’s Q, 160 Samuelson oscillator, 51 Total factor productivity, 53 Savings, 49 Total sum of squares, 184 Savings rate, 49 Transfer payments, 130 Savings rate and household financial situation, 50 Trend, 174 Say’s law, 82 Trend indicator, 53 Seasonal cycle, 47 T-Stat, 187 Seasonal unemployment, 40 Twin deficits, 134 Seasonality, 175
PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES 197 U Unconditional transfers, 130 Unemployment, 40 Unemployment rate, 39, 40
V Value-added tax, 131 Value added, 32 Value at risk – VaR, 152 Variance, 173 Venture capital, 157 Vertical equity, 137 Vertical fiscal imbalance, 143 Vertical integration, 19
W Wage rigidity, 44 Wagner’s law, 125 Weak-form market efficiency, 159 Wealth effect, 13 Weighted mean, 173 Working-age population, 39 World Bank, 94 World Bank Group, 95 World Trade Organization – WTO, 115
X X-11, 175 X-11-ARIMA, 175 X-12, 175
Y Yield curve, 149 Yield rate, 149
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206 PRACTICAL GUIDE TO ECONOMIC CONCEPTS AND THEORIES To view our publications: www.desjardins.com/economics
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