Posted by Anjali Kaur on Jun 28, 2022

Economic Factors and Financial Markets

As a dealing representative, your clients will expect you to have an understanding of the Canadian financial markets, and the economic factors that affect markets, including business cycles, government policies, and other elements.

Economic Indicators

The economic health of a region is represented by economic indicators. The three common indicators that your clients may ask you to explain are:

  • Gross Domestic Product (GDP)
  • Inflation Rate
  • Unemployment Rate

Gross Domestic Product (GDP)

The quantity of goods and services produced by a country is one of the primary indicators of the health of the economy. Gross Domestic Product (GDP) is a measure of the total market value of all the final goods and services produced in the economy in a year. GDP is measured in dollars.

GDP values are usually referred to as either “nominal” or “real”. Nominal GDP is expressed based on current market prices, while real GDP is adjusted for inflation, to remove the effect of price increases.

An increase in real GDP is interpreted as a sign that the economy is doing well, while a decrease indicates that the economy is not working at its full capacity.

An increase in GDP typically means higher profits for companies and increased dividends or higher stock and sector-related mutual fund prices for investors. On the other hand, a decrease in GDP typically indicates lower company profits and decreasing returns to investors.

Consumer Price Index (CPI)

The cost to purchase goods and services within a country is an important economic indicator. A price index measures many different prices in the economy. The most well-known and widely used price index calculated by Statistics Canada is the Consumer Price Index (CPI). To prepare the CPI, Statistics Canada tracks the retail prices of a basket of about 600 goods and services purchased by a typical household. This includes food, housing, transportation, furniture, clothing, and recreation. Items in this basket of goods and services are weighted to reflect typical consumer spending habits.

To give an accurate reflection of the price of goods and services, CPI is always calculated in relation to a base year. The current market value of this basket divided by its value in the base year and multiplied by 100, becomes the Consumer Price Index.

An increase in CPI could mean that investors have less money available to invest. It could also mean that those who rely on investment income for living expenses may find that they need to use more of their investment income to cover their basic living expenses.  

Annual Inflation

The rate of change in the price of goods and services is an important indicator of an economy’s price stability. Inflation is a rise in the general level of prices in an economy over a period of time. The amount that you can buy with your dollar, called purchasing power, falls as the rate of inflation rises. If the general price level falls, it is called deflation.

The rate of change in the general price level, year over year, is called the Inflation Rate. On a year-to-year basis, the inflation rate is measured as follows:

The following table shows the relationship between CPI and the Annual Inflation Rate. Note that the CPI is always in relationship to a base year while inflation is the year-to-year change in CPI.

Distributive Effects of Inflation

A major effect of unanticipated inflation is a redistribution of real income from lenders to borrowers. Unanticipated inflation results in lenders receiving less real income and borrowers benefiting from cheaper than expected loans.

Caitlyn borrows $100 from Terence in a year when prices are stable (the rate of inflation is zero) at a 2% interest rate. After one year, Terence expects to receive $2 in real income.

If prices rise by 5%, then Terence would need $105 to buy what $100 bought a year ago. The $102 he receives represents a reduction in real income of $3. On the other hand, Caitlyn has benefited from a loan now worth $105 for only $102.

Measures of Employment and Unemployment

The unemployment rate is the percentage of the labor force that actively seeks work but is unable to find any. The labor force is defined as the total of all those employed and unemployed in the economy. Individuals who do not have a job and are not actively looking for one are excluded from the labor force.

In Canada, employment and unemployment numbers are collected monthly by Statistics Canada. The unemployment rate is defined as the percentage of the labor force that is currently unemployed and actively looking for work.

The unemployment rate is a key indicator of the health of the economy. In general, when economic growth is strong, the unemployment rate tends to be low and when the economy is stagnating or in recession, unemployment tends to be higher. Variations in employment numbers can also reflect structural changes in the economy as new technology replaces labor or forces it to be employed in another way.

Unemployment and GDP typically move in opposite directions. An increase in GDP typically means lower unemployment as companies hire additional labor to meet the growing demand. Lower unemployment typically means investors have more funds available to spend, save or invest.

Full employment represents the highest number of both skilled and unskilled workers that a given economy can employ at any one time. In Canada, the full employment rate is considered to be less than 6% unemployment.  

Business Cycles

The Canadian economy moves in cycles that include periods of economic expansion followed by periods of economic contraction. The period of economic expansion is not of the same length in every cycle. Furthermore, a period of economic expansion is not necessarily as long as a period of economic contraction. A period of at least six consecutive months of economic contraction is called a recession. These irregular waves in the level of economic activity are called business cycles or economic cycles.

The GDP growth rate is the change in GDP compared to the previous year and is the indicator that is often used to illustrate the economic/business cycles and to compare growth between economic regions. A period of increase in GDP followed by a period of decrease in GDP is referred to as a business cycle.

This graph shows two business cycles of economic expansion followed by economic contraction.

Over time, the GDP rate moves in an opposite direction to the unemployment rate. In periods of expansion stock prices tend to rise and in periods of contraction, they fall.

Fiscal Policy

Governments try to stabilize their economies and maintain high employment, steady economic growth, and price stability. There are two main tools to accomplish this: fiscal policy and monetary policy.

Fiscal Policy

Fiscal policy is the government’s use of taxes, transfer payments, and spending to influence the overall level of economic activity. The government controls how much tax is collected from Canadian citizens and corporations. The government also controls their spending and transfer payments. Government spending refers to the amount that the government spends on products and services. Transfer payments are payments from the government without an exchange of goods or services. Examples of transfer payments are unemployment benefits, subsidies, social security payments, and other welfare benefit payments.

An expansionary fiscal policy is meant to stimulate economic growth through increased spending, increased transfer payments, or reduced taxes.

For instance: A person’s disposable income is equal to his or her income, with fewer taxes plus transfer payments. Reduced taxes or increased transfer payments will increase his or her disposable income. This represents an expansionary fiscal policy, and eventually, this sort of policy can result in increased inflation as prices adjust to new levels of disposable income.

Conversely, a restrictive or contractive policy is meant to slow down an overheating economy through reduced transfer payments, reduced spending, or increased taxes. The result of a restrictive or contractive policy is that real GDP and price levels eventually drop as economic activity slows.

Monetary Policy

The Bank of Canada serves as the government agency responsible for monetary policy. It is also the bank to banks and for the federal government. Monetary policy is about making changes to the money supply for the purpose of changing short-term interest rates.

The duties of the Bank of Canada are to:

  • regulate currency and credit in the best interests of the economy
  • control and protect the Canadian dollar
  • influence the level of production, trade, prices, and employment through monetary action

To fulfill these duties, the Bank of Canada may do one or more of the following:

  • increase (redeposit) or decrease (drawdown) the Government of Canada’s deposits with the chartered banks
  • participate in open market operations by buying or selling treasury bills through a designated group of investment dealers and banks
  • change the bank rate to signal its intentions regarding monetary policy

If increasing demand for credit and consumer products during a period of economic expansion causes prices to move upward too rapidly, the Bank of Canada can raise interest rates. This increases the cost of borrowing money and eventually reduces the amount of money moving around the economy. This can help to slow down an overheating economy.

In contrast, during periods of recession, the Bank of Canada may reduce interest rates to stimulate growth. The cost of borrowing money goes down, more people and corporations borrow, there is more money in the system and economic activity accelerates.

Useful Links

Most recent GDP numbers provided by the World
Most current GDP growth rate provided by the World
Statistics Canada, to view the most recent inflation rate, unemployment rate, and GDP growth
Bank of Canada, monetary

Thank You!

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