CHAPTER 2: THE

ECONOMIC ENVIRONMENT

Contents
WHY ECONOMICS? 1
THE BASICS 1
DETERMINANTS OF SUPPLY AND DEMAND 2
ACHIEVING EQUILIBRIUM 4
THE ECONOMIC CYCLE 5
THE GLOBAL ECONOMIC SYSTEM 12
MONEY 13
THE RESERVE SYSTEM 14
DIGITAL CURRENCY 15
KEEPING IT ALL IN CHECK 16
MONETARY POLICY 16
FISCAL POLICY 19
CURRENCY EXCHANGE RATES 19
MONETARY AND FISCAL POLICY TOGETHER 20
HOW DOES IT WORK? 21
SOURCES FOR THIS CHAPTER 21

WHY ECONOMICS?

Economics is the social science dedicated to understanding the production, distribution, and consumption of
goods and services. Why does it matter to the financial planner? As we go through the concepts in this course, we
will see that almost every product, service, concept, and program can be impacted by economic factors.
Understanding the basics of economics will help us to understand where our clients might encounter
uncertainty. In being aware of possible uncertainty, we can help our clients to prepare for it. Almost no part of our
financial world is the same today as it was ten, twenty, or fifty years ago. Most, if not all, of the changes that have
come about, can be traced back to economic factors.
Economics is commonly broken down into microeconomics and macroeconomics. Microeconomics deals with
individual actors in the economy, such as a household or manufacturer. Macroeconomics is concerned with the big
picture, such as how markets react to events.
In this chapter, we will cover some of the basic concepts fundamental to economics. These concepts become
especially important when we discuss investments in course 4, but we will see that in nearly every course throughout
the rest of the program we will encounter these concepts again.

THE BASICS

There are a variety of economic theories (you may be familiar with some of them already; even in high school
many of us were exposed to the ideas of economists such as John Maynard Keynes, Karl Marx, and Adam Smith)
but we are going to keep it straightforward in this text. Unfortunately, it is almost impossible to teach economics
without it being skewed towards the teachings of one economist or another. (Much of the material in this chapter is
derived from the work of Keynes.) If you find the concepts presented here interesting, you might delve further into

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these ideas and develop your own understanding of economics. Given that, like this text, most writing on economics
presupposes one philosophy or another, you would most likely be wise to educate yourself.
Regardless of whose theory we subscribe to, there are two concepts that we must understand:

• Demand. Demand refers to the quantity of a good (or service) that consumers would be willing to acquire at
a given price. Keep in mind here that we are dealing at the macro level; just because you may not want a
Hello Kitty® steering wheel cover, it doesn’t mean there is no demand for it. Demand is influenced by the
purchasing power available to consumers, the price of other similar goods, and a variety of other factors.
Demand is typically illustrated as such:

Price

Quantity Demanded

Demand, then, is taken from the point of view of the consumer. As the price increases, the consumer will
demand less of that good.

• Supply. Supply refers to the relationship between the price of a good (or service) and the quantity available
at that price. There are several factors that influence supply, such as the cost of manufacturing a good, the
amount of labour available to manufacture a good, and the supply of other similar goods. The supply curve is
typically drawn as such:

Price

Quantity Supplied

As the price of a good increases, producers will manufacture more of it, all else being equal. Supply, then,
is best regarded from the point of view of the producer.

In theory, a good will always move towards its equilibrium price because of the relationship between supply
and demand. The equilibrium price is the point at which the price for a good exactly matches its supply and its
demand. If the price is too low, then demand will increase (“Hey, these shoes are nice, and they’re not too
expensive. We should go shopping!”) driving the price back up. If the price is too high, then demand will decrease
(“These shoes are pretty nice, but they’re quite expensive. Let’s get those other ones.”) driving the price back down.
In theory, then, the price is always moving towards equilibrium.
Producers and distributors will seek a price at which profits will be maximized. Within the constraints of the
cost of production, they will seek a price at which they can receive the maximum possible profit.
Some clothing producers choose to manufacture garments that will sell for a high price, but that only a few
people will buy. The producer believes that they make a large profit a small number of times. Other clothing
producers choose to manufacture garments that will sell for a low price, but that a great number of people will buy.
This producer believes they will make a small profit a great number of times.

DETERMINANTS OF SUPPLY AND DEMAND

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 Several factors will determine both the supply and demand for a given good or service. In the clothing example,
above, we looked at price, and a comparable item. These are just two of the many influential factors.
Demand is generally seen to be influenced by:

• The Price of the Good or Service. As above, consumers will be more prone to purchase a less expensive
item, and more hesitant to purchase an expensive item. This factor, as with all the other factors described
below, assumes that all else is equal. It’s not necessarily fair to compare a high-quality item to a low-quality
item, though, if they serve a similar function, a consumer might regard both goods the same way.

• The Price of Related Goods or Services. There are two categories of related goods, and both can influence
the demand for the good or service in question.
The first category is substitutes. Substitute goods would be those that consumers see filling the same role.
For example, a laptop computer might be a substitute for a desktop computer. The underlying assumption
here is that the laptop computer purchase would cause the consumer not to buy a desktop computer. If these
really are substitute goods, there should be an inverse relationship between the two.
The second category of related goods is complements. Complementary goods would see their sales
increase based on the sale of the reference good. For example, a portable second monitor is something that a
consumer would likely only buy if they have a laptop computer. The portable second monitor would be a
complement to the laptop.
The concept of related goods can get a bit murky. For example, an Amazon Prime subscription is likely a
related good to a Netflix subscription. But is it a complement or a substitute? Do people buy Amazon Prime
because they bought Netflix, or as an alternative to Netflix?

• Consumer Income or Wealth. Consumer income is the money available to consumers to make purchases.
As consumer income grows, the demand for goods and services should grow as well. This will not
necessarily hold true in all circumstances, as some goods and services may be more attractive to consumers
with lower incomes.
Consumer income can be further broken down into what are likely more meaningful categories. After-tax
income is what’s available to the consumer. But disposable income, the amount available to consumers, is
likely what is more important. Disposable income is based on the income left to consumers after mandatory
payments are made. Mandatory payments generally include debt payments and child and spousal support.
A financial planner might find themselves helping clients to maximize income. It is important to
distinguish between total income, after-tax income, and disposable income. Each tells a different story. If a
consumer’s total income stays roughly the same, but disposable income increases, this is likely a successful
financial planning engagement.
At a macroeconomic level, an increase in the overall tax burden for the population should reduce
disposable income, which should subsequently reduce demand. Further than that, though, taxes create
additional inefficiencies. Governments have a cost to collect taxes. Manufacturers must consider that, when
they price a good, consumers will be paying that price plus the tax cost. This can provide a disincentive and
reduce supply as well as demand.

• Consumer Expectations of Future Prices, Income, or Wealth. Consumers are likely not expecting that
circumstances will stay the same. Will the price of the good in question reduce over time? Is now the right
time to buy? Will the consumer’s future income increase?
Consumer expectations are important policy determinants. If consumer sentiment is already negative, then
it may not be an ideal time for a government to apply fiscal policy decisions (discussed later in this chapter)
that might amplify that negative sentiment. If consumer expectations are overwhelmingly positive, then a
government may wish to apply measures to slow down a potentially overheated economy before a bubble is
created.

• Consumer Behaviour. How do consumers make purchase decisions? Is the consumer making a rational
decision, where they have weighed their need for a good, and determined the optimal price? Or, is the
consumer motivated by ease of purchase, barriers to purchase, an artificial sense of urgency, or other factors?
Demand for goods or services might not match with what would be ‘ideal’, as consumer behaviour does not
always lead to rational decision-making. We will discuss decision-making models further in chapter 16.

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 • Number of Consumers. How large is the market for a good? A larger market for a good should increase
demand.

• Price Elasticity. If the price of a good increases, does demand subsequently drop? That is the measure of
elasticity of demand. For elastic goods, when price goes down, demand should go up, and vice versa.
Not all goods are elastic. Some staples, such as loaves of bread, are subject to inelastic pricing. At the
other end of the spectrum, luxury goods are often inelastic. With some goods, it is a high price that helps to
drive demand, creating an aspect of exclusivity.1

Supply is generally seen to be influenced by:

• Price of goods and services. As we saw in the supply curve, in the previous section, goods and services with
a higher price will motivate producers to produce more of that good or service. Price, then, is an important
determinant of supply.

• Cost of producing goods and services. What are the input costs of production? If a supplier must spend an
amount very close to the price that consumers will pay, the supplier must consider whether it’s worthwhile
producing that good or service.
Some of the costs will be related to raw material inputs, but labour and distribution costs must also be
considered.

• Price of related goods and services. If there are substitute goods available, the supply of the good in
question might be reduced. This might happen because producers choose to supply the substitute goods
instead.

• Producer expectations. Producers have the difficult task of determining the appropriate supply of a good or
service to meet demand. It can happen that a producer guesses that consumers will demand a very large
quantity of something, and incorrectly create an oversupply. This creates an inefficiency in the market due to
wasted resources. Producers who underestimate demand, and produce too little supply, risk alienating
consumers.

• Number of sellers. How many producers are active in the same market? The number of sellers can influence
supply. Of course, most producers would prefer that there are fewer producers to compete with. This doesn’t
always hold true, though. Consider electric vehicles. Their adoption is increasing, and part of the reason for
this is that there are many producers (sellers).

ACHIEVING EQUILIBRIUM

As discussed above, supply and demand should be moving in concert towards a state of equilibrium. The
equilibrium price is also known as the competitive price or the market clearing price.
As the factors influencing supply and demand change, the point at which equilibrium is achieved will also
change. For example, if there is a decrease in labour costs, that would shift the cost of producing goods and services.
Those production costs would now be lower, allowing a producer to provide a larger supply. This shift in the supply
curve would cause the equilibrium price to be reduced.
Conversely, an increase in consumer wealth should cause the demand curve to shift to the right. This would
increase the equilibrium price. Each of the effects described above can have a similar impact on the equilibrium
price.
The most efficient markets are seen to be in a perpetual state of equilibrium. The financial markets that we will
explore in chapters 10 and 11 are the best example of this. Supply and demand are constantly shifting, and the price

1
This is a fun example of a good whose high price drives demand. The economic term for such goods is Veblen
Goods. [Link]

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reacts nearly instantly to those price changes. Not all markets are so efficient. Labour markets are generally
perceived as inefficient. It can take years for the supply of labour to adjust to shifting demands.
Not all goods and services have prices that move towards a state of equilibrium. Governments occasionally
place restrictions on how goods and services are priced. Examples include agricultural goods and auto insurance, in
some provinces. In these cases, there is a sacrifice of efficiency for a degree of certainty for consumers and
producers.
Arbitrage, which is the exploitation of a pricing inefficiency, is a further consideration in achieving equilibrium.
Arbitrage strategies normally involve acquiring an inefficiently priced good or service at a low price, and then
selling it at a higher price. This may be possible where markets are not efficient, or where the market has not
recognized that one good is potentially a substitute for another.
An example of an arbitrage transaction might arise with stocks that trade on more than one stock exchange. The
Canadian insurance giant Manulife is one such example, with its shares trading on both the Toronto Stock Exchange
and the New York Stock Exchange. It could happen that, due to the interplay between the movements in stock prices
and currency fluctuation, that an attentive trader might notice a price inefficiency. Exploiting that price inefficiency
would be an example of arbitrage.
Just the opportunity to employ this arbitrage transaction is helpful in removing inefficiencies. With a major
company like Manulife, the markets are likely to respond very quickly to any sort of pricing inefficiency. In this
regard, arbitrage opportunities contribute to pricing equilibrium.
The more efficient the market, the quicker equilibrium will be achieved. As we will see in Chapter 10, the stock
market is a highly efficient, highly reactive market, and arbitrage opportunities as well as supply and demand
pressures work very quickly there.
Consider the alternative of a relatively small town in a relatively remote area. If that town has, for example,
only one shoe store, then shoes will likely be priced with that factor in mind. Shoe prices will not react quickly to
any sort of changes. Arbitrage opportunities would be limited to the number of people who are willing to drive to the
closest big city to purchase shoes, or those who are comfortable purchasing shoes through online retailers.
The rate at which goods and services achieve equilibrium is an important indicator of a properly functioning
economic system.

THE ECONOMIC CYCLE

The economy is seen to move in cycles. This results in the economic cycle, also known as the business cycle.
The economic cycle will look familiar to many of you:

Peak or
Boom
Expansion
Contraction

Recovery
Recession

Trough or
Bust

So how do we know where in the economic cycle we are at any given time? There are three sets of indicators.
These indicators tell us either where we are going, or where we are right now, or where we have been. Economists
rely on these indicators to tell us about the economy. Because economics is a social science, it is hard to know for
sure what an indicator tells us. Economists seldom reach a consensus when indicators are released. Those of you
who read the business section of the news on a regular basis will recognize some of the indicators. The indicators are
normally broken down into three categories:

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• Leading Indicators. Leading indicators tell us where we are going. They allow forecasting of the direction
that the economy is taking. They are seen to be useful in a time horizon of about 6-24 months and should be
taken in aggregate. Examples of leading indicators include:

o Orders of Durable Goods. Durable goods are consumer goods expected to last longer than three
years. These are typically discretionary purchases, such as new cars, furniture, and consumer
electronics. The perception among economists is that people will only buy these goods when they are
confident in their ability to afford them.

o Housing Starts. Like durable goods orders, housing starts would be an indicator that consumers are
looking to make big-ticket purchases. Housing starts also represent a boost to employment numbers, as
those involved in home construction will have jobs for the foreseeable future. A housing start is
measured as construction starting on any residence that is likely to house a family.

o Commodity Prices. Commodities are the raw inputs into other goods. A commodity has the same
character regardless of how it originated. This would apply to natural goods, such as wheat, iron ore, or
oranges. It also applies to some manufactured items, such as computing power. Because commodities
are inputs into other goods, an increase in commodity prices is reflective of a desire by manufacturers
to produce more goods. This should lead to increased economic activity.

o Manufacturers’ New Orders. Much the same as how housing starts represent individual consumer
behaviours, manufacturers’ new orders represent corporations’ behaviours. Presumably, a
manufacturer’s orders for materials and supplies will increase in response to consumer demand. This
should be a good indicator that the economic cycle is moving into an expansionary or recovery phase.

o Stock Market Returns. As we will see when we discuss investments, the pricing of publicly traded
shares is based largely on investor speculation. Investors will pay a higher price for a share when they
believe that company will grow or become more profitable in the near future. Good returns in the
market are a likely indicatory of an economic recovery, while poor performance of the market is a
likely indicator of a coming recession.
The stock market is generally seen to operate in cycles, which are indicators of the direction of the
market. Some cycles are very short-term, covering periods of just a few months. An example of a
short-term cycle of this nature is the “January effect”, which posits that stock prices increase more in
January than in any other month.
A better-known example of a cycle is associated with the terms “Bull Market” and “Bear Market”.
These periods are generally 1-3 years in length. A bull market (think of a charging bull) means that
stocks are generally increasing in value, and a bear market (think of a hibernating bear) means that
stocks are dropping in value.
Longer-term cycles of 10-30 years are known as secular cycles. Over a span of 10-30 years, the
market will have an overall upward or downward direction, but within that market there will be
periodic bull markets or bear markets. There might be, for example, a 30-year secular bull market
interrupted by two or three bear markets. These bear markets will generally be precipitated by a
correction, which is a drop of 10% or more from a market high. Chapter 5 includes a section dealing
with measures of market returns.

• Concurrent Indicators. Concurrent indicators tell us where we are in the economic cycle. In theory, they
change at the same time as the whole economy changes. There are several concurrent indicators:

o Personal Income. The combined amount of income from self-employment, employment, and
investing is an indicator of the current state of the economy. This information is primarily gathered
from tax returns.

o Retail Sales. Just as personal income measures how much people are earning, retail sales measures
how much people are spending. Retail sales is typically measured through consumption taxes, such as
the GST (Goods and Services Tax).

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 o Industrial Production. We saw that manufacturers’ new orders was a leading indicator. That should
lead to increased production, which is the indicator of where the economy is today.

o Manufacturing and Trade Sales Volume. How much inventory are manufacturers selling? If they are
selling more inventory than the previous quarter, this is a positive sign. If they are selling less, then this
is a negative. This can be a useful indicator for where the economy is today.

o Non-Agricultural Payroll. How many people have jobs? Employment is a valuable indicator of the
state of the economy. Agricultural payrolls are left out because agriculture is cyclical on its own.
Employers in that sector hire based on the seasons, not based on when there is more or less demand for
what they produce.

o Gross Domestic Product (GDP). Gross Domestic Product is a measure of the total economic output
of a state. It measures the total output within the political boundaries of that state.
GDP includes consumer spending, investment spending, government spending, and net exports.
Net exports would be all exports less all imports, and this could be a negative input into the GDP
calculation. If exports are greater than inputs, the country has a trade surplus. If the opposite is true,
there is as trade deficit. This concept is also referred to as the balance of trade.
We will look at Canada’s figures from 2018 to help understand this. Canadians spent
$1,607,381,000,000 (yes, just over $1.6 trillion) in 2018. This compares to $1,571,546,000,000 in
2017. This represents a change of 2.3% from year to year. This change would be referred to as a
change in nominal GDP. However, some of this change would be attributable to inflation. With
inflation taken into account, the Canadian economy grew by 1.9%, from 2017 to 2018. This is referred
to as the change in real GDP.2
GDP per capita is also an important measure. It tells us how productive the economy is per person.
It is sometimes used as a proxy for quality of life. Because of the US Dollar’s position as the reference
currency, which we will discuss later in this chapter, GDP per capita is normally expressed in US
Dollars. In 2018, Canada’s GDP per capita was $46,410.3
At one time, Gross National Product (GNP) was a more frequently used indicator. GNP refers to
the total economic output of all actors resident within that state. So a Canadian company that
manufactures goods in Brazil would contribute to Canada’s GNP, but not to GDP. A Norwegian
company that manufactures goods in Canada would contribute to Canada’s GDP, but not to GNP.
There are three methods available for the measurement of GDP. In theory, all should provide the same
end result:

▪ Product (or Output) Approach. The product approach adds the production of all types of
business to arrive at the GDP.

▪ Expenditure Method. Private consumption is added to government spending, plus gross

investments, plus exports (net of imports).

▪ Income Approach. The income approach adds all income that flows from businesses to
households. This can include wages, dividends, interest, investment income, and other
amounts.

When measuring GDP, certain amounts are not included. Notably, transfer payments do not
represent production. Transfer payments include programs such as Employment Insurance and Old
Age Security. Those amounts boost the incomes of their individual recipients, but they do not represent
enhanced productivity.

2
[Link]
3
[Link]

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 GDP is an important indicator of the size and health of an economy. There are many factors that
can influence GDP for good or for bad:

▪ Political change. Some governments are seen as more friendly to business; GDP will usually
increase when a business-friendly government is elected. Stability of government can also
positively influence GDP.

▪ International conflict. Later in this chapter, we will discuss the fragility of the global
economic system. Conflict in other nations can reduce GDP expectations.

▪ Technological advancements. Technologies that create efficiencies will increase GDP. The
threat of technology replacing jobs may have a harmful effect on GDP, but the evidence here
is mixed.

▪ Medical discoveries or disease. If a country is spending inordinate amounts on health care,

that represents spending, but it does not likely translate into positive long-term economic
activity.

▪ Environmental disasters. As with health care, spending on disasters represents economic

activity, but not likely future growth.

▪ Geopolitical factors. What is happening around the world? If a country is particularly reliant
on imports and exports, it will feel the effects of geopolitical factors. For example, if terror
attacks are taking place regularly, that may curtail certain types of economic activity.

▪ Domestic government policy. Sometimes, governments will impose measures that might limit
economic growth for other policy ends. For example, the Government of Canada sometimes
sacrifices other economic opportunities to protect Canadian farmers’ interests and help ensure
the long-term viability of that industry.

▪ Foreign government policy. In a similar manner, the activities of foreign governments might
limit Canada’s growth opportunities. At the time of this writing, the Chinese government is
calling into question the quality of Canadian meat imports. If this issue is not resolved
quickly, it will likely hurt Canada’s GDP growth.
This can extend to foreign monetary policy as well. Canada, as a major exporter of
resources, is reliant on other countries’ ability to purchase those resources. If one of our major
customers devalues its currency, for example, this could hurt Canada’s GDP growth.

GDP, while a widely used figure, can be problematic. It has often been used to represent the
individual levels of wealth in an economy, but this can be a false picture. Some of the reasons that are
normally cited for not trusting GDP include:

▪ It counts activity that is not positive in nature. For example, if smoking is widely available,
there will be higher instances of associated illnesses. This creates economic activity, but it’s
not economic activity that anybody wants.

▪ It doesn’t account for lifestyle. If one country has a normal 40-hour work week and the same
GDP as another country with a 50-hour work week, is GDP telling the whole story?4

▪ GDP only accounts for legal activity. Black market (illegal) activity and grey market
(informal activity where income may not be reported) will not show up in typical GDP

4
This is an example of an alternative to GDP that is increasingly referenced in economic literature:
[Link]

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 figures. This is a greater problem in lesser developed markets, where illegal activity tends to
be more prevalent.

GDP is a useful tool for assessing the health of an economy. If GDP grows at a high rate, that is
likely a good indicator of inflationary activity. At the same time, low interest rates generally give more
opportunities for growth. This leads to a tension, where inflation generally leads to higher interest
rates, but lower rates create more inflation.
GDP growth will also influence demand for a country’s currency and other assets. This creates a
cycle in which good GDP growth creates inflation, which creates increased demand, which increases
the flow of investment capital, which increases GDP. However, this trend is not necessarily helpful in
all cases. We have seen some of this in Canada, where demand for real estate assets in Vancouver and
Toronto has made these assets unaffordable for those living in those areas and earning modest
incomes.
This also leads to volatility in asset prices. When foreign capital is driving domestic asset prices,
those assets are now subject to global trends. The Canadian oil and gas sector in 2021 is potentially
victim to this trend, as foreign capital provided much of the value for these assets. A combination of
factors, ranging from increased appetite for green technologies, to US shale oil production, to Canadian
domestic politics, has hurt the foreign demand for Canadian assets.
GDP is a very large figure that can tell a story. At the same time, the vast amount of information
that it represents can make it difficult to pick out what the true story is.

• Lagging Indicators. Lagging indicators are useful for describing the end of a period in the economic cycle.
Taking the whole body of lagging indicators into account can be a useful confirmation of what cycle has just
passed. Some commonly used lagging indicators include:

o Unemployment Duration. The duration of unemployment is inversely proportional to the economic

cycle. Long periods of unemployment are representative of the bottom of the cycle. Short periods of
unemployment normally occur near the top of the cycle. The reason that we consider unemployment a
lagging indicator is that companies will not normally reduce their workforces until there has been a
pronounced drop in business activity. This pronounced drop comes after the GDP has already fallen
off. Unemployment lags behind the other indicators as a representation of the economic cycle.

o Inventory Levels. As we saw in the leading and coincident indicators, companies will step up their
level of production when the economy is expanding or recovering. A sign that this expansion or
recovery has ended would be excess inventory held by corporations.

o Ratio of Consumer Credit to Personal Income. Consumers will have changed their habits as the
economy expands or recovers. Debt will have been cheap, and consumers will have taken on debt
expecting their levels of personal income to continue growing. Once personal income stops growing,
though, consumers will be left with large amounts of debt. If there is unemployment, those consumers
will have the same amount of debt and no income to deal with it.

o Private Sector Capital Investment Levels. Government investment is not a good indicator, because
governments tend to borrow and invest in contractionary periods. Private investors, though, will curtail
their investment activity once it looks like the economy has slowed down.

o Exchange Rate. The exchange rate for currency (demand for currency) responds to economic data.
Because so much of the data takes time to become available, compile, and release, the exchange rate
will also be a lagging indicator.

There are a couple of concepts that we must define before we are ready to move on. These ideas become very
important as we examine the consequences of the economic cycle. We must further investigate:

• Inflation. The actual cause of inflation is a subject of some debate. The most commonly held theory today is
that it is caused by an increase in the supply of money. Inflation is a measure of the change of the price of

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consumer goods. Inflation is normally measured by comparing last year’s Consumer Price Index (CPI) to the
current year’s CPI. The CPI is a basket of about 600 goods and services that most households would
regularly purchase. The price of this basket of goods and services is referred to as the General Price Level.
The CPI is measured as a base against a raw score of 100. The last time Statistics Canada set the raw
score was in 2002. In October of 2020, the CPI was 137.5. This means that, on average, consumer goods cost
37.5% more in 2020 than they did in 2002. CPI is not, of course, perfect. Changes in technology and
consumer preference mean that most households probably purchase different goods today than they did in
2002 (consider newspapers and DVD rentals, both of which are being replaced by other media). Statistics
Canada works to make sure that CPI is representative of reality. The formula for measuring inflation is:

Current Year’s CPI – Previous Year’s CPI

Inflation =
Previous Year’s CPI

CPI from January of 2018 was 132.3, and from January of 2019, was 134.2. Over the year in question
consumer goods increased in price by (134.2 – 132.3/132.3) = 1.4%. This refers to the “All-items” CPI,
which is the basket of goods that includes all manner of regular household purchases.
The CPI is often adjusted to exclude certain values. Some economists refer to a concept called “Core
CPI” or “Core Inflation”, which removes volatile items such as energy and food costs. In Canada, this is
roughly synonymous with CPI-Trim, which is Statistics Canada’s CPI figures with the 20% highest and
lowest inflationary items removed. This creates a less volatile inflation figure.
CPI may be useful in a financial planning scenario, but the planner must be cautious. CPI figures use an
‘average’ household, which means there are many assumptions that may not apply to a given client scenario.
The planner should consider what items in a client’s situation are different from the base assumptions. For
example, a client who bikes everywhere is not going to be impacted by the inflation associated with
transportation expenses, which mostly relate to vehicle purchases and maintenance. Examining Statistics
Canada’s CPI figures, which are available at
[Link] can help the planner determine the extent
to which CPI is a valid measure for a client.
In 2020, Statistics Canada introduced a personalized inflation calculator. A client can input their typical
monthly and annual spending into the calculator to arrive at a personalized rate of inflation.
[Link]
Inflation is not always the gradual increase to which we are generally accustomed. There are other terms
used to represent possible variations on traditional inflation:

o Deflation. If we use the formula above and arrive at a negative number, we have experienced
deflation. The real cost of goods and services has decreased. While on the surface this might seem
positive, it can create significant problems. In a deflationary period, it is very difficult for banks to pay
interest. Banks cannot very well assess negative interest to their account holders. Because the cost of
goods and services is decreasing, though, cash is increasing in its relative value with only the passage
of time. This provides a disincentive to deposit money in the bank. We will see later in this chapter that
our economy is built on the expectation that banks will attract deposits. A period of prolonged
deflation can have devastating effects on the banking system, potentially leading to economic collapse.
Some economists have theorized that the depression of the 1930s was caused by deflation and the
subsequent inability of banks to continue to do business.

o Disinflation. When inflation has been at a certain level (say, 3%) for a period of time and then slows
down (to, say, 1.5%) then we have disinflation.

o Stagflation. We will see as we go through this chapter that in conventional economic theory, high
interest rates are a mark of a strong economy, while high unemployment is a mark of a weaker
economy. They should not, then, occur at the same time. When we look at attempts to control inflation
and unemployment, we will see that those measures can work in opposition to one another. This
creates a difficult-to-manage condition known as stagflation.

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 o Reflation. Reflation is a term which is, for the most part, synonymous with recovery, as discussed
below.

o Hyperinflation. Hyperinflation is, thankfully, a rare situation in which inflation is so high as to render
currency near meaningless. Hyperinflation often arises when a government takes drastic measures to
try to stabilize itself, such as issuing huge amounts of new currency without any backing for that
currency. This can lead to the currency having no value, which forces the government to issue even
larger amounts of currency, which will lose its value even more quickly, and further devalue any
previously issued currency. Hyperinflation often occurs in politically unstable states. This often leads
to the introduction of a barter system (which makes the collection of taxes nearly impossible) or the
use of some other currency (such as US Dollars).

Inflation creates problems for governments. Where inflation is normal (most Western governments have a
target inflation rate of around 2% today) it is a manageable problem. Where inflation is quite high, though, it
brings with it a range of social and economic problems. Those who work in professional jobs and in the
skilled trades tend to have incomes that grow to keep pace with inflation. Service industry workers, unskilled
labourers, migrant workers, and many others do not generally see their wages keep pace with inflation. This
causes them to be left behind financially during periods of inflation. This means that, in many cases, those
people end up in the care of the government. This might mean dealing with the judicial system, the health
care system, or the social welfare system. Inflation also makes it challenging for the government to provide
basic services, as the cost of providing those services increases during periods of inflation.
Inflation is a lagging indicator of the economic cycle. Because it takes some time for the full effects of
economic activity to be felt, changes in Consumer Price Index or Gross Domestic Product won’t normally
show up until several months after the causal event.

• Unemployment. Unemployment refers to the number of unemployed as compared to the total number of the
workforce. Those who would not normally be employed (such as children, students, and the disabled) are not
considered as part of this statistic, nor are full-time members of the military. The unemployment rate is
calculated as:

Number Unemployed
Unemployment Rate = x 100
Civilian Workforce

There are varying levels of unemployment. A certain amount of unemployment is desirable, as it means
that there are workers available to accommodate expansion by employers. As unemployment gets too high,
though, it creates economic and social problems. As is the case with high inflation, this creates a strain on
various government services. It also reduces the amount of productivity in the economy, thereby reducing the
amount of taxes collected by governments. Governments will, then, look for ways to reduce unemployment.
Unemployment rate is a lagging indicator of the economic cycle. A high unemployment rate means that
the economy has recently been in a contractionary phase. A low unemployment rate means the economy has
recently been in an expansionary phase. This lag happens because it takes time for employers to adjust to
conditions; an employer can’t instantly adjust the size of its workforce to meet demand.

Now that we have examined the economic indicators, we will have a look at the characteristics of each phase in
the economic cycle. It is useful to understand what is happening during each phase in order to be able to predict
certain activities. You will recall that the phases in the economic cycle are:

• Recovery. The recovery phase follows a period of contraction or recession. After a contraction, or recession,
we will identify a trough. (The indicators discussed previously help us to identify this trough.) The recovery,
then, brings us out of that trough. Periods of recovery are indicated by high unemployment (employers are
not yet willing to grow their workforces) and higher GDP (there is more money being spent). It can be
difficult to distinguish recovery from expansion. During a period of recovery, households will invest more,
borrow more, and spend more. (Note that investing is different than saving. Investment refers to putting your
money into the economy - stocks and corporate bonds, for example - while saving refers to putting your
money in the bank.)

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 • Expansion. Expansion is when the economy pushes towards a new high. Periods of expansion are marked by
low unemployment, increases in GDP, and high inflation. As in a recovery, households will also spend more,
invest more, and borrow more during this phase. This is typically when inflation will be at its highest.

• Peak. The peak, strictly speaking, is not a period in the economic cycle. Rather, it is the point at which the
cycle switches from expansion into contraction.

• Contraction. Contraction sees the economy start to shrink. The GDP will be lower during this period. Stock
market returns will be driven down, and interest rates may be higher. This will encourage saving rather than
investing. Borrowing will be discouraged. Households will spend less, invest less, and save more. We will
often see this period marked by disinflation.

• Recession. A recession marks two or more consecutive quarters of contraction in the economy. A recession
normally looks like a contraction but is accompanied by high unemployment. Borrowing will be even less
common, while fear about the economy will encourage households to save.

• Trough. As with a peak, a trough is not a period, but is, rather, the break between recession and recovery. At
the time of this writing (late 2010) economists are desperately watching leading indicators (housing starts are
a good example) for any sign that the current recession has ended.

THE GLOBAL ECONOMIC SYSTEM

Our world is increasingly interconnected. Governments and corporations, and even individuals to an extent,
operate in a world where global factors have an influence on financial decisions.
While there are ebbs and flows in this trend, globalization sees the traditional barriers between nations being
broken down. The increased interdependence between nations has advantages and disadvantages. More participants
in the market means an increased amount of efficiency – the approach to equilibrium is quicker. Access to
inexpensive labour markets has reduced the cost of goods, but it has also meant that manufacturing jobs have moved
from developed economies to less-developed economies.
This interconnectedness leads to a degree of fragility in the markets. Because every entity has a role, when one
entity fails, the consequences extend to others. As a recent example, Brexit was a phenomenon that caused concern
in many other countries, and the full impacts of its eventual outcome are uncertain. On the surface, this is an internal
political matter that should only impact one country – Great Britain. But many other countries rely on Great
Britain’s trade with Europe. The domino effects of Brexit are likely to be felt in every major economy.
We previously discussed equilibrium and arbitrage. As markets are increasingly interconnected, arbitrage
opportunities become more available. A famous example of this took place in 1997 and 1998, when George Soros’
Quantum Fund bet against the Bank of Thailand, which was trying to manage its currency against a variety of
pressures. Soros’ fund detected weaknesses in the Bank of Thailand’s handling of its currency and used derivatives
(to be discussed in chapter 12) to bet against the Bank. The Bank’s handling proved clumsy, and the Quantum Fund
benefited richly. This exploitation of an inefficiency was possible because of Thailand’s connection to other
markets, notably the US Dollar in this instance. The baht (Thai currency) was significantly devalued as a result.
Arguably, it achieved its true value, which might be an example of equilibrium, as discussed earlier in this chapter.
The fallout from events in Thailand extended to other Southeast Asian nations. Almost every major economy in
the region saw foreign capital leave in very large amounts, significant drops in currency valuations, and stock
markets that underwent major drops in value. Even the US stock market, which seems large enough to be insulated
from such outcomes, experienced a single-day loss of 7.2% of its value (based on the Dow Jones Industrial Average,
which will be discussed in chapter 10). One theory is that the flight of capital from Asian economies led to over-
investment in tech companies, which ultimately brought about the popping of the dot-com bubble in 2001. In 2001
and 2002, the NASDAQ stock exchange, which represents many American tech companies, saw its value drop by
78% from its 2001 high point.
The global economic system provides increased opportunities. At the same time, it leads to additional risk.
Because of the interconnectedness of all entities, it can happen that events halfway around the world have effects
that are not felt until years later in other economies.

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MONEY

What is money? Most of us probably think of money as the coloured pieces of paper and coins that we carry in
our wallets and use to buy things. However, this is only a small part of the story of what money is. Money is
represented in many other ways. To begin, let’s look at the three purposes of money:

• Medium of Exchange. Money’s most immediate and most obvious purpose is to buy goods and services.

• Store of Value. The monetary system is useful in that it allows us to save and retrieve our money for use in
the future.

• Unit of Account. Money is useful in that it gives us something tangible with which to attach value to
concepts. We might say a business is profitable, but what does that mean? If we know that the business had
net earnings of $100,000, then that tells us something understandable about the profitability of that business.

At one time, it was commonly taught that money held a fourth purpose – a standard of deferred payment –
meaning that money could be used to settle a current debt at some point in the future. It is generally accepted today
that this is a combination of the three functions discussed above.
How do we know the value of a dollar? What gives it value? At one time, money was issued based on the
amount of gold (and prior to that, silver) held in a state’s reserves. Countries used to accumulate precious metals as a
store of wealth, and then issue currency to stimulate economic growth. That system made it very easy to calculate
the value of currency; it was directly related to the ratio of currency issued to the amount of precious metals held in
reserve. This is no longer the case, as throughout the 1960s and 1970s, systems which had fixed the amount of
currency to the amount of gold become untenable as countries (notably the United States) began issuing currency
without regard to the amount of reserves held.
This collapse of the Bretton Woods system (Bretton Woods being the system of locking in currency exchange
rates that was established by the Allied Nations near the end of World War II) brought about a system in which
money has value because the government says it has value. This is known as the fiat money system. In the fiat
money system, when currency is originally issued, the issuing government uses a fiat (a declaration) to assign value
to that money. The toonie that you are carrying in your pocket does not have $2 worth of metal in it. You know it is
worth $2 because the Bank of Canada tells you it is so. You also know that if you go to a merchant in Canada, you
will be able to exchange your toonie for something that is worth two dollars. If something terrible happened in our
country and our government became destabilized, merchants might not be willing anymore to take your toonie in
exchange for goods.
As previously discussed, the amount of currency issued only tells a small portion of the story about how much
money is out there. The money supply can be measured several different ways. Some of the more common measures
are:

• M0. Not usually an official definition, M0 refers to the amount of paper and coins in circulation. This
includes amounts held by individuals and by banks, other than central banks (e.g. the Bank of Canada).

• M1+. As we move from M0 through to the M2++ money supply, we will see the items included in the money
supply increase. The M1 money supply includes currency held by entities other than banks, but also
incorporates chequing accounts (held at both banks and other deposit-taking institutions), negotiable
instruments, and traveller’s cheques. M0 and M1+ are the narrow measures of money.

• M2. M2 includes currency held outside banks, plus all bank accounts (both chequing and saving). M2 also
includes bank issued money market instruments. Note the distinction between banks and other deposit-taking
institutions. Banks have a special place in the financial system, as we will see later in this chapter. The other
deposit-taking institutions (whose deposits are not included in the M2 money supply) include trust
companies, mortgage companies, credit unions, government savings institutions, and caisses populaires.

• M2+. Includes M2, plus deposits at other deposit-taking institutions, plus individual annuities at life
insurance companies, and money market mutual funds.

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 • M2++. Includes all M2+ items, plus Canada Savings Bonds, publicly traded bonds, and mutual funds. The
M2 money supplies are referred to as the broad measures of money.

• M3. M3 has fallen out of use but was formerly a broad measure of money designed to capture all liquid and
nearly liquid items. It would have included all the items described above, plus certain short-term contracts to
purchase certain securities.

Obviously as we move through the various measures of money supply, we go from the most liquid form of
money (currency) to less liquid forms (mutual funds, bonds, Canada Savings Bonds). The central bank (the Bank of
Canada, in this country) exerts greater control over the narrower measures of money. In fact, the differences
between the various money supplies are a set of indicators to tell us where we are in the economic cycle. Through
the rest of this chapter we will look at some of the factors that determine how much money is in the money supply.

THE RESERVE SYSTEM

As mentioned previously, banks have a special place in the financial system. We know that banks provide
savings opportunities, lending, mortgages, and a variety of services which many of us access daily. However, we
can also get many of these services from non-bank deposit taking institutions, such as credit unions, trust companies,
and caisses populaires. The discussion around the Reserve System is specifically focussed on banks.
Most states have a central bank in one form or another. The central bank is responsible for monetary policy,
which we will describe later in this chapter. Canada’s central bank, the Bank of Canada, acts as a bank to the banks.
Individual citizens do not have accounts at the Bank of Canada. Only the banks transact business there. The Bank of
Canada performs many vital roles in the management of the Canadian financial system. It provides money to the
banks that then deal with consumers. It acts as a clearinghouse for transactions between the banks. It provides funds
to the banks to help meet requirements for short term liquidity.
The money that the Bank of Canada provides to the consumer banks (this includes the banks we are all familiar
with – RBC, TD, Scotiabank, CIBC, BMO, National Bank, but there are 78 banks operating in Canada at the time of
this writing) flows out to consumers for their use.
The amount of money that flows to consumers depends on the amount of reserves that banks are mandated to
retain. At one time, the Bank of Canada set a reserve requirement for the banks, indicating that they had to retain a
certain amount of capital based on their total deposits. Today, there are no reserve requirements for Canadian banks,
but Canadian banks, which are known for being quite conservative, still operate as if there were a reserve
requirement. Accounting rules still generate some necessity for banks to hold reserves to match their deposits.
It is useful, for a proper understanding of the banking system, to look at the reserve system in application. Let’s
imagine that we have a central bank, and only one consumer bank, XYZ Bank. The central bank sets a reserve
requirement of 10% and issues $1000 to XYZ Bank. We will see that the consumer bank multiplies, to great effect,
the amount of money available to the consumer:

Total in Circulation
Central bank issues $1000
XYZ Bank lends $900 to Sara, keeping $100 back as a reserve. $900
Sara spends the $900 buying a couch from Sofia.
Sofia deposits the $900 into XYZ Bank.
XYZ Bank lends $810 to Jill, keeping a $90 reserve. $1710
Jill spends the $810 buying a TV from Bill.
Bill deposits the $810 into XYZ Bank.
XYZ Bank lends $729 to Karim, keeping an $81 reserve. $2439
Karim spends the $729 buying a vacation from Phil.
Phil deposits the $729 into XYZ Bank.
XYZ Bank lends $656.10 to Erin, keeping $72.90 as a reserve. $3095.10
This process continues all the way until zero, increasing the amount of
money in circulation using the formula:
Money in Circulation = Funds in Central Bank ÷ Reserve Requirement $10,000

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 = $1000 ÷ 10%

In practice today, the reserve system is not nearly so simple. Banks still use reserves, but the required reserves
are based on complex formulas that incorporate default risks and liquidity risks for specific groups of borrowers. A
bank might choose to lend to a riskier group, charging higher rates, but it will be able to lend less than it would with
a safer group of borrowers, because the riskier borrowers will require a higher reserve.
As we can see, effective banking practices greatly amplify the amount of money in circulation. Effective
banking practices are responsible for much economic growth. Bankers are constantly looking for ways to increase
the money supply without increasing their own risk. This follows a normal pattern that has been repeated throughout
history. The banks find a way to put more money in circulation. Initially, the product has little impact. Over time,
the impact grows until many banks are using it. Competition forces some entities to relax their risk management
requirements, taking more and more risk. A bubble builds around the product in question and eventually the banks
learn that they have taken too much risk. These bubbles are not unique to banking products. Financial history is
dominated by the expansion and bursting of bubbles. We are often critical of this cycle, but it is a normal part of
economic growth.

DIGITAL CURRENCY

As long ago as 1998, it was hypothesized that a currency system could exist outside the system of government-
issued currency that we are all familiar with. This hypothesis came to reality in early 2009, with the introduction of
the cryptocurrency known as Bitcoin. The first in a line of digital currencies, or cryptocurrencies, Bitcoin remains
the most widely held, traded, and known of the digital currencies.
As of June of 2020, there are approximately 3 to 6 million people using Bitcoin, and a total of just over
$160,000,000,000 USD worth of Bitcoin in circulation.
While there was much initial speculation about the possibility for digital currency to overtake fiat money as the
global currency of choice, this trend has either stalled or stopped. Even the purpose of digital currencies has become
blurred. Some people do hold it as a medium of exchange, which you may recall is one of the three key purposes of
money. Many others, though, hold it strictly as a speculative investment.
Most digital currency comes into existence via ‘mining’. Mining is the process of putting computers to work to
solve equations. Once a number of equations are solved, a unit of digital currency comes into existence. The number
of equations that must be solved to create a unit increases each time a unit is created, meaning it gets subsequently
harder to mine new units. This has basically become an effort to convert energy into currency, because the
computers that are put to work mining bitcoin are using energy to run their processors to perform the requisite
number of calculations.
Owners of digital currency hold their investments in a ‘digital wallet’. Digital wallets have a variety of uses,
but, in North America, they are best known as repositories for digital currency accounts. This presents a bit of a
problem for digital currency users, as they must access their digital wallet to access their digital wallet. Many
merchants do not accept digital currency as a medium of exchange.
Digital currency is tracked via blockchain technology. Blockchain refers to a system in which a transaction has
three records. Traditional accounting practice has seen transactions with two records in a ledger – a debit and a
credit. Blockchain technology creates a ledger with three records – a record of the previous block (or record); a
timestamp indicating when the transaction took place; and transaction data, indicating the parties involved in the
transaction. Each record is cryptographically secure, meaning that the data is hard to alter. Blockchain technology
was originally developed for use in Bitcoin. Since then, it has been experimented with in various commercial
applications, such as supply chain management.
Digital currency is somewhat problematic from a government’s perspective. As we have seen in this chapter,
governments prize their ability to track transactions so they understand what is happening in the economy. Digital
currency transactions are difficult for governments to track. Taxation is another problem, and many governments
have warned investors that digital currency-related gains are taxable. In Canada, gains associated with digital
currency are generally treated as capital in nature, but can also be business income, if the investor treats their digital
currency activity as a business. This will be described in more detail in chapters 7 and 9.
An entire ecosystem has arisen around digital currency investments. There are thousands of digital currencies in
circulation today. Bitcoin and Ethereum are the two largest, but there are many others. There is an entire language

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around these investments. For example, an investor who bought a digital currency on speculation and is now holding
on for a price increase is often referred to as a HODLer (Hold On for Dear Life).
Digital currency represents an exciting opportunity for an alternative to traditional currency, but that potential
has gone mostly unrealized to this point. Digital currency assets have been highly volatile, which makes it unsuitable
for holding the same way that we normally hold cash. While some of the bigger entities have weather significant
volatility, there have been problems with stability among some of the digital wallet providers. Investors should be
wary about using digital currency as the core of an investment strategy.

KEEPING IT ALL IN CHECK

As previously discussed, both inflation and unemployment present problems for a government. Some growth is
ideal, but rapid growth is hard to manage. Correspondingly, governments will implement measures to keep
economic growth at a manageable level. The consequences of these measures are a subject of much debate. For the
purposes of this course, we will teach them in their basic form, as taught by the economist John Maynard Keynes.
There are two sets of measures used by governments to control and stimulate growth. They are monetary policy
and fiscal policy. Monetary policy involves measures taken by central banks to control the amount of money and
securities in circulation. Fiscal policy includes measures taken by elected governments such as taxation, regulation,
and spending. The goal of these policies is to create manageable growth. Most governments target growth as
indicated in the following diagram:

Excessive
Growth
Growth
Target

Growth
Target

Insufficient
Growth

We will see, as we go through the following sections, that fiscal and monetary policy measures can have a
direct impact on our personal financial affairs.

MONETARY POLICY

Having already discussed some of the functions of central banks, we are prepared to further examine monetary
policy. If we assume that the central bank wants to slow rapid growth and spur the economy out of a recession, then
we can understand why and how the following measures might be implemented.

• Manipulation of Interest Rates. This is likely the monetary policy instrument that gets the most attention.
Eight times per year the Governors of the Bank of Canada announce changes in the overnight rate. The
overnight rate is the target for the rate at which the consumer banks lend to each other on a short-term
(overnight) basis. It is frequently necessary for the banks to do this to maintain liquidity. The Bank of
Canada’s manipulation of the overnight rate has varying effects on the economy:

o Increase in Interest Rates. When the Bank of Canada perceives economic growth to be too great,
measures will be taken to slow that growth. The Bank has set its target for inflation at between 1 and 3
percent. If inflation is too high, the Bank will look for ways to reduce that growth. One tool that is
available is an increase in interest rates. By increasing interest rates, the bank makes it harder for
consumers to borrow money to make purchases. This would have a direct impact on, for example,
orders of durable goods. As we have seen earlier in this chapter, reducing the orders of durable goods
should slow the economy, reducing inflation.

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 o Decrease in Interest Rates. Conversely, when the economy is slowing, the Bank will decrease interest
rates. This will make it easier for consumers to borrow money, therefore easier to make the big-ticket
purchases that would be reflected in an indicator such as orders of durable goods.

o Bank Rate. The bank rate is the rate at which the Bank of Canada lends to other banks. This rate is
seldom used, as the banks are encouraged to lend to each other to create liquidity. The bank rate is
normally 25 basis points (.25%) higher than the overnight lending rate. A bank rate of 1.25% means
that the target for the overnight rate – which is the actual outcome that the Bank of Canada is normally
most concerned with – is likely 1.00%.

o Prime Lending Rate. There is a common misconception that the Bank of Canada sets the Prime
Lending Rate. The Prime Lending Rate, or Prime Rate, is the rate set by each consumer bank on which
they base their consumer lending. In theory, a bank will lend money to its best clients at the Prime
Rate. The consumer banks need to make money when they lend money, and one way that they can do
so is to charge their borrowers a higher rate than they themselves are paying. When the Bank of
Canada increases or decreases the target overnight rate, the consumer banks will typically increase or
decrease their Prime Rates to match. There is no obligation to do so, and sometimes, the Prime Rate
will vary slightly from bank to bank. In contracts that refer to Prime Rate, a distinction must be made,
such as “Royal Bank Prime Rate”.
The prime lending rate is another lagging indicator. Because financial institutions adjust their
lending rates in response to activities, we normally don’t see the prime rate respond immediately to
economic conditions. If there has been inflation (growth), then banks will normally have increased
their prime rate. If there has been no inflation, the prime rate will normally be lower.

• Increasing or Decreasing the Money Supply. This measure, which is less frequently used, involves direct
manipulation of the amount of money in circulation. A central bank might increase the money supply to
create liquidity and spur the economy out of a recession. A decrease in the money supply would contract the
economy.

• Issuing Government Securities. In course 2 we will examine securities in some detail. For the time being, it
is sufficient to know that a security represents a promise related to a debt, asset, or cash flow. Governments
issue securities to raise capital and to give investors a safe place to keep their money. Government securities
are generally seen as very safe investments with a low risk of default. This low risk investment also means
that returns associated with government securities are very low. An investor uses government securities to
remove uncertainty but gives up growth opportunities. This also means that when an investor chooses
government securities, that investor is not helping to grow the economy. The available supply of government
securities has an impact on economic growth:

o Issue Government Securities. When the economy is growing too quickly, central banks will issue
government securities. The availability of these safe, low-growth investments will get investors away
from riskier growth-oriented securities. By doing so, the government will slow economic growth.

o Reduce Government Securities. When the economy is slowing down, central banks will reduce the
availability of government securities, encouraging investors to put their money into other investments
with more prospects for growth.

As of late 2020, an extended period of low interest rates has seen both government and personal
borrowers take advantage of cheap debt at levels that are unmatched in history. This creates a bit of a
conundrum. Cheap debt (low interest rates) helps spur economic activity, which is likely a good thing. There
are many concerns, though, about what happens if debt becomes expensive. Any increase in interest rates is
likely to hurt borrowers.
Given that governments are both very large borrowers and, to some degree, in control of interest rates,
there is some question about their motivation to raise interest rates. Some attribute this conflict of interest to
the current state of most western economies’ Debt-to-GDP ratios. Debt-to-GDP is an indication of the ability

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 of a country to service and pay its debts. It is roughly analogous to total debt service (TDS) ratio, which we
will discuss in chapter 3.
The World Bank indicates that a developed economy can support a Debt-to-GDP ratio of up to 77%,
meaning that the country has $.77 of debt for every dollar of domestic production. For developing economies,
the limit is $.64 per dollar of GDP. Beyond that, carrying debt leads to a burden that will reduce economic
growth for that country.5
As of 2018, Canada had a debt-to-GDP ratio in the high 80% range, or in the low 90% range, which is a
touch on the high side, but generally pretty healthy. It briefly crept over 100% in the mid-90s but has
otherwise hovered between about 70% and 90% in recent history. By comparison, the United States has a
ratio of just over 100%, while Germany is in the mid-50s, and Japan is around 225%.
However, this ratio is not always as revealing as it seems. The Americans, for example, have a lot of debt
held by their social security program, which is not incorporated into their calculations. A good amount of
Japan’s debt is held by its own citizens, which is less concerning than if foreign entities held it. The measure
above indicates Canada’s Federal Government debt and does not reflect Provincial Government debt.
In Canada, there are three levels of government that can issue debt:

o Federal Government. The Federal Government is a major debt issuer in Canada. Government of
Canada bonds play a vital role in many portfolios. They are generally considered a very safe asset.
Returns are quite low, but investors have a great deal of certainty and stability associated with these
bonds.
The Federal Government is not generally constrained in how much money it can borrow.
Occasionally, government debt becomes an election issue, and may influence how voters determine
who will comprise the next government.

o Provincial Government. Provincial Governments borrow at varying levels. Ontario, for example,
carries a very large debt load. For a long time, Alberta did not use debt financing at all.
Provincial debt tends to be slightly riskier than federal debt. Provincial governments generally
have to offer slightly higher returns to offset this risk.

o Municipal Government. Municipal Governments have their ability to borrow constrained by

provincial legislation. There are a wide variety of rules across the country, but as a few examples6:

▪ Nova Scotia municipalities can borrow no more than 30% of their source revenues.
▪ PEI municipalities can borrow no more than 10% of assessed real property value.
▪ Newfoundland municipalities have no restriction on their ability to borrow.

While many taxpayers find the idea of governments carrying debt distasteful, government borrowing fills
an important role. It can help to shore up a weak economy. It gives governments a source of funds when
revenues might be in decline. Government bonds are a valuable part of many investment portfolios.

Monetary policy is extremely difficult to manage properly. Changes do not always have the desired impact. In
June of 2010, the Bank of Canada increased interest rates even though Canada was in a recession. This increase in
interest rates was not done with the desire to help Canada out of the recession; instead, it was done with the goal of
giving the Bank of Canada some ability to reduce interest rates later, if necessary. Further, the Bank’s own policies
indicate that any change should take 24 months to have the desired effect. With such a long span between a decision
being made and its consequences being felt, it is very difficult to make a positive correlation between action and
consequence.
Also, central banks recognize that there is only so much that they can control. The Bank of Canada has a goal of
controlling the price of currency within Canada’s borders. This means that control over exchange rates is outside of
the Bank of Canada’s goals. Exchange rates are the rate at which Canadian currency can be purchased using foreign
currency. We most often refer to exchange rates using the US dollar as the baseline, but there is an exchange rate

5
[Link]
6
[Link]

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between the Canadian dollar and every other currency. Most often an increase in interest rates will also increase the
demand for Canadian dollars, as foreign investors know that an investment in Canada will have a greater yield.
Conversely, a decrease in interest rates will result in a decrease in demand for Canadian currency. Canada, being a
resource-based economy which imports most manufactured goods, relies heavily on a currency which trades low
enough to attract purchasers of our commodities. At the same time, our currency must be strong enough to purchase
foreign-manufactured goods.

FISCAL POLICY

While the Bank of Canada implements monetary policy, our elected politicians implement fiscal policy. Fiscal
policy includes legislative and policy measures designed to stimulate or restrict economic activity. As with monetary
policy, fiscal policy can have a variety of unforeseen effects. Instruments of fiscal policy include:

• Taxation. Governments will use tax measures for a variety of reasons, but one goal of tax changes is to have
an impact on the economy. An increase in taxes will usually restrict economic activity. A decrease in taxes
should have the opposite effect. Assuming this is true, governments should increase taxes in a boom and
decrease taxes in a recession. This has not always been the case, though. Sometimes elected governments use
tax changes purely as a vote-buying strategy. This can have harsh economic consequences later. A recent
example of taxes being used to stimulate the economy came in 2009, when the government passed legislation
enacting the Home Renovation Tax Credit, which was designed to encourage homeowners to spend money
renovating their homes. This was done at a low point in the economy to spur economic activity. This can be a
double-edged sword, as Canadians who should probably have been saving were encouraged to spend in order
to stimulate the economy.

• Government Spending. As with tax measures, government spending is done with a variety of purposes in
mind. In theory, government spending should increase during a recession. This should keep the economy
going and allow companies to stay busy despite a lack of economic activity. During an expansion
government spending should slow down. If governments hold true to this cycle, it has the additional benefit
of allowing governments to buy goods and services when demand is otherwise low, which will allow those
governments to pay a lower price.
Governments will choose to either spend into a surplus position, or a deficit position. A surplus means
that spending is less than current cash flow, while a deficit means that spending is more than current cash
flow. In a surplus year, a government will normally pay down debt. In a deficit year, a government will
normally take on debt. This is normally projected in a government’s budget for the year; most Canadian
governments will issue a budget in the February-April time frame, and an update in the October-December
time frame. The budget will project spending and income levels. These are all unknown quantities until the
year-end.

• Regulation. More difficult to get a handle on, government regulation can have an impact on the economy.
All else being equal, deregulation should stimulate the economy, as companies have less rules in which to
operate and will be allowed to focus more on key business activities. Regulation should slow the economy as
companies are forced to work within a framework of rules. Regulation can be done for a other reasons, such
as consumer protection.

As with monetary policy, the implementation of fiscal policy can have unintended consequences. Despite that,
governments will sometimes aggressively pursue fiscal policy measures in pursuit of an economic goal.

CURRENCY EXCHANGE RATES

Currency exchange rates are something of a wildcard in all this. Governments generally want to control their
exchange rates, but this is sometimes outside of government control. We saw an example of this with the Thailand
story earlier in this chapter.
Exchange rates refer to the value of one country’s currency against another. The US Dollar is often used as the
reference currency. It may be easier to look at two currencies, and how they compare to US Dollars, than to compare
them to each other.

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 The US Dollar plays an important role as the Reserve Currency of choice for most countries. This means that
countries hold it so that they have funds on hand to complete various transactions. While reserve currency values are
not publicly available, it is estimated that the US Dollar forms at least 60% of currency reserves, globally. This gives
the US a significant advantage. Other countries will borrow US Dollars at lower rate than other currencies because
of its widespread acceptance. The US Government can use this position to impose sanctions on other governments.
Most currency values fluctuate based on supply and demand. Investors will generally seek currencies that are
stable, driving up the value of those currencies. This is not always desirable. Canada, for example, generally benefits
from having a currency that is slightly lower than US Dollars. This gives Canadian firms an advantage, because US
firms have an inherent discount when buying labour and materials from Canadian suppliers. Conversely, snowbirds
(Canadians who spend their winters in the United States) would prefer that the Canadian dollar is stronger.
The value of a country’s currency is generally perceived as a lagging indicator.
Some governments do not allow their currencies to fluctuate based on supply and demand. Prior to the 1997
crisis described above, Thailand’s baht was pegged to the US Dollar, meaning its value was specifically linked to
the US Dollar, with no opportunity for fluctuation on its own. This has been a relatively common practice in
developing economies. The biggest downside is that it removes any opportunity for that country to use a set of
monetary policy tools.
Perhaps better known, the Chinese currency (Renminbi, of which the Yuan is the primary spending unit) has
been subject to much direct manipulation by the Chinese Government. Today, the Yuan floats based on supply and
demand, but not its own supply and demand. Its price floats based on a basket comprising a set of foreign currencies.
The Chinese government maintains this price by controlling how much currency is in circulation.

MONETARY AND FISCAL POLICY TOGETHER

Governments use all the tools described in this chapter together. Much care must be taken to minimize
unintended consequences. It can happen that a sloppy implementation of policy can have disastrous consequences;
the story of ‘The Man Who Broke the Bank of England’ is a great example of this. In 1992, the British government
was slow to implement policy measures to reflect the true value of the pound. As a result, currency speculators, most
famously including George Soros, were able to profit by shorting (as described in chapter 12) the British pound.
The policies described in this chapter can generally be described as contractionary (designed to slow economic
growth) or expansionary (designed to spur economic growth). The following chart breaks this down:

Monetary Policy Tools Expansionary Example Contractionary Example

Interest Rates Mortgage interest rates should fall, Business financing will become more
allowing more people to buy more expensive, causing businesses to
expensive homes. reduce capital spending.
Money Supply Consumers can spend more on Businesses will have to work harder to
discretionary purchases, such as toys find capital, reducing the amount being
and vacations. spent on major projects.
Government Securities Treasury bills will be very unattractive, Savers will invest in boring
compelling savers to invest in government securities, saving their
businesses, instead. money for a rainy day.
Fiscal Policy Tools Expansionary Example Contractionary Example
Government Spending Construction companies will have Construction companies will have to
many government projects available rely on the private sector for work,
and a steady flow of work. resulting in less revenues.
Taxation Taxpayers see their average tax Taxpayers have additional taxes
payable decline, freeing more dollars imposed on them, giving them less
for discretionary spending and dollars to spend.
investing.
Regulation Oil and gas companies can operate Oil and gas companies have many
relatively unconcerned about regulatory hoops to jump through,
environmental controls, reducing the reducing the investment and capital
cost of doing business. dollars that are available.

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HOW DOES IT WORK?

Steve and Helen have been renting an apartment for the past four years. Now they are considering having a
baby, but before they do, they would like to purchase a home. They want to know if now is the right time to
purchase the home, or if they should wait. They have heard many of their friends talk about the money they saved by
choosing a variable rate mortgage, and they would like to know if this is right for them. (Fixed and variable rate
mortgages will be described in chapter 3.)
Let’s say that currently inflation is low. Unemployment is relatively low. Interest rates are low and have been
for some time. There have been no major tax changes for a few years.
Given that inflation is low, they should not count on big increases in the price of the house. Markets are not
always perfectly correlated to inflation. They could potentially wait to buy, and not see big increases in the housing
market.
Low unemployment right now creates some uncertainty. This being a lagging indicator, it is likely that the
economy is already substantially into its current cycle. This means the current cycle could end at any time.
Employment will not start to reduce until after the current cycle is over. However, it also means that Steve and
Helen have security in their jobs and should be able to replace those jobs should either of them become unemployed.
Low interest rates now might make this an attractive time to buy. Whether they choose a variable rate or a fixed
rate mortgage, their current interest rate will be quite low. We know it is normal for a government to increase
interest rates in order to slow growth. Do Steve and Helen wish to lock in their rate now, or can they choose a
variable rate mortgage and keep an eye on the situation, moving to a fixed rate if rates start to increase? As long as
they know what to watch for, this might work. There is probably no perfect answer to this question but
understanding the underlying factors will help them to decide.
If taxes stay at their current level, Steven and Helen should be in the same condition they are currently in.
However, it is likely that the government might increase tax rates or remove tax incentives as the economy
accelerates. This might make now the best time to buy, as there might be tax incentives presently available that
might not be available in the future.
There are many other factors that must be considered in helping Steven and Helen with this financial decision.
However, a good understanding of the economic cycle can help them to make informed choices about their financial
future.

SOURCES FOR THIS CHAPTER

There is a huge amount of reading available on economics. Some sources that you might find useful or interesting
are:

Niall Ferguson. The Ascent of Money. (London, 2008). This is a great examination of the factors that have shaped
the global economy. It contains many useful anecdotes about the rise and fall of financial systems.

Website of the Canadian Bankers Association: [Link] This site includes good basic information about banks
and their role in the economy.

Website of the Bank of Canada: [Link] This site includes excellent detail, including easy to follow
diagrams, regarding monetary policy at work.

Website of Statistics Canada: [Link] This site includes the core information about inflation, as well as
many economic indicators.

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