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What is the economy?

Rounding it up

  • The economy refers to the production, consumption, and trade of goods within a country. It’s affected by your every decision, even your morning coffee purchase.

  • In turn, the economy affects you as well, through interest rates, employment, and government policies.

  • Four major industries fuel Canada's economy: real estate, oil, gas, and energy, manufacturing, and tourism.

  • In light of COVID-19, the future of Canada’s economy remains uncertain. But there are some positive signals to look at, like the growing tech and renewable energy sectors.

11 min read

Barry Choi
#economy#government#recession#industry

Even if you have no interest in business news, it's unlikely you would have missed some of the headlines in the last year. The COVID-19 pandemic has resulted in many small businesses closing permanently, housing prices have increased, and the tourism sector has lost tens of thousands of jobs. This news affects Canada's economy directly, but what does that mean for you specifically? And, what is the economy anyway?

In simple terms, the economy is anything related to the production, consumption, and trade of goods within a country. Government policy, the job market, and even individual decisions you make all affect the economy.

You wouldn't think something as simple as deciding to focus on savings instead of buying a coffee would matter much, but it does in the grand scheme of things. How the economy works can be quite interesting, and you don't need to be an economics major to understand it.

Does the economy affect me?

Although you may not be paying attention to the large scale economy, it works around you every day. For example, when the Bank of Canada lowers interest rates, they're trying to encourage people to spend. When they want to slow inflation, they’ll increase interest rates, which encourages people to save.

Now think about your job for a second. You get paid to perform tasks and what you do with that money is up to you. Suppose you decided to spend it on a nice meal. In that case, you'd be helping the staff at the restaurant and the farmers who produced the food since the business has to purchase ingredients.

Consumer confidence, which is your overall feelings towards the economy, is often an economic indicator. When you’re confident about your job and the state of the economy, you’re likely to spend. However, if you’re worried about where things are headed, you’ll usually start to save and spend less. How you, your family, and your community feel has a direct effect on the economy.

Government policy is also one of the most significant factors that affect the economy. If they choose to invest in specific sectors, it could create jobs. Even providing tax incentives to companies greatly affects the economy as it could bring jobs to particular cities.

"In simple terms, the economy is anything related to the production, consumption, and trade of goods within a country."

How does Canada’s economy work?

Canada has a strong economy with a variety of sectors generating money for the country. Canada's gross domestic product (GDP) was just over $1.73 trillion USD in 2019 which ranked as one of the world's top ten economies.

Let's back up for a second. What is GDP? It's the value of all goods and services made within a country, usually measured within a year. If a country's GDP is rising, then the economy is growing. However, if it starts to fall, the country's economy may be retracting. It's basically a quick way to see how a country's economy is doing.

Even though Canada's economy is diverse, four major industries fuel the country's income.

Real estate

Housing prices in Canada increased quite a bit over the last two decades due to real estate demand. Houses and condos have been popping up all over the country, and it seems like builders can't construct homes quickly enough. While this is great for the economy, there are concerns that the rising costs will make housing unaffordable for many people.

Oil, gas, and energy

The oil and gas industry saw massive growth in the last 50 years, but when the price of oil fell in 2014, the country was forced to diversify. Many Canadians don't realize that Canada has the third-largest oil patch in the world. Alberta is home to much of that oil, so the local economy heavily relies on the sector.

Someone in Ontario may not care about a pipeline contract being cancelled, but for many Albertans, that could be their livelihood. It's also worth noting that both the provincial and federal governments factor in royalties from oil producers as part of their budget. When the price of oil falls, it could significantly affect the government’s economic plan.

Traditional energy sources such as coal, uranium, and other mineral deposits are found throughout the country and exported. While this is good for our economy, the government has shifted to more sustainable energy sources such as hydroelectricity. This energy can be exported to our neighbours to the south, which helps stimulate Canada's economy.

Manufacturing

The manufacturing industry helps Canada's GDP. Bombardier, which produces planes, trains, and buses in Quebec is a brand that’s recognized worldwide. Canada also makes many vehicles for Chrysler, General Motors, and Ford, which are then exported to the rest of the world.

As you can imagine, lumber is also a popular export since we have vast forests. Canadian beef and seafood are also in demand as they can be found on menus all around the world.

Tourism

Ironically, many Canadians haven't visited any provinces outside of where they live, yet tourism is a major industry. People from all over the world travel to Canada every year to see our cities and explore our nature. The money they spend on hotels, attractions, food, and retail contributes to the Canadian economy.

Despite Canada's strong economic position in the world, it still relies heavily on natural resources. For the country to grow economically, it'll need to continue to diversify. That said, building different industries doesn't happen overnight. It usually takes time and significant investment. This is a tricky balance for our government as they've been under pressure by citizens in recent years to exercise fiscal responsibility. In other words, Canadians are tired of seeing the government waste money when they may be struggling with their own monthly bills.

"Despite Canada's strong economic position in the world, it still relies heavily on natural resources."

How does the economic cycle work?

Interestingly enough, the economic cycle (sometimes referred to as the business cycle) is very easy to recognize when looking at current and past data. The four stages are as follows:

Contraction / Full recession

Due to the COVID-19 pandemic, Canada is arguably in the contraction phase of the economic cycle. We've seen our GDP drop in two consecutive quarters, which is the definition of a recession. Interest rates have dropped, and consumer expectations are relatively low. Rising unemployment and stagnant prices are also a major concern for everyday citizens.

Trough / Early recovery

When countries are in a recession, they want to get to the trough stage as quickly as possible. This is when you'll hear about government spending. It's their way to try and stimulate the economy. While incentives can help, a recovery only happens if consumer confidence increases and they start spending again. When people are buying again, manufacturers will ramp up production.

Expansion / Late recovery

Early recovery leads to late recovery where the economy really starts to pick up. Many consumers have dropped their expectations, but they're still spending. Around this time, interest rates begin to rise, and industrial production will usually flatten.

Peak / Early recession

When growth hits its maximum rate, it reaches its peak. Unfortunately, things can only go down from here, which leads to an early recession. Consumer expectations start to fall again, and interest rates can be at the highest levels Canadians have seen in some time.

It's easy to see how these four stages have played out throughout the years when looking at things historically. However, it's nearly impossible to know when something will change as we're experiencing them in real-time.

Canada's GDP had seen year-over-year growth for many years, but the pandemic has put things on a downward trajectory. It's hard to tell when things will start to recover, but the government will try to use policy to improve things.

How does Canada's economy depend on the United States?

This may or may not surprise you, but 65 percent of Canada's economic growth depends on trade. With the United States being Canada’s direct neighbour, they’re the country’s number one trade partner. While having a lot of trade is good for the economy, relying so much on it to fuel the economy can be tricky. It can prove especially challenging at times since Canada is mostly dancing with one partner.

As a result, the Canadian government needs to maintain a healthy relationship with our neighbours to the south. Our politicians' decisions could anger their counterparts in the United States, resulting in changes to the trade agreements or the implementation of new taxes. It's also worth noting that new political leaders on either side of the border may have different visions for the country, which could affect trade policy.

Canada also imports many products from the United States, such as food, electronics, vehicles, chemicals, and more. You really can't talk about Canada's economy without considering the United States since both countries are so intertwined. It's in the best economic interests of both nations to maintain a relationship that encourages open dialogue.

How does monetary policy affect the economy?

Interest rates controlled by the Bank of Canada (BoC) are one of the most significant factors that affect the economy. The core objective of the BoC is to keep inflation low and stable. To keep things under control, they can raise or lower interest rates.

If inflation is under control and interest rates are stable, Canadians are more likely to spend since they'll have increased consumer confidence. Companies may even hire more people as their outlook on the economy could be positive.

Generally speaking, the BoC likes to keep inflation around two per cent. This target was first introduced in 1991 by the federal government and the BoC. The number is reviewed every five years to ensure that it's still a reasonable expectation for inflation. Overall, the government and BoC want stable prices for all Canadians.

One term you may have heard of is the overnight rate, which is the key interest rate set by the BoC. It's a benchmark used for loans between financial institutions. With this rate in mind, lenders set interest rates for consumer loans. If the BoC lowers interest rates, then consumers will be able to borrow money for less. On the flip side of things, if interest rates go up, your cost of borrowing increases. That said, saving your money is much more appealing when interest rates are up.

Monetary policy may not sound very interesting, but it has a direct effect on us. When interest rates are low, it's cheaper to borrow money. This is handy if you're looking to purchase a home or car since your monthly payments will be low. That said, with the lower cost of borrowing, many people tend to take on bigger loans. That could be an issue in the future if interest rates rise and you need to renew your loan. If you’re already stretched to your max, any increase in your monthly bills could be crippling.

What role do taxes play in the economy?

Another way you contribute to the economy is with the taxes you pay. Although many Canadians like to complain about the amount of taxes they pay, what we pay and what we get in return is pretty reasonable compared to other parts of the world. Tax revenue represents about 32 per cent of Canada's GDP and helps pay for things such as:

  • Health care

  • Libraries

  • Employment insurance

  • Roads

  • Old Age Security

  • Schools

How much you're taxed depends on how much you make and where you live. Under Canada's marginal tax system, you would pay more taxes as you earn more income. To be clear, the higher taxes only apply to the higher tax brackets that you fall into. You can never earn less by working more.

Tax brackets are set at the federal and provincial levels, but there are many ways to lower your taxable income, such as making Registered Retirement Savings Plan contributions or donating to a charity. For most people, taxes are taken at the source (right off your paycheque), but self-employed individuals will need to set aside some of their income to pay their eventual tax bill.

"When interest rates are low, it's cheaper to borrow money. This is handy if you're looking to purchase a home or car since your monthly payments will be low."

What does Canada’s economy in the future look like?

It will be a rough ride in the short-term until the vaccine for COVID-19 is widely distributed to the world. Even then, it'll take years before the tourism and service sectors recover as it will take quite some time before people are ready to travel again. Other industries that have survived the lockdowns more effectively, may still be hesitant to expand until it's clear that consumer confidence has returned.

That said, there are some positive signals to look at. The demand for doctors, nurses, and personal support workers will likely encourage students to pursue careers in the health care sector. Real estate still continues to be popular across the country, especially in Ontario and British Columbia, which will lead to more construction jobs. Renewable energy is also part of Canada's future as they diversify away from oil and gas. The country's tech sector has also continued to grow and is becoming a major player globally.

For consumers, the good news is that the Bank of Canada has already signalled that they'll keep interest rates low for a few years. This will allow the economy to slowly recover.

Admittedly, businesses may not be ready to jump right back into things, but the government has made some announcements to help reboot things, such as $19 billion to help provinces and territories safely restart their economies and the pledge of $15 billion for transit.

There's no denying that government programs, including CERB/CRB have helped individuals and the economy, but we also have to think about the long-term costs. Canada was already running the largest deficit in seven years in 2019. Can you imagine what things will look like after all the costs associated with COVID-19 are factored in? Eventually, the budget will need to be balanced, which may result in spending cuts and increased taxes.

As the economy begins to recover, our government will try to use policy to improve things. In the meantime, it’s important to remember the many internationally recognized companies like Shopify, Air Canada, and Lululemon that were founded right here on Canadian soil. And, Canada is also recognized as having one of the safest banking systems in the world. There’s always a silver lining! When it comes to something like the economy, a historically dull dinner topic, it can affect even you, everyday. Keeping up with how it’s doing will help you make informed decisions about your money — even if it’s something as simple as "to buy another snake plant or to not?"

Barry Choi

Barry Choi is a personal finance expert based in Toronto who makes frequent media appearances. His website Money We Have is one of Canada's most trusted sources for all things related to money and travel.

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