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New Zealand Monetary Policy

Introduction

The global economy is wading through the deepest downturn in the post–World War II period, as the financial crisis spreads in almost all nations in the world. A number of advanced economies have fallen into recession, and economies in the rest of the world have their growth interfered. The world economy in 2008 has been affected by the unexpected macroeconomic changes. Inflation has caused prices of basic commodities to rise associated in part to the increased demand in China and other developing countries. New Zealand being the world’s 60th largest economy has a GDP of $92.51 billion, and a population of 4.2 million.

International trade mainly with Australia, the United States and Japan is a backbone to this economy. Therefore the current economic crisis experienced by these countries is transmitted to New Zealand economy. Primarily, the agricultural products that they export are by far limited to cover the advanced manufactured goods imported by the declining manufacturing New Zealand economy, (Guttmann (2004). The 1970s expansionary fiscal policy in New Zealand failed as a result of policymakers delegating inflation control to non-monetary devices. The concept of monetary policy neglect explains why the problems of inflation could not be contained up to the 1980s. Others are of the view that the reformation process.

The fiscal policy is the government effort to influence economic activity by altering its taxes, deficit, spending and debt policies. These changes can either be an increase or a decrease in the taxes; whereby a decrease in taxes (or increase in transfer payments) increases households’ disposable incomes. This in effect forces up the consumers’ consumption demand curve by shifting the aggregate demand outwards to the right. Similarly, a decrease in the interest rates increases the amount of money in supply, therefore shifts the aggregate demand to the right. On the other hand, monetary policy involves changes in interest rates and money supply. The people’s spending increases when there is an increase in money supply, thus increasing aggregate demand with a rightward shift, (Charles, 2008).

Impact of the policies on macroeconomic goals

In attempting to discover the role that monetary policy is playing, it is important to first know the objective of the policy; which at times is price stability. Secondly, with greater credibility of the policy, there is less likelihood that the price stability and its output objectives will clash. Last but not least, the role of the policy will rely on the source of the shock; i.e. if it is structurally induced from the supply side then it would be important to consider monetary accommodation, and a lot of precaution should be taken to prevent deviating from the price stability focus.

According to Boettke & Coyne (2003) and Sautet (2005), early reforms have eventually made the New Zealand economy more vibrant and prosperous by positively impacting the entrepreneurial environment. In effect, the unemployment rate is low and the growth rate above average. In the entrepreneurial environment, the most beneficial thing about the policies is that the profitability, growth and innovation are guaranteed. Historically, however, the 1980s reforms derive its roots more than a decade before. At the close of the 1800s New Zealand and Germany had already put in place comprehensive social legislation which took the form of women’s voting rights, labour reforms and a pension scheme for the ‘deserving poor’.

The rise of protectionist policies like import licensing in many other countries including New Zealand included negatively impacted economic performance. The economy started to decline and in an approximated 50-year period, they experienced a slow steady downfall in their standard of living. On the contrary, there was a massive exodus of New Zealanders by the end of 1970s in the hope for better living standards overseas. Prior to joining the European Union in 1973, New Zealand’s economy was the most regulated in the OECD. In attempting to control balance of payment, it not only retained foreign exchange controls, high tariffs and import licensing, but also embraced other harmful practices such as high taxes generated revenues for subsidies to major industries with the agricultural sector benefiting the most. The employment model of welfare was used by the government in an effort to maintain wages and employment.

According to Grossman (1982), the reforms were attempted first in the 1970s via liberalization of import licensing and deregulation in the transport and meat processing industries. However economic changes were proposed later in 1980. Of the economic reforms undertaken as a package five areas of policy include: the tax system, the labor market, international trade, fiscal management and monetary policy including establishment of Reserve Bank independence. The first policy of the tax system entailed a reduction of the top marginal income tax rate and implementation of the new value-added. As a result the tax system affected entrepreneurial discovery as it influenced the pure monetary gains that are generated through exchange. Secondly, the labor market liberalization involved the adoption of compulsory arbitration (1894) and compulsory union membership (1936). Thus in 1984 free foreign exchange investment was possible in New Zealand. This in effect raised the variety of goods and services available thus positively impacting consumer welfare.

Monetary policy and the Reserve Bank policy ensured containment of inflation by making the monetary policy a long-term instrument used by the government. On the other hand, the Reserve Bank was n longer used to fund fiscal deficit; instead they focused at operational independence, price stability and accountability. In 2002 there was a change from 0-2 percent to 0-3 percent annual increase in consumers’ price index consistent with price stability. In addition a stable monetary environment is sure to convey information about demands and supplies necessary for enjoying profitable opportunities. Finally the fiscal policy and balanced budgets adopted the Fiscal Responsibility Act that aided in controlling government spending, therefore reduced budget deficits and public debt, (Bryce, 2004, 13).

The above policies resulted in government spending rising from approximately 22 to 35 percent of GDP in 1970 and 1983. Consequently, the government debt rose from approximately 5 percent to more than 30 percent of GDP; and continued to grow to 51percent by 1992. These trends were however not exceptional. Because their effects combined with extensive market regulation and state ownership of many enterprises, hampered growth and led to the relative impoverishment of New Zealand’s people. For instance, unemployment, negligible in the 1960s, was pushing above 4 percent of the labor force by the late 1970s.

The GDP measures the total value of goods and services produced in New Zealand over a specified period; or the total spending by expenses by consumers, government, firms, plus exports less imports. Increase in demand (shift in demand curve), both price and quantity will increase, and vice versa. Thus an increase in the OCR by the Reserve Bank reduces demand, putting downward pressure on prices thus reducing inflation. Similarly, a decrease in OCR will have an opposite effect, resulting in an increase in inflation.

In this inflationary economy, the Reserve Bank should use contractionary monetary policy. This involves lowering the money supply (through selling bonds to mop up the excess money thus contracting monetary base) and increasing nominal interest rates. This will increase the value of NZ$, decrease consumption and investment in effect lowering the aggregate demand. The results will be price stability, economic growth, full employment, increased equal distribution of income and reduction in the deficit in current account, (Tom and Rick, 2009).

Current Economic Growth.
Figure 1: Current Economic Growth.
Money market.
Figure 2: Money market.

Currently most banks hold accounts at the Reserve Bank and the banks are charged interest at the rates related to the OCR, hence market interest rates are held around the Reserve Bank OCR level. However, New Zealand financial institutions are net borrowers in overseas financial markets and so long-term market interest rates are also affected by prevailing offshore interest rates. Therefore changes in overseas rates can cause changes even if the OCR doesn’t change. On the other hand, a decrease in the OCR (interest rates) results when the AD increases; due to increase in consumption, investments, government spending and decrease in net exports.

AD/AS and Business Cycles

The AD/AS diagram represents the effects of inflation and downturn in any economy. The New Zealand case is characteristic of increases in prices of commodities coupled with the worldwide credit crunch as shown in the Figure 3 below.

Foreign current Market.
Figure 3: Foreign current Market.

A business cycle is divided into two main phases: a recession phase where the economy activity declines, and an expansion phase, Grossman (1982) suggests the use of a classical approach when analyzing turning points of world economies from the 1960s to the present day. Thus the two most universal components of a cycle are Duration (number of quarters from peak to trough) and amplitude (the percentage change in GDP from peak to trough). The ratio of amplitude to duration, known as slope of recession (or expansion) can also be computed.

AS/AD curves.
Figure 4: AS/AD curves. Source: Jones, (2008).

The shift in AS to AS1 is a result of increases in the prices of commodities, while the downward shift in AD to AD1 is an indication of the financial turmoil that the country experienced and as a result the two shocks lead to offsetting effects on inflation. Both reduce short-run output and the economy therefore moves from point A to point B.

Crowding out effect is the decrease in private expenditures due to an increase in government purchases. While implementing the fiscal policy, the direct effect (crowding out effect) involves an increase in government expenditure which displaces firm investments and/or private spending. However, the indirect effect whereby the government finances its expenditure increase by debt, then interest rates are likely to increase.

A full business cycle has been passed since New Zealand underwent an elaborate set of reforms. For instance, in 1991 the economy entered recession with a structural deficit of approximately 3 % of GDP, net public debt of about 50% of GDP and the government’s lack of economic credibility. Upon the consolidation that was adopted, its structural position improved substantially; followed by a series of tax cuts and priority expenditure increases. Surprisingly, six years later, the economy was running a structural surplus of around 2.3% of GDP and net debt lowered to 24% of GDP.

Effectiveness of the policy

One of the major aims of monetary policy is to keep the general prices level standard in the long term. In the New Zealand case the Reserve bank through the personal accountability of the Governor not only regulates price level stability but also ensures an independent desire to achieve these goals. Despite the government’s constant effort to establish monetary policy, the problem of control still interferes with the effectiveness of the program. A number of reasons determine how effective the monetary policy should be implemented in order for it to achieve its objectives. First, when formulating a policy it is important to remain within the target at the same time being able to forecast the effects of inflation in say, two years. The second criteria of evaluating effectiveness is taking into consideration the cost which can either be based on impact on output and employment or as a result of fluctuations in the instrument of monetary policy.

However, there are recent challenges in trying to maintain price stability. In early 1994, the Reserve Bank had to balance the risk of missing its inflation target in the short run with the risk of increased inflationary pressures outward bound. The bank instead, accepted the risks but just waited upon their diminishing by not taking any action. These and other measures that were taken by the New Zealand Bank have positively impacted their target to control inflation. Along with the micro-economic and fiscal reforms, sustainable economic growth has been ensured along with a clear welfare gain from increased credibility and lower risk premium, (Laidler, 1978).

According to Tom and Rick’s (2009) report on Recession in New Zealand Deepens, recession is still worsening with evidence of economy shrinking in the three months to September 2008. In the statistics, economic activity decreased by 0.4 percent in the September quarter due to declines in June and march quarters. The current account deficits also grew underlining the country’s vulnerability to the worldwide credit crisis.

The annual deficit of $15.5 billion was increased to 8.8 percent of GDP by the $NZ6 billion for that quarter, at the end of September 2008. New Zealand’s current account deficit is listed 25th best of the 30 OECD countries after Iceland. Other analysts view it as a “huge debtor nation” with international liabilities of $297.1 billion and assets of only $131.2 billion. The impact on ordinary people’s lives is clearly being seen when as a nation they are spending more than they are saving. A report released accounts for the unemployment rate at 4.2 percent and forecasting its increase to 7.2 percent by 2010. This trend is worsening because for the first time since the Great Depression of 1930s, people formed queues outside the Auckland City Mission; considering that in the four weeks prior to Christmas, the Mission gave out food to 6,000 people.

Conclusion

The implementation of the monetary policy is however faced with a lot of challenges; the most being the time lag that occurs between applying a policy and the moment when the effects of that policy are evident. In this case, it can take up to 24 months for the results to take effect and the Reserve bank should take actions for the future of the economy and not because of what is currently affecting the economy. Sometimes, there are economies that are growing in certain areas while not growing in others. An example is when there is increased demand but weak exports worsened by high dollar that fuels cheap exports. This situation the inflationary risks were so high causing the Reserve Bank to raise the OCR in 2004 and 2005. Lastly, the Reserve bank ought to take care of ‘price shocks’ relating to key commodities such as oil which can easily contribute to inflation. The government’s reaction to situations of recession ought to be timely and effective so as to give time for certain policies to take effect. For monetary policies, it is important to lay down specific aims and objectives to guide various enforcers in a case where the current government does not complete its mission while in power.

Bibliography

Bollard, A, (2003). Country and Central Bank Watch: ANZ National Bank. Web.

Boettke, & Christopher C, (2003). Entrepreneurship and Development: Cause or Consequence? Advances in Austrian Economics 6: 67?87.

Charles J. (2008). Current Macroeconomic Events: A Supplement to Macroeconomics. New York: Columbia University Press.

Grossman, Herschel I. (1982). “Book Review: Asset Accumulation and Economic Activity,” Journal of Monetary Economics, Vol. 10(1), 134−138.

Guttmann, Simon (2004). The Rise and Fall of Monetary Targeting in Australia. Manuscript, Monash University.

Laidler, David (1978). “Review: Towards Full Employment and Price Stability,” Journal of Economic Literature, Vol. 16(3), 1040−1044.

Peters,T & Wilson, R. (2009) Recession in New Zealand deepens, Published by the International Committee of the Fourth International (ICFI). Web.

Reserve Bank of New Zealand. 2002. Joint press statement by Finance Minister Michael Cullen and incoming Reserve Bank Governor Alan Bollard. Web.

Tom P & Rick W, (January 2009). Recession in New Zealand deepens. Sydney: Ambassador Press. 32–72.