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ECON111 ESSAY

Monetary Policy is a set of tools employed by the Reserve Bank of New Zealand
(RBNZ) used to help control inflation in the New Zealand economy. Its centerpiece,
the official cash rate (OCR) is designed to restrict or expand the money supply and
thus control the general price level; however it has had a deteriorating effect at
keeping inflation down as the domestic financial system increasingly turns to
International investors to fuel a demand hungry New Zealand economy. Aside from
its decreasing ability to keep inflation under control, the negative impacts such as
foreign exchange issues have created distortions on the New Zealand economy
which unquestionably will have long term consequences for the New Zealand
economy. To deal with the arising issues the OCR is having the government must
take a more proactive approach on helping to maintain price level stability.

The tradable and non-tradable price indexes have both shown growth between the
June quarters of 1999 and 2007. There has been an increase in the non-tradable
price index by 32.3% and the tradable price index by 11.2%. Non-tradable price
increases have been widely controversial, especially in areas such as electricity
charges and “one of the biggest contributors to recent price rises has been local
government rate rises” (Finny, 2007). Tradables have shown a fairly non constant
trend during the time period with even deflation in the price index during the period
from September 2006 to June 2007. These are likely to be attributable to both
exchange rate and imported good price fluctuations. Overall the CPI has increased
by 22.6% in the time period (diagram 2). M3 has increased by approximately 101%,
an increase almost entirely attributable to large increases in NZ dollar funding. The
OCR has followed a fluctuating path from its start of an average of 4.54% in June
1999 to an average of 8.1% in June 2007 (diagram 1).

The RBNZ acts as the central bank for New Zealand - servicing the smaller trading
banks. Like a trading bank the RBNZ charges interest on loans and pays interest on
deposits, the rate of interest is known as the OCR. The RBNZ runs Settlement Cash
Balances where it lends money to trading banks that don’t have enough money to
settle debts they owe to other trading banks at the end of each day. It also has a
deposit facility where banks can earn interest if they have a positive net surplus of
funds at the end of each day. With the existence of the RBNZ’s services there is no
incentive for a trading bank to lend money to another trading bank at a rate below
the OCR because they would receive a higher interest with a deposit at the Reserve
Bank.

Unlike a registered bank, the RBNZ’s main goal is to provide stable economic
conditions for New Zealand with most emphasis placed on price level stability. As
one of its most powerful tools, the OCR is increased to help control inflation and
decreased to stimulate economic growth. When it is increased it works in a two step
process. Firstly it increases interest on settlement cash balances thus trading banks
increase their reserve ratio (decrease the ratio of deposits that are re-injeted into
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the economy as loans). This results in a decrease in the money supply, reducing
inflation. Secondly it then makes the cost of borrowing greater for consumers as
interest payments on loans will increase; thus people have less money to consume
as it is going to paying higher interest. This will reduce aggregate consumption,
generating a fall in Aggregate Demand (AD) and reducing inflation (diagram 3).

When the OCR was first introduced it was an effective means of controlling inflation
in a relatively closed financial system, however serious weaknesses have arisen
since its inception - of specific concern has been its inability to bring down the non-
tradable inflation rate which has suffered large inflationary pressures. A major
weakness is the lag effect OCR changes are suffering due to large numbers of fixed
interest loans. Also as the New Zealand economy has to an ever increasing degree,
opened itself to the world, the registered banks have increasingly relied on foreign
investment to finance their lending. Being pushed by a consistently high inflation
rate, the OCR is one of the highest in the OECD. Along with a stable political
situation, New Zealand has become a very attractive economy to invest into for
foreigners. What most commonly occurs is that banking institutions issue bonds
overseas such as Uridashi’s and Eurokiwis which makes an easy to use, ready made
platform for foreign investors to bring their money into the New Zealand system.
The banks thus have a far greater supply of loanable funds at their disposal than
the New Zealand system alone could offer them. The results of this are that New
Zealander’s borrow far more from the financial system than they deposit, causing a
disproportionally high level of consumption. The strong consumption has the effect
of causing general price level rises due to AD increases. The RBNZ has no choice
but to raise the OCR in response to help control inflation. More foreign investment
comes into the New Zealand system and the process repeats itself - the Reserve
Bank has little effective power to intervene and the traditional effect of the OCR is
nullified.

In the long term there will be many negative consequences arising as a result of the
current situation. Effects have been seen recently in the foreign exchange market
with record strengths for the New Zealand dollar which has been “exceptionally high
and unjustified” (Spencer, 2007). The cost of imported goods has significantly
dropped along with reduced exports, causing a deficit in the current account
balance. The Balance of payments is thus kept in equilibrium by the inflow of
foreign investment into the financial account. The problem this is causing is that
New Zealanders are spending on consumer products rather than using the money
for investment. Investment would bolster and enhance New Zealanders’ economic
position in the future by expanding AS and creating greater wealth for New
Zealanders. Consumption spending may increase the standard of living now but
there are little future gains from it. There is also significant debt to foreigners which
will need to be paid back in the future. This would also deteriorate New Zealand’s
economic position into the future with an outflow of income used to pay back the
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debt currently being incurred. The result is a future outflow of money from the New
Zealand economy causing a reduction in potential GDP and limiting New Zealand’s
potential growth in the future.

Some argue that the challenges faced by the current policy regime must be more
thoroughly researched, but there is consensus that there are ways of achieving the
ultimate goal of price stability through vehicles other than monetary policy’s
traditional weapon of the discount rate. It must be accepted that the RBNZ has lost
much of its ability to stabilize prices and “barrels of ink are expended second-
guessing the way Alan Bollard has done his job” (Fallow, 2007). The RBNZ could
reintroduce the Reserve Ratio but the strength it may have is questionable; however
is an option being looked at by the RBNZ. Responsibility thus falls on central
government to align economic policy with the need to keep inflation under control.

Government expenditure has seen large expansion since 1999. A large portion of
this expenditure is directed at welfare which in turn is almost entirely spent on
consumption, in turn increasing AD. The government is also known for inefficient
expenditure commonly seen in failed departmental projects, high levels of
bureaucracy and disproportionally high administration costs. The opportunity cost of
this is an increased AS which would help to reduce general price levels.
Unprecedented introduction of new regulation and the so called “red-tape”
phenomena has stifled growth; the high costs associated with regulation force up
costs for producers and encourage businesses to move production off-shore where it
is comparatively cheaper. This has resulted in a stagnation of AS while AD
increases, causing inflation.

There are many ways for the government to align its policy with those that reduce
inflation. By removing unnecessary regulation, compliance costs for businesses
would reduce and supply would increase as a result. It would also discourage New
Zealand producers from out-sourcing their production, helping to strengthen the
supply side of the New Zealand economy. Coupled with a focus on efficient
government spending, AS would increase - stimulating growth and reducing the
general price level. By reducing expenditure on welfare the government could also
reduce inflation by decreasing consumption, in turn reducing AD. A capital gains tax
on the housing (a key component of the CPI) would help reduce house price
inflation. The Reserve Bank has encouraged such policy and openly comments that
“tightening of tax rules applying to housing investment (would help) moderate the
amplifying effect of credit on the housing cycle” (Bollard, 2007). It may also have
the affect of more money being invested into areas that offer economic expansion
such as the share market, increasing AS and thus reducing the general price level.

Strong inflation is a very relevant challenge being faced by the New Zealand
economy with data showing that it is a problem that must be confronted if New
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Zealand is to have favorable economic conditions. Traditional control’s such as

monetary policy’s discount rate are increasingly losing ability to stabilize price
levels as their effect are being undermined by a surging foreign investment. To
achieve price level stability the central government must move to write economic
policy that discourage inflationary spending through potential tools such as a capital
gains tax which would help stabilize the CPI. It must also focus on encouraging AS
growth through more efficient government expenditure and policy to decrease
compliance costs. Price stability is vital to have a strong and successful economy
and should be a key goal of both the RBNZ and government.

Word Count = 1646

Diagram 1:

Diagram 2:
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Diagram 3:

References:

Bollard, Allan. “Monetary Policy Press Release.” Reserve Bank of New Zealand.
Wellington, New Zealand.
8 March. 2007.

Brian, F. (14. Sep. 2007). Tight inflation control unfashionable but necessary. New
Zealand Herald.
Retried September 30, 2007, from
http://www.nzherald.co.nz/author/story.cfm?a_id=16&objectid=10463452
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Finny, Charles. “Press Release: Wellington Regional Chamber of Commerce.”

Wellington Regional
Chamber of Commerce. Wellington, New Zealand. 8 March. 2007.

Spencer, G. 27 June. 2007. Opinion article by Reserve Bank Deputy Governor Grant
Spencer. Reserve
Bank. Retrieved 1 October. 2007, from
http://rbnz.govt.nz/speeches/3049397.html