Achievement Standard 91227 eg 2 merit What is inflation Inflation is a rise in the general price level. The current PTA (policy target agreement) signed in December 2008, defines price stability as annual increases in the Consumers Price Index (CPI) of between 1 and 3 per cent on average over the medium term. If there is deflation (negative inflation): Consumers will put off spending due to decreasing prices which will result in a decrease in aggregate demand (total demand for commodities). Also quantity supply will decrease due to a fall in prices and a decrease in AD. If there is excessive inflation (above 3% inflation) has many negative effects on the economy: Consumption- Due to rising prices consumers will spend more to try and buy goods before the prices increase while they are relatively less expensive Saving- Real value of savings decline. Prices rise faster than saving can accumulate. This causes people to save less. Incomes rising more slowly than inflation- Those with little bargaining power or on a fixed income, will tend to find real incomes falling so purchasing power decreases. Firms trading internationally- If our interest rates are high, overseas competitors gain cost advantages. Exports- NZ exports become less competitive Cost of production- Cost of production increases as nominal wages increase Imports Imports become relatively cheaper than NZ made goods so imports increase and exports decrease If inflation is 1-3% 1-3% is the desired rate of inflation because it s not deflation but it s limited inflation. At this rate the economy can grow steadily and sustainably.
How does the RBNZ attempt to lower inflation RBNZ (Reserve bank of New Zealand)-The RBNZ is a government created institution. The RBNZ is NZ s central bank. The RBNZ is not a competitor in the banking system, it is a controller and regulator of the banking system. The main roles of the RBNZ are to -Act as a central bank to the government and other banks. -Implement monetary policy -To act as a regulator for the overall banking system A key role of the RBNZ (Reserve bank of New Zealand) is to keep inflation between 1-3% on average over the medium term. Monetary policy is the action taken by the RBNZ to influence the interest rates through the money supply in order to influence economic activity and achieve price stability. The main monetary policy tool for the RBNZ to control inflation is the official cash rate (OCR). The OCR is the interest rate set by the RBNZ. The RBNZ will pay interest.25% lower than the OCR to the registered banks for their settlement cash deposits and will lend to registered banks at.25% above the OCR. Settlement accounts are accounts held at the RBNZ by registered banks. Each day millions of transactions, using the banking system, take place between the customers of each bank. At the end of each day banks are required to settle their accounts. The deposits held at the RBNZ in their settlement accounts are used to do this. If inflation is too high (above 3%), the RBNZ will implement a tight monetary policy (increase the OCR). An increase in the OCR will mean that banks are now earning more interest from their settlement accounts held at the RBNZ. This means that banks will increase the rate of interest as they are now less willing to lend at a lower interest rate due to the increased OCR. An increase in OCR will also mean that banks are keeping more money in their settlement accounts therefore making money in the economy scarcer. Due to money being scarcer, banks will increase the interest rates. Money supply and interest rates Interest rate(r) (graph 1) MS2 MS r2 r1 MD Graph showing that a decrease in the money supply causing an increase in interest rates Q2 Q1 Quantity of money (Q) Therefore increasing the OCR will cause interest rates to increase.
An increase in interest rates causes households to save more. Because households are now using a greater portion of their disposable income to save they now have less money to spend. Therefore consumption decreases. Consumption is a component in aggregate demand (C+I+G+(X-M)=AD) therefore if consumption decreases AD must also decrease. Increased interest rates will also cause the demand for NZ dollars to increase (due to overseas investors getting more interest from saving in NZ) resulting in an appreciation of the NZD (see graph 2). Due to an appreciation in the NZD, NZ products are now more expensive for people overseas. This will mean there will be less demand for NZ products resulting in a decrease in exports. Exports are a component in AD (C+I+G+(X-M)=AD) so a decrease in exports will result in a decrease in AD. An increase in interest rates causes firms to invest less as borrowing is more expensive and more of a risk. Because firms are investing less and investment is a component in AD (C+I+G+(X-M)=AD) a decrease in investment will cause a decrease in AD. A decrease in AD causes a decrease in the price level (graph 3) therefore bringing the rate of inflation closer to the desired level (1-3%). Therefore an increase in interest rates will result in a decrease in AD NZD appreciating effect (graph 2) PNZ%/US% SNZ% D(NZ$) D(NZ$)2 This graph shows demand for NZD increasing from D(NZ$) to D(NZ$)2 which causes the price level of the NZD to appreciate from to. Qe Qe2 Quantity DNZ%
Effect of a decrease in AD (graph 3) Price level(pl) Pl AS 0 AD AD2 Ye2 Ye Yf This model shows AD decrease from AD1 to AD2 which causes Pl to decrease from Pl1 to Pl2. Therefore a decrease in AD causes a decrease in price level which causes less inflation A tight monetary policy will cause the NZD to appreciate. An appreciation in the NZD will cause import prices to decrease. Therefore the price of importing oil will decrease so firms are paying less for oil. Oil is a major cost of production so if the price of oil decreases, there will be a significant decrease in the cost of production. If the cost of production decreases aggregate supply (AS) will increase as firms can now produce more at each price. Therefore a tight monetary policy will cause AS to increase Effect of an increase on AS (graph 4) Price level AD AS AS2 Ye Ye2 Yf
This model shows AS increase from AS to AS1 which causes the price level to drop from to. Therefore an increase in AS causes a decrease in price level which causes less inflation Effects of a tight monetary policy on other areas Employment- An increase in the OCR will cause interest rates to increase this will lead to a decrease in investment and consumption. Investment and consumption are components in AD so a decrease in investment and consumption will cause a decrease in AD leading to a fall in production and output. This will mean that there will be less jobs available as firms now need less workers. Job growth will fall which may lead to a fall in unemployment. Inequality- with an increase in the OCR interest rates rise. This means that borrowers will suffer more than savers. Low-Middle income families with mortgages will be disadvantaged as they now have to pay a lot more through interest payments. High income people and those without mortgages will be comparatively better off. Those with savings will benefit the most as they are now getting a higher interest rate. Trade- with an increase in the OCR interest rates will increase. This may mean that NZ s interest rates are higher than overseas interest rates and so overseas investors will be more willing to save their money in NZ as our interest rates are higher. This causes an appreciation in the NZD (see graph 2) as the demand for NZD increase. This will mean NZ s exports become more expensive and so the amount exported may fall. Imports may rise as they become cheaper due to the high dollar value. This causes demand for NZ products to fall as they become relatively more expensive due to imported goods being cheaper. A way to counteract this negative effect of a tight monetary policy can be to place a tariff (tax on imports) on imported goods. This raises the price of imported goods which causes NZ products to become more competitive. Growth- Increase in the OCR will cause interest rates to increase. This will lead to a decrease in consumption, the AD will decrease leading to a fall in production and output. This will cause a reduction in the rate of growth in the economy (graph 3). To counteract this government can issue more R and D (research and development grants). This may lead to better and more advanced machinery which would increase a firm s productivity. Therefore more research and development may lead to more future growth. Education spending on things such as job training schemes will cause productivity to increase as workers are more efficient. An increase in productivity will cause an increase in output as firms can now produce more with the same amount of resources. Pl AD AS AS2 This graph shows that an increase in AS from AS to AS2, causes output to increase from Ye1 to Ye2 which means there s more growth Ye1 Ye2 Yf(output)
Current economic situation Article from stuff.com 1. Inflation could dip below 1 per cent this year and below the Reserve Bank's target range for the first time, Bank of New Zealand says. The Reserve Bank is required to maintain annual inflation between 1 per cent and 3 per cent in its agreement with the Government. But BNZ economists believe the Reserve Bank's forecast for inflation in the short term is too optimistic. BNZ is forecasting the Consumer Price Index (CPI) will increase by 0.5 per cent for the June quarter, reducing annual inflation from 1.6 per cent to 1.1 per cent. From there BNZ expects inflation of just 0.2 per cent for the September quarter, which would see annual inflation "plumb an even lower low, of 0.9 per cent and below the Reserve Bank's target band for the first time on record". The Reserve Bank in its June Monetary Policy Statement expected a 0.7 per cent lift in third quarter inflation and annual inflation of 1.4 per cent. 2.The Reserve Bank will cut the official cash rate at least 25 basis points in June because of high bank-funding costs, a slower housing market and falling commodity prices, says economists Info metrics. "It now appears more than likely that the Reserve Bank is going to cut the official cash rate in June," it said. The mix of high bank funding costs, a slower housing market and lower commodity prices "have convinced us" the Reserve Bank would cut the rates on June 14. 3. There is a 40 per cent chance of official interest rates being cut before Alan Bollard steps down as Reserve Bank governor in September, according to market pricing. The Reserve Bank left the official cash rate at 2.5 per cent yesterday, but warned that could be "reassessed" should the dollar remain high despite falling commodity prices, opening the door to a rate cut or rates staying on hold for even longer.
Expansionary monetary policy is where the government decreases the OCR which creates an opposite effect to increasing the OCR. If more growth is needed in our economy, the RBNZ will implement an expansionary monetary policy (decrease the OCR). At the moment NZ has very low growth so the government is implementing an expansionary monetary policy. A decrease in the OCR will mean that banks are now earning less interest from their settlement accounts held at the RBNZ. This means that banks will decrease the rate of interest as they are now more willing to lend at a lower interest rate due to the decreased OCR. A decrease in OCR will also mean that banks are keeping less in their settlement accounts therefore making money in the economy less scarce. Due to money being less scarce, banks will decrease the interest rates. Money supply and interest rates Interest rate(r) r r2 MS MS2 Graph showing that an increase in the money supply causes a decrease in interest rates MD Q1 Q2 Quantity of money (Q) Therefore decreasing the OCR will cause interest rates to decrease. A decrease in interest rates causes households to save less because they are getting less interest from their savings. Because households are now using a smaller portion of their disposable income to save they now have more money to spend. Therefore consumption increases. Consumption is a component in aggregate demand (C+I+G+(X-M)=AD) therefore if consumption increases AD must also increase. Decreased interest rates will also cause the demand for NZ dollars to decrease (as overseas investors are getting less interest from saving in NZ) resulting in a depreciation of the NZD (see graph 6). Due to depreciation in the NZD, NZ products are now less expensive for people overseas. This will mean there will be more demand for NZ products resulting in an increase in exports. Exports are a component in AD (C+I+G+(X-M)=AD) so an increase in exports will result in an increase in AD. A decrease in interest rates causes firms to invest more as borrowing is less expensive and less of a risk. Because firms are investing more and investment is a component in AD (C+I+G+(X-M)=AD) an increase in investment will cause an increase in AD. Therefore a decrease in interest rates will result in an increase in AD
An increase in AD causes greater growth but also a rise in price level. NZ s current rate of inflation is 1.5% therefore it is in the desired range. This means that the government can implement an expansionary monetary policy to increase growth without worrying about the effects on inflation. Effect of an increase in AD (graph 5) Price level(pl) Pl AS 0 AD2 AD Ye Ye2 Yf This model shows AD decrease from AD1 to AD2 which causes Ye to increase from Ye1 to Ye2. Therefore an increase in AD causes an increase in output which means there s more growth NZD depreciating effect (graph 6) PNZ%/US% D(NZD$)2 SNZ$ D(NZ$) This graph shows demand for NZD decreasing from D(NZ$) to D(NZ$)2 which causes the price level of the NZD to depreciate from to. Qe1 Qe Quantity
A loose monetary policy will cause interest rates to decrease. If interest rates decrease, investment will increase as borrowing is less expensive and less of a risk. An increase in investment will cause an increase in productivity as firms production is now more efficient with more machines. An increase in productivity causes an increase in AS. A loose monetary policy will also cause the NZD to depreciate. A depreciation in the NZD will cause import prices to increase. Therefore the price of importing oil will increase so firms are paying more for oil. Oil is a major cost of production so if the price of oil increases, there will be a significant increase in the cost of production. If the cost of production increases aggregate supply (AS) will decrease as firms now produce less at each price. However even though the RBNZ is currently implementing a loose monetary policy at the moment, the NZD hasn t depreciated therefore producers will not have to pay more for oil. There for a decrease in the OCR will cause an increase in AS Effect of an increase on AS (graph 7) Price level AD AS AS2 Ye Ye2 Yf This graph shows that if AS increases from AS to AS2, output increases from Ye to Ye. Therefore an increase in AS will cause increased economic growth.
Alternative government policies Fiscal policy - Fiscal policy is the governments decision on taxation and revenue. Expansionary fiscal policy is when taxation is less than revenue and so the government is spending more (this is an injection of money into the economy). Government spending is a component in AD (C+I+G+(X-M)=AD) so an increase in government spending will cause an increase in AD. A decrease in taxation will help to stimulate the economy (initially at least). Direct tax cuts results in households having more disposable income therefore causing an increase in consumer spending. Consumption is a component in AD (C+I+G+(X-M)=AD) so an increase in consumption will cause an increase in AD. An increase in AD causes an increases in output which leads to economic growth (see graph 5). Supply side policies - Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side potential of an economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth. Government reducing company taxes. This means cost of production for decreases causing AS to increase which causes more growth (see graph 7). An increase in AS will lead to prices of commodities becoming cheaper where demand and supply meet at equilibrium. This decrease in commodity price will cause increased quantity demand for commodities as they are now more affordable. An increase in consumption causes an increase in AD as consumption is a component in AD. This leads to further economic growth (see graph 5). Companies are now selling more therefore the government is also receiving more revenue from indirect tax. The government could also consider more targeted supply side policies such as spending more on subsidies so domestic exporters can compete with importers. A subsidy is money payed to producers from the government so producers can lower the price of their goods. Producers receive more revenue from the subsidy therefore they are willing to supply more at each price. At a lower price consumers also demand a higher amount of goods as they are more affordable (see graph 100). Increased government spending also causes an increase in AD (as government spending is a component in AD. This leads to further economic growth (see graph 5).
Effect of subsidies (graph 100) Price level D S S+subsidy Qe Qe2 Q