A layperson s guide to monetary policy

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1 1999/8 17 December 1999 A layperson s guide to Executive Summary Monetary policy refers to those actions by the Reserve Bank which affect interest rates, the exchange rate and the money supply. The objective of in New Zealand is low inflation. The main tool of in New Zealand is the Official Cash Rate (OCR), which is the interest rate on overnight borrowing and lending between banks and the Reserve Bank. Changes to the OCR affect all short-term interest rates and, through these, the amount of spending in the economy and, consequently, inflation. Changes to interest rates also affect the exchange rate, which will affect the prices of imports and exports. The precise effect on inflation of a change to the OCR is difficult to predict, and usually occurs with a lag of a year or more. Besides inflation, also impacts on economic growth, employment and the balance of trade, but only in the short-run. Other policies also affect inflation, and these policies need to be taken into account when setting the OCR. New Zealand s system is in many ways similar to those operating in other countries. Introduction Monetary policy provides a key way by which Government affects the economy. The purpose of this paper is to answer the commonly asked questions on how works in New Zealand. The paper s more technical terms are printed in italics and defined in the glossary. What is monetary policy? To quote the Reserve Bank: In the New Zealand context, refers to those actions by the Reserve Bank, affecting interest rates, the exchange rate and the money supply, taken in order to influence the pace of spending and, by that, inflation. 1 1 Reserve Bank. The impact of on people. Wellington : Reserve Bank of New Zealand, p. 1.

2 Why is important? Monetary policy is important because of its effect on the economy. Its most direct influence is on interest rates and the exchange rate. Through these, can affect factors such as inflation, economic growth, employment, and the balance of trade. How does work in New Zealand? The Reserve Bank is the institution charged with implementing monetary policy in New Zealand. It operates under (1) the Reserve Bank of New Zealand Act 1989 and (2) the Policy Targets Agreement it signs with the Government. The Reserve Bank Act contains the broad directions. It states that has the economic objective of achieving and maintaining stability in the general level of prices. 2 The Policy Targets Agreement (PTA) contains the specific details. For example, the current PTA 3 states that the annual inflation rate 4 is to be kept within a range of 0 to 3 percent. The Reserve Bank is then given independence to implement in the way it thinks best meets the targets. What are the operational details? The key operational feature of in New Zealand is the Official Cash Rate or OCR. The OCR is the interest rate which applies to overnight borrowing and lending between banks and the Reserve Bank. Banks can borrow money from the Reserve Bank at a rate 0.25 percent higher than the OCR, or lend money to it at a rate 0.25 percent lower than the OCR. The OCR works by effectively setting the boundaries for overnight interest rates. Banks are unlikely to lend overnight for rates less than they could receive from the Reserve Bank, nor to borrow at rates higher than they would pay the Reserve Bank. Competitive pressures from the banks similarly limit the interest rates on other overnight borrowing and lending. By affecting overnight rates, the Reserve Bank has a strong influence on short-term interest rates such as the 90 day bill rate and floating mortgage rates. This is because loans of different terms can, to some extent, be substituted for one another. How do interest rates affect inflation? Interest rates impact upon inflation both directly and via the exchange rate. They do this mainly by influencing people s spending decisions. A fall in interest rates lowers the cost of borrowing. Existing loans become easier to service, leaving more cash to be used in other ways. New loans become cheaper. This means that consumers can more easily afford to go to restaurants or buy new cars, and businesses can better afford to hire new staff, purchase more equipment, or give higher wage rises. Total spending in the economy rises as a result. The economy grows more rapidly, with businesses expanding to meet the 2 However, the Government may substitute another objective by making an Order in Council. 3 Signed on 16 December The inflation rate that the Reserve Bank targets will be defined as the annual quarter-on-quarter change of the CPI index, but only from the June 2000 CPI onwards. Until then, the latest CPI will be compared with the previous year s CPI after adjusting the previous year s value to exclude the effect of interest rates and section prices. 2

3 higher demand for goods and services. A fall in interest rates also tends to lower (depreciate) the value of the New Zealand dollar. This happens because lower interest rates reduce the return international investors receive from holding New Zealand financial assets, thereby reducing their demand for these assets and putting downwards pressure on the dollar. 5 A depreciating currency raises the price received by exporters, giving them a higher income in New Zealand dollar terms. It also raises the price of imports in New Zealand dollar terms, making New Zealand consumers and businesses more likely to buy local products. The result is, again, a rise in total spending on New Zealand goods and services, and economic expansion. Increased spending and economic expansion eventually lead to rising inflation. One reason is that scarcities begin to develop. Expanding businesses require more workers, raw materials and other inputs into production. Eventually demand for these outstrips their supply, and businesses are forced to pay higher prices to ensure that they obtain the inputs required. Consumers also find themselves forced to pay higher prices to ensure that they obtain what they want when the supply of goods and services is limited. With money to spare (because of increased jobs, wages and profits), consumers and businesses may also be more prepared to pay higher prices. A further source of higher prices is the rise in import prices resulting from the fall in the value of the dollar. As these higher prices become generalised, inflation results. A rise in the OCR will result in a similar chain of events, but in the opposite direction. How precise is this effect? The precise impact of changes on inflation is difficult to forecast. This is due to the economy being a complex entity and to the time it takes for an OCR change to impact on inflation. As was shown above, the impact is neither direct nor immediate. While overnight interest rates will respond quickly, longer-term interest rates may not. Some overseas investors will respond quickly to changing interest rates, but most consumers and businesses will not. Furthermore, it takes time for any rise in spending to lead to economic expansion and for cost pressures to result. The timing and extent of the inflationary response is dependent on many factors. For example, the level of people s inflationary expectations is important. If there is a history of high inflation, people will expect a drop in the OCR to lead to higher inflation and will act to pre-empt it. Workers will demand higher wages and businesses will increase prices. The level of scarcity in the economy is also important. Price pressures will develop faster and more strongly if an economy s resources are already close to being fully utilised than if they are not. These factors mean that it is difficult to know both when and how much an OCR change will impact on inflation. The Reserve Bank believes that there is gap of a year or more between an OCR change and the 5 A currency s value is, like most prices, set by supply and demand. As demand for the currency falls, its price (in this case, the value of the dollar) also falls. 3

4 inflationary outcome. 6 The US Federal Reserve Board mentions a lag of one to three years, or more. 7 This all means that it is difficult to get exactly right. Data delays and the complexities of a modern economy make it difficult to predict the state of the economy in the future. Thus, it is hard to know exactly what the optimal level of the OCR should be at any given time. What else does affect besides inflation? While in New Zealand is solely targeted at inflation, it also impacts on other aspects of the economy, such as economic growth, employment and the balance of trade. A key distinction here is the short-term and the long-term impact. In the short-term, say the next year or so, lower interest rates are likely to increase economic growth and employment growth (in the manner described above). They may also lower the trade balance, due to the higher returns from exporting and the lower returns from importing. However, it is generally recognised that has no ability to influence these factors in the long term. Lower interest rates may induce higher spending, but as an economy s resources become fully utilised, this results solely in higher prices rather than economic expansion and job growth. High growth of spending and inflation are also likely to negate gains in the trade balance if excess demand cannot be met by domestic supply, then spending spills over into imports, while inflation reduces the price competitiveness of New Zealand products. This inability of to have a long-term impact in these other areas is the main reason why its sole focus in New Zealand is inflation control. Inflation is viewed as distorting the allocation of resources and making it more difficult to assess investment opportunities. It is also seen as essentially taxing savers and people on fixed incomes and wages. Do other policies affect inflation? Other policies also impact on inflation. A key one is fiscal policy, which encompasses Government s spending and taxing activities. Inflation is also affected by policies which impact on the costs of business and the level of competition. These other policies need to be considered when deciding upon an appropriate stance of. If inflationary pressures are being pushed up by the setting of other policies, the OCR would probably need to be set at a higher level than it would otherwise be if Government s inflation targets are to be met. Are there other tools of besides the OCR? The Reserve Bank has only used the OCR since 17 March There is a vast range of other tools available to a country, many of which have been used in the past in New Zealand. These include market-based tools such as: the central bank changing various other interest rates it controls the central bank changing the level of its net purchases or sales of debt in the market. 6 Reserve Bank. Monetary policy statement, November p Federal Reserve Bank of San Francisco Economic letter, 1 January

5 They also include non-market based tools such as: controlling the interest rates of other financial institutions exchange rate controls controlling the amount of money leaving or entering the country directing banks as to how much money to keep to meet their capital requirements and/or what this money is to be invested in directing banks how much to lend and/or whom to lend to. Over the past couple of decades, there has been increased recognition, both in New Zealand and abroad, that these non-market based tools may create distortions and are difficult to implement without widespread evasion. How does New Zealand s compare with systems overseas? New Zealand s system of is not unusual in international terms. Controlling inflation is the principal objective of most countries monetary policy. As in New Zealand, it is the sole objective in Canada, the United Kingdom, the European Monetary Union, Sweden, Japan and Brazil. In the case of the United States, it is one of two objectives, the other being the promotion of maximum output and employment. However, the Federal Reserve Board recognises that in the long run, output and employment cannot be set by. 8 In Australia there are three aims: (1) the stability of the currency ; (2) the maintenance of full employment; and (3) the economic prosperity and welfare of the people of Australia. But the Reserve Bank of Australia recognises that its principal contribution to the achievement of sustainable growth in Australia in the long run is to control inflation. 9 Like New Zealand, most other countries implement principally by influencing the interest rates on overnight and other borrowing and lending between banks and the central bank. What technical terms are most commonly used when describing monetary policy? The Reserve Bank is said to be loosening when it lowers the OCR. When it raises the OCR, it is tightening monetary policy. The overall level of interest rates, exchange rates and money supply is referred to as the level of monetary conditions. These are said to be loose when interest rates are low, the New Zealand dollar is weak, and the money supply is higher than normal; they are tight if the opposite applies; otherwise they are neutral. The monetary conditions index (MCI) is one measure of the level of monetary conditions. It reflects the level of interest rates and the value of the New Zealand dollar 10, and increases if either rises. 8 US : an introduction. Federal Reserve Bank of San Francisco economic letter, January About the RBA:. Reserve Bank of Australia Website ( 10 As measured by the interest rate on 90 day bank bills and the TWI (trade weighted index) exchange rate. 5

6 Glossary 11 Balance of trade: The excess of exports over imports. The balance is in surplus if exports exceed imports, and is in deficit if exports are less than imports. Central bank: Major regulatory bank in a nation s monetary system, generally government controlled. Its role normally includes control of the credit system, the note issue, supervision of commercial banks, management of exchange reserves and the national currency s value as well as acting as the Government s banker. Inflation: Persistent upward movement in the general price level together with a related drop in purchasing power. Money supply: The total stock of money in the economy. Andrew Morrison, Economist Parliamentary Library For further information, contact Andrew (ext.9202) Copyright NZ Parliamentary Library. Except for educational purposes permitted under the Copyright Act 1994, no part of this document may be reproduced or transmitted in any form or by any means, including information storage and retrieval systems, other than by Members of Parliament in the course of their official duties, without the consent of the Parliamentary Librarian, Parliament Buildings, Wellington, New Zealand. 11 These definitions are from Reuters glossary: international economic and financial terms. (Essex : Longman Group UK Limited, 1989). 6

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