Inflation and Monetary Policy

The NZ Financial System Government Banks with Reserve Bank of New Zealand (RBNZ) The Public Banks with Registered banks: e.g. ANZ, BNZ. Westpac etc Non-Bank deposit-taking institutions e.g. saving institutions, finance companies

Maintaining Price Stability The Reserve Bank ensures that money retains its buying power. –It is responsible for maintaining price stability i.e. guarding against inflation or deflation in order to protect the value of people’s incomes and savings. Inflation = an increase in the general level of prices over a period of time. Inflation = Change CPI x 100 Original CPI e.g. YearCPI Inflation = 1010 – 985 x = 2.54%

Inflation, Disinflation and Deflation Inflation = increase in general price level Disinflation = rate of inflation is decreasing Deflation = decrease in average price level +ve -ve % change in price level A B C D Years Text Book Activity C3.6 Page mins

Why do we need stable prices? Key reason is to keep export prices competitive. Rising prices make NZ exports more expensive compared with competing products Low inflation also means Businesses can plan for the future People are encouraged to save rather than borrow Firms more likely to invest in new production Wages and prices are consistent

Policy Targets Agreement The Reserve Bank’s responsibilities are set out in the Policy Targets Agreement: a contract between the Minister of Finance and the Governor of the RBNZ Policy Targets Agreement: required to keep inflation between 1% and 3% in the medium term.

Monetary Policy Monetary Policy – Changing interest rates or the money supply to influence the level of economic activity. Monetary Policy Tools Official Cash Rate Moral Suasion Open Market Operations

Monetary Policy Official Cash Rate (OCR) – Interest rate set by the Reserve bank to implement monetary policy, so as to maintain price stability The Reserve Bank in NZ now directly influences interest rates using the OCR. By setting the OCR the RBNZ is able to substantially influence short term interest rates. Short term interest rates have a big impact on the overall level of economic activity in the country and therefore on inflation.

Influence on Interest rates by OCR The reserve bank pays financial institutions 0.25% below the OCR for money deposited in the Reserve Bank settlement accounts The reserve bank charges interest at 0.25% above the OCR for overnight cash to banks. The Reserve Bank also sets no limit on the amount of cash it will take in or let out.

OCR The Reserve Bank reviews the OCR eight times a year. Only in exceptional circumstances would the Reserve Bank make unscheduled adjustments to the OCR. The OCR is much more simpler and easier understood than earlier systems.

Effects of the OCR Reserve Bank increases OCR from 2.5% to 3% Financial Institutions pay 3.25% on loans, up from 2.75% Financial Institutions get 2.75% on settlement accounts up from 2.25% Various Financial Institutions will then increase their own interest rates to consumers and producers. Consumption rate falls as consumers will begin to save more. Investment will fall as producers pay more interest on loans Aggregate demand for goods and services in the economy falls The Inflation Rate will fall

Monetary Polices Loose Monetary Policy – Lowering the OCR to stimulate the economy and encourage economic growth Tight Monetary Policy –Increasing the OCR to dampen economic activity

Open Market Operations (OMO) The buying and selling of government securities (bonds) in the open market in order to expand or contract the amount of money in the banking system.  Purchases by the government of government bonds owned by banks inject money into the banking system and stimulate growth  Sales of government bonds by the government withdraw money from the banking system and contract the economy.  Sell stock to reduce money supply and buy back stock to increase money supply

Moral Suasion The Reserve Bank lets the market know about what its expectations are for the future. This then lets markets predict as to what the RBNZ might do in the future and thus people will change behaviours to favour themselves in the future. The RBNZ Monetary Policy Statements are one example of how the RBNZ tells the financial markets (banks etc) about its actions.