Interest Rates and the Business Cycle

The Official Cash Rate - OCR The OCR is an interest rate set by the RBNZ The RBNZ can influence interest rates in the economy through the OCR

The OCR How the RBNZ influences interest rates with the OCR. Banks borrow ‘overnight cash’ from the RBNZ. The RBNZ charges interest rates 0.25% above the OCR for loans Banks also deposit cash with the RBNZ. The RBNZ pays an interest rate 0.25% below the OCR for these deposits.

Example The RBNZ announces that the OCR is 2.5% What interest rate do banks pay the RBNZ for loans? Banks pay 2.75% for loans from the RBNZ What interest rate does the RBNZ pay banks for deposits? The RBNZ pays 2.25% for deposits by banks.

What is the OCR The RBNZ uses the OCR to effect interest rates thus manipulates the level of Spending, Investment, and Net Exports in the economy. The C + I + (X – M) component of AD (GDP)

How the OCR effects spending (C) An increase in the OCR leads to….. an increase in interest rates it becomes more attractive to save less attractive to borrow. spending will drop A decrease in the OCR leads to….. a decrease in interest rates it becomes less attractive to save cheaper to borrow Spending will rise

How the OCR effects Investment (I) An increase in the OCR leads to…… an increase in interest rates more expensive to borrow Less attractive to invest A decrease in the OCR leads to….. a decrease in interest rates more attractive to invest cheaper to borrow

OCR and the exchange rate (X – M) When the OCR rises, (overseas) investors will place their money in our banks. In order for overseas investors to invest their money in NZ they must demand the $NZ. The $NZ dollar appreciates, which makes exports more expensive and imports cheaper. When the OCR falls, (overseas) investors will take their money out of banks in NZ and invest elsewhere. They then sell (supply) the $NZ to buy (demand) another currency. The $NZ depreciates, which makes exports cheaper and imports more expensive.

What is happening at the moment? OCR unchanged at 2.5 percent Date 28 April 2011 The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent. Reserve Bank Governor Alan Bollard said: “The outlook for the New Zealand economy remains very uncertain following February’s Christchurch earthquake. “As was expected, business confidence, consumer spending and tourism activity all declined sharply following the earthquake. The OCR was cut as insurance to help limit these adverse effects. Confidence and consumer spending have since shown signs of recovery, but many firms and households remain adversely affected in Christchurch. To date, activity in the rest of the country appears relatively unaffected, with housing market turnover and business investment beginning to increase.

What is happening at the moment? “Trading partner growth remains robust, helping push New Zealand’s export commodity prices higher. Along with relatively favourable climatic conditions, the improved price outlook is supporting a pickup in on-farm investment. Higher oil prices and the elevated level of the New Zealand dollar are both unwelcome. They will have some dampening effect on economic activity. “Headline inflation is currently being boosted by recent increases in indirect taxes. Annual inflation is expected to settle comfortably within the target band once these tax increases drop out of the annual rate. “Given the outlook for core inflation and continued economic disruption stemming from the earthquakes, the current level of the OCR is likely to remain appropriate for some time.”

The Business (Trade Cycle Over time fluctuations in economic activity occur. The trade cycle shows us how fluctuations in the levels of output, employment, income and trade affect the level of real GDP.

A Typical Trade Cycle Real GDP Peak Recovery Recession Boom Time Real GDP Peak Recovery Recession Boom Trough/Depression

Trade Cycles Boom Peak (Turning point) Recession Rising interest rates High eco activity “Full” employment Great optimism Businesses operating at capacity Peak (Turning point) Eventually rate of growth must slow down. Even if economy is still growing it is now doing so at a decreasing rate Recession Rising unemployment and business failures Savings may increase as people fear unemployment Business activity slows down

Trade Cycle Depression (Trough) Recovery Unemployment stabilised Low level eco activity Excess capacity Interest rates low Low consumption , low saving Eventually some major piece of capital equipment will need replacing- injection of investment lead to recovery Recovery Rise in real GDP slow at first, speeds up Rehiring of workers as demand increases Unemployment falls Consumption increases Start workbook page 56 question 6,7 and page 58 question 12 and 13

The Business Cycle A business cycle is identified as a sequence of four phases: Expansion (A speedup in the pace of economic activity=higher GDP) Peak (The upper turning of a business cycle) Contraction (A slowdown in the pace of economic activity=lower GDP) Trough (The lower turning point of a business cycle, where a contraction turns into an expansion)

The Economy’s Sustainable Growth Path Change in Growth This is the economy’s capacity to supply goods and services over time without the rate of inflation increasing (GDP increases at sustainable rate which matches increase of resources) Time

A – Positive Output Gap. The economy is trying to produce a level of GDP that is above the sustainable growth path of the economy (using resources faster than they can replenish). Demand for resources exceeds supply therefore price level and inflation will occur. B – Negative Output Gap. The economy is producing below the sustainable level of output (some resources are idle). Demand for resources is less than the supply therefore general price level will drop causing disinflation or deflation. Change in Growth a b

A. AD increases causing inflation B. AD decreases causing disin/deflation

Governments use of OCR The government manipulates the OCR to level out the peaks and troughs. When in recovery the government will increase the OCR (increasing interest rates) to discourage excess consumption and investment in order to minimise the peak. When in recession the government will decrease the OCR (decreasing interest rates) to encourage consumption and investment in order to minimise the trough.