Category Archives: Interest Rates

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.


The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

A2 Economics – Liquidity Trap

Just covering this with my A2 class and have gone through the theory with them. The liquidity trap is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.

The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Policies to overcome a liquidity trap

Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Governments and central banks like there to be “just enough” growth in an economy – not too much that could lead to inflation getting out of control, but not too little that there is stagnation. Their aim is the so-called “Goldilocks economy” – not too hot, but not too cold. One of the main tools they have to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save.

But when interest rates are almost at zero, central banks need to adopt different tactics – such as pumping money directly into the economy. This process is known as quantitative easing or QE.

Helicopter Drop. Milton Friedman  advocated bypassing the commercial banks and money could be paid directly to consumers . This policy was termed a ‘helicopter drop’ to indicate the idea of a central bank dropping money from a helicopter. If deflation is a real problem, the Central bank could give money credits which have to be spent by a certain date – to stop people just saving the extra money.

Is it time to ‘short’ the Aussie dollar

Although I wrote recently on Australia avoiding the ‘resource curse’ this video from the FT suggests otherwise and that the Aussie Dollar in 2019 is going to be volatile. The slowing down of the Chinese economy accompanied by a trade dispute with the US has meant lower demand for the Aussie Dollar. Imports of commodities, especially iron-ore, have slowed as China recorded significant reduction in exports and imports in December last year – see graph below:

A lot will depend in the US Fed and its interest rate stance and whether with weaker inflationary pressure and a slowing economy there could be a drop in rates which would help the Aussie Dollar. The cother concern is the exposure that commercial banks have in the mortgage market. Housing has long been a favoured investment option in Australia and with the housing market slowing banks could be left exposed with defaults on mortgages. So is it time to dump the Aussie Dollar?

Falling exchange rate – causes and effects.

Auckland house prices 73.8% overvalued against income.

Whilst there has been a lot of talk about Auckland’s flattening house prices the city is ranked only behind Hong Kong (94.1%) as the most unaffordable city in the Economist’s ‘cities house price index’ – house prices in Auckland are 73.8% overvalued compared to the average income. This figure is ahead of Sydney, Amsterdam, London, New York, Paris and Vancouver – see graph from The Economist – showing how housing is basically unaffordable in proportion to earnings.

There are 3 reasons why house prices globally have been accelerating at such a high rate – Demand, Supply and the cost of borrowing.

Regional population growth in Auckland has been significant and although is slowing it still has the fastest population growth in NZ. With the influx of people and the housing construction more jobs become available which in turn attracts workers from other areas. Furthermore foreign investors have played their part in increasing demand although this has reduced over the last year with the government putting in place regulations with home ownership.

Housing has become particularly scarce with supply unable to keep up with demand. But recent consent figures for 2018 show that 13,000 were issued in Auckland compared to 10,000 in 2017. Auckland was previously building too few houses relative to population growth, leading to a worsening housing shortage as indicated by a rise in the estimated number of people per dwelling.

Low interest rates
Since the GFC economics has been dominated by fiscal and monetary policies to stimulate aggregate demand. Tax cuts have added to consumers bank balances but it is monetary policy that has been particularly prevalent with record low interest rates encouraging consumers to borrow money and buy property. Furthermore with the stock market becoming a fickle location for investment investors sought the so-called safety of the housing market and in many cities did particularly well.

But prices are starting to level off and in some cities falling in a response to variety of reasons – rising  yield on treasury bonds – tighter regulations on overseas buyers – uncertainty about Brexit – China tightening up on capital outflows of the super-rich.

Source: The Economist – Buttonwood – November 10th 2018

Turkey’s economy – stuffed

Inflation at 25%, Central Bank interest rates at 24%, Lira down 30% in value since the start of the year. What hope is there for the Turkish economy?

Wages and salaries haven’t kept pace with inflation and the reduction in demand has led to higher unemployment. There is pressure on the central bank to keep interest rates to avoid the lira collapsing. However this makes it expensive for businesses to borrow money and thereby reducing investment and ultimately growth.

No pain no gain – there is no alternative for Turkey other than undertaking painful and unpopular economic reforms. Remember what Reagan said in the 1980’s “If not now, when? If not us, who?”  He was referring to the stagflation conditions in the US economy at the time and how spending your way out of a recession, which had been the previous administration’s policy, didn’t work.

In order to the economy back on track things will need to get worse but President Erdogan has the time on his hands as there is neither parliamentary nor presidential elections in the next five years. This longer period should allow him the time to make painful adjustments without the pressure of elections which usually mean more short-term policies for political gain. Beyond stabilising the lira, which helped to ease the dollar-debt burden weighing on the country’s banks and corporate sectors, the 24 per cent interest rate level the central bank imposed also brought about a long-overdue economic adjustment. A cut in interest rates discourage net inflows of investment from foreigners and the resulting depreciation would accelerate the concerns about financial stability and deteriorating business and consumer confidence. Below is a mind map as to why a rise in the exchange rate maybe useful in reducing inflation.

10 years after GFC – what we’ve learnt

Thanks to colleague Paul Chapman for this article from Mercer ‘Health Wealth Career’. Its looks at the 10 lessons learnt from the GFC and 3 thoughts from what we might expect in the future.

Lesson 1 – Credit cycles are inevitable. As long banks are driven by growth and profit margins their decision-making inevitably leads to greater risk and poorer quality. The growth from 2005-2008 was generated by leverage.

Lesson 2 – The financial system is based on confidence, not numbers. Once confidence in the banking system takes a hit investors start to pull their money out – Northern Rock in the UK.

Lesson 3 – Managing and controlling risk is a nearly impossible task. Managing risk was very difficult with the complexity of the financial instruments – alphabet soup of CDO, CDS, MBS etc. A lot of decisions here were driven by algorithms which even banks couldn’t control at the time. Models include ‘unkown unkowns’

Lesson 4 – Don’t Panic. Politicians learnt from previous crashes not to panic and provided emergency funding for banks, extraordinary cuts in interest rates and the injection of massive amounts of liquidity into the system. The “person on the street” may well not have been aware how close the financial system came to widespread collapse

Lesson 5 – Some banks are too big to be allowed to fail. This principle was established explicitly as a reaction to the crisis. The pure capitalist system rewards risk but failure can lead to bankruptcy and liquidation. The banks had the best of both worlds – reward was privatised with profits but failure was socialised with bailouts from the government. Therefore risk was encouraged.

Lesson 6 – Emergency and extraordinary policies work! The rapid move to record low policy interest rates, the injection into the banking system of huge amounts of liquidity and the start of the massive program of asset purchases (quantitative easing or “QE”) were effective at avoiding a deep recession — so, on that basis, the policymakers got it right.

Lesson 7: If massive amounts of liquidity are pumped into the financial system, asset prices will surely rise (even when the action is in the essentially good cause of staving off systemic collapse). They must rise, because the liquidity has to go somewhere, and that somewhere inevitably means some sort of asset.

Lesson 8: If short-term rates are kept at extraordinarily low levels for a long period of time, yields on other assets will eventually fall in sympathy — Yields across asset classes have fallen generally, particularly bond yields. Negative real rates (that is, short-term rates below the rate of inflation) are one of the mechanisms by which the mountain of debt resulting from the GFC is eroded, as the interest accumulated is more than offset by inflation reducing the real value of the debt.

Lesson 9: Extraordinary and untried policies have unexpected outcomes. Against almost all expectations, these extraordinary monetary policies have not proved to be inflationary, or at least not inflationary in terms of consumer prices. But they have been inflationary in terms of asset prices.

Lesson 10: The behavior of securities markets does not conform to expectations. Excess liquidity and persistent low rates have boosted market levels but have also generally suppressed market volatility in a way that was not widely expected.

The Future

Are we entering a period similar to the pre-crash period of 2007/2008? There are undoubtedly some likenesses. Debt levels in the private sector are increasing, and the quality of debt is falling; public-sector debt levels remain very high. Thus, there is arguably a material risk in terms of debt levels.

Thought 1: The next crisis will undoubtedly be different from the last – they always are. The world is changing rapidly in many ways (look at climate change, technology and the “#MeToo” movement as just three examples). You only have to read “This Time is Different” by Ken Rogoff and Carmen Rheinhart to appreciate this.

Thought 2: Don’t depend on regulators preventing future crises. Regulators and other decision makers are like generals, very good at fighting the last war (or crisis) — in this case, forcing bank balance sheets to be materially strengthened or building more-diverse credit portfolios — but they are usually much less effective at anticipating and mitigating the efforts of the next.

Thought 3: The outlook for monetary policy is unknown. The monetary policy tools used during the financial crisis worked to stave off a deep recession. But we don’t really know how they might work in the future. Record low interest rates with little or no inflation has rendered monetary policy ineffective – a classic liquidity trap.

Source: Mercer – September 2018 – 10 Years after the GFC – 10 lessons

RNBZ can’t seriously be thinking about reducing the OCR

Today’s labour market data showed a drop in unemployment from 4.4% to 3.9% and an employment rate of 68.3% the highest since the HLFS survey was first reported in 1986. The
unemployment rate of 3.9% is the lowest since June 2008 and towards the lowest bound of the RBNZs estimated 4% to 5.5% range for the Non-Accelerating Inflation Rate of Unemployment (NAIRU). See graph below:

Tomorrow the RBNZ present their November Monetary Policy Statement (MPS) and these figures give them limited time to change any policy direction. Remember that the RBNZ is now tasked “supporting maximum sustainable employment within the economy” alongside its price stability mandate of 1-3% CPI with a target of 2%. However these figures seem to suggest that further easing is not required to meet employment objectives.

What is the Natural Rate of Unemployment?

The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).


The natural rate of unemployment will therefore include:
Frictional unemployment – those people in-between jobs
Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

Source: BNZ – Economy Watch – 7th November 2018

Questions about the next recession.

Ryan Avent of ‘The Economist’ considers how the next recession might happen — he asks the following questions:

  1. When will the next recession be?
  2. Where will it begin?
  3. Is the world prepared for a recession?
  4. What are the obstacles?
  5. What should governments do?

Very good viewing for macro policies – Unit 4 and 5 of the CIE A2 Economics course.

With the downturn in an economy, cutting interest rates has been the favoured policy of central banks. But the use of quantitative easing (QE) might mean the end of conventional monetary policy with rates already at record low levels – by pushing rates into negative territory they are actually encouraging a deflationary environment, stronger currencies and slower growth. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Liquidity Trap

Economic Consequences of Trump

Very good video from Project Syndicate looking at the recovery of the US economy and if it is sustainable. Also was Trump responsible for the growth or Obama? Maybe Janet Yellen and central bankers with such low interest rates for a long period of time. However if there is another downturn do governments have the tools to grow the economy again? It seems that central banks have run out of ammunition i.e. no room to cut interest rates further. There is agreement that the levels of employment are not sustainable in the future and the focus should be on assisting low wage work and help people prepare for and keep work- ‘reward work’.

  • Features Nobel laureates Angus Deaton and Edmund Phelps, along with Barry Eichengreen,
  • Rana Foroohar author of ‘Makers and Takers’
  • Glenn Hubbard Dean of Columbia Business School

A2 Revision: Keynes 45˚ line

With the Cambridge A2 exam coming up here is a revision note on Keynes 45˚ line. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X