Tag Archives: Monetary Policy

RBNZ announce QE

Below is a link to a very good interview with RBNZ Governor Adrian Orr on Radio NZ ‘Morning Report’ programme. Loads of good material on monetary policy – useful for discussion purposes with my A2 class today – online.

Radio New Zealand – Adrian Orr interview

The Monetary Policy Committee decided to implement a Large Scale Asset Purchase programme (LSAP) of New Zealand government bonds. The programme will purchase $30 billion of New Zealand government bonds, across a range of maturities, in the secondary market over the next 12 months. The programme aims to provide further support to the economy, build confidence, and keep interest rates on government bonds low. The low OCR – 0.25%, lower long-term interest rates, and the fiscal stimulus recently announced together provide considerable support to the economy through this challenging period.

Keynes v Monetarist – Powerpoint download

Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the theory that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:

– C+I+G+(X-M)
– 45˚line
– Circular Flow and the Multiplier
– Diagrammatic Representation of Multiplier and Accelerator
– Quantity Theory of Money
– Demand for Money – Liquidity Preference
– Defaltionary and Inflationary Gap
– Extreme Monetarist and Extreme Keynesian
– Summary Table of “Keynesian and Monetarist”
– Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

Coronavirus – impact on the NZ economy

Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen

National Radio – Don Brash interview

A2 Revision – Liquidity Preference

With the A2 multiple choice tomorrow here is a mind map on liquidity preference. The liquidity preference or the demand for money is the sum of the transactionary, precautionary and speculative demand for money. Only the speculative demand is inversely related to interest rates. It is the speculative demand that students find difficult to understand. This is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.  Demand is interest elastic – i.e. is affected by changes in interest rates. Below is a mind map and some notes.

Adapted from CIE AS A Level Revision Guide by Susan Grant

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑. If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

AS and A2 Macroeconomics: Internal and External Balances

In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.

Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.

External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.

In the diagram right the point of internal and external balance is the intersection of the two axes, with neither boom nor slump, and with neither a current account surplus nor a deficit.

The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.

The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.

In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.

Monetary Policy in New Zealand – what the OCR means.

The Monetary Policy Committee of the Reserve Bank of New Zealand (RBNZ) operates monetary policy in New Zealand through adjusting the official cash rate (OCR). The OCR was introduced in March 1999, and is reviewed 7 – 8 times a year. The recent amendment to the Reserve Bank’s legislation sets up a Monetary Policy Committee that is responsible for a new dual mandate of keeping consumer price inflation low and stable, and supporting maximum sustainable employment. The agreement continues the requirement for the Reserve Bank to keep future annual CPI inflation between 1 and 3% over the medium-term, with a focus on keeping future inflation near the 2% mid-point.

Through adjusting the OCR, the Reserve Bank is able to substantially influence short-term interest rates in New Zealand, such as the 90-day bank bill rate. It also has an influence upon long-term interest rates and the exchange rate. In theory this is what the impact should be:

Higher interest rates = contractionary effect which leads to lower inflation and less employment growth

Lower interest rates = expansionary effect which can lead to higher inflation but more employment growth.

However the Reserve Bank of New Zealand acknowledge that it is a very complex mechanism as interest rates impact the aggregate demand through various channels – C+I+G+(X-M) – and over varying time periods.

On a normal day consumers, producers, government etc undertake financial transactions involving the commercial banking system. At the end of each day they need to ensure that their accounts balance but some registered banks may find that they are short of funds following the net aggregate result of these transactions, while others may find that they have substantial deposits.

Commercial banks that are have positive balances can leave this money with the Reserve Bank overnight. They receive the OCR on deposits up to a threshold level, and then receive the OCR less 1% for the remainder. Commercial banks that have a negative balance can borrow overnight from the Reserve Bank at an overnight rate of the OCR plus 0.5%. Therefore if you use the current OCR rate of 1% you get this situation. Remember that 50 basis point = 0.50% and 100 basis points = 1.00%.

Banks have the option (and incentive) of borrowing from each other, and using the Reserve Bank as a last resort. In doing so, both parties gain as the lending and borrowing rate tends to mirror the OCR (given the level of competition in the banking market). Those banks with excess deposits can then receive an overnight rate close to one percent (rather than a zero interest rate on any funds over the threshold level). Those banks who need to borrow funds can do so at around the OCR rate, rather than at 1.50 percent. The interest rate at which these transactions take place is called the overnight interbank cash rate see graph below.

Source: Grant Cleland – Parliamentary Monthly Economic Review – Special Topic – October 2019

50 basis points cut by RBNZ – are they going negative?

The 50 basis points of the OCR (Official Cash Rate) by the RBNZ took everyone by surprise. Cuts of this magnitude generally only occur when significant events happen – 9/11, the GFC, the Christchurch earthquake etc. However the US China trade dispute have significant implications for global trade and ultimately the NZ economy. The idea behind such a cut is to be proactive and get ahead of the curve – why wait and be reactionary.

The Bank has forecast the OCR to trough at 0.9 percent, indicating a possible further interest rate cut in the near future. The RBNZ believe that lower interest rates will drive economic growth by encouraging more investment but you would have thought that such low rates wold have been stimulatory by now. I don’t recall the corporate sector complaining too much about interest rates and according to the NZIER (New Zealand Institute of Economic Research) latest survey of business opinion only 4% of firms cited finance as the factor most limiting their ability to increase turnover. The problem seems to be an increase in input costs for firms which is hard to pass on to consumers.

Lower interest rates have a downside in the reduction in spending by savers and this could also impact on consumer confidence. Any hint of further easing seems to encourage financial risk-taking more than real investment. Central bankers have thus become prisoners of the atmosphere they helped to create. There is still a belief amongst politicians that central bankers have the power by to solve these issues in an economy and politicians keep asking why those powers aren’t being used.

Are negative Interest rates an option?

The idea behind this is that if trading banks are charged interest for holding money at the central bank they are more likely to make additional loans to people. Although this sounds good negative interest rates on those that hold deposits at the bank could lead to customers storing their money elsewhere.

The European Central Bank sees that negative interest rates have an expansionary effect which outweighs the contractionary effect. An example of this is Jyske Bank, Denmark’s third-largest bank, offered a 10-year fixed-rate mortgage with an interest rate of -0.5%. for a ten-year mortgage – in other words the bank pay you to take out a mortgage.

However negative interest rates is seen as a short-run fix for the economy. Getting people to pay interest for deposit holdings may mean that banks have less deposits to lend out in the long-run and this may choke off lending and ultimately growth in the EU.

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.

Sources:

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.