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Fiscal And Monetary Policies Pursued By Nz Government Economics Essay

Over generations the world’s population has become wealthier and healthier and the economic growth has far exceeded population growth in almost all the countries. However over the past recent 200 years the Economic Growth has become a regular phenomenon. Earlier each generation was barely better off that the last. Off-late despite its recent occurrence Economic Growth is taken for granted. Along with steady increase in Trade and innovation, the desire for higher standard of living remains the main driving motivation. We can say Economic growth generates wealth and stimulates people choices. The choices may vary from a range across health, wealth, education, shopping spree, holiday, capital investment. At the level of Economy a difference between, just an estimate, a one percent and four percent average annual growth makes an enormous difference in the volume of goods and services available to the population in a country. Conversely without growth in economy and with ongoing growth in population, the range of choices will decline and we can also see a decline in standard of living of people of that country. In a world in which capital and labour are increasingly mobile, in these circumstances if the country’s resources opt to reside elsewhere, this will further hamper the growth prospects.

From the perspective of a monetary policy, we need to have a comprehensive understanding of the growth process as a prerequisite for determining appropriate policy settings. In order to maintain low and stable inflation, monetary policy always aims at aggregate demand does not deviate substantially from supply capacity over a period of time. Better knowledge of growth process by Reserve Bank and the factors which influence economy’s productive capacity or potential output, the higher is the probability of maintaining the price stability without interfering with the output, interest rates and the exchange rate.

We need to understand that economic growth is not the only goal that the policy makers at Reserve Bank seek to address. The Social and environmental factors are also very important determinants of welfare of people. These factors do not directly impact GDP but are supportive of a sustainable economic growth. For example the policies adopted by a nation which improve the social cohesion, or allows ample opportunity for the national resources to be utilized sustainably, May over a period of time contribute towards the improvement of economic growth. We also need to understand the time we need to work and time we need to spare for leisure as these decision influence the level of capital and manpower available to generate output. Similarly social policy choices need to be made say, promoting the income quality and to strengthen an individual’s investment in education and other professional skills. It is very important for the makers of policy and public at large to be informed about the options available and the relationship between the social and economic growth objectives. Next we shall discuss the New Zealand’s economic growth experience. Further we shall discuss on a range of factors which are important for a country’s prospects for a sustainable economic growth. Then we shall discuss factors which have influenced economic growth in New Zealand (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1).

New Zealand’s Economic growth performance

New Zealand is a small island located South of Australia. It is an independent nation within the British Commonwealth. The British Monarch, although constitutional head of state, does not plays on active role in the administration of the New Zealand’s government. While the population of New Zealand is just over 4 million, it’s easy to find – or get away from the- crowd. Auckland is the biggest city with over 1.5 million residents followed by Christchurch, Wellington (the capital) or Dunedin.

Ever since the 1950’s the economic life in New Zealand has changed considerably. During this period New Zealand was highly dependent on production of primary commodities. A large proportion of the economic activities was controlled by the government thru state ownership and regulation. 1990s saw New Zealand transformed into more open economies. Over this period the per capita income doubled.

The “golden years” – During this period (1950-1960) economic activity majorly was concerned with producing primary products. New Zealand endowment of natural resources and past investment gave a very strong comparative advantage in production of primary products. Also because of its colonial history, New Zealand has easier access to the British Markets. In 1953, primary activities accounted for 26% of economic growth directly.

The “turbulent years” – During this period (1960-1970) wool prices fell almost 40% and wool accounted for almost 33% of New Zealand exports at that time. This price fall had a major impact on the economy and this pushed it into recession and then started turbulence period in New Zealand’s history (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1).

During the 1970s, the terms of trade fluctuated considerably, (from 1971-1974) high demand for commodities globally helped and pushed term of trade up 50%. This impact was reversed by oil supply restrictions imposed by OPEC cartel. As a result of this the world economy went into recession and the demand for New Zealand’s products contracted, this was clearly evident from the current account deficit which reached 14% of GDP (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1). To make things more difficult restriction on Britain’s entry to the EEC in 1972, many countries increased their effective rates of protection for agricultural products and therefore curtailed New Zealand as primary producer to reap the benefits of competitive advantage. In response the government then ran expansionary fiscal and monetary policies so as to attempt to stimulate demand and also protect domestic living standard. This kind of policies would have helped in short term, however because of the permanent “supply-side” nature of the changes that were faced, demand management tools proved unsustainable for supporting the economic growth (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1).

Over the 1970s unsustainable Monetary and fiscal policies contributed to a general worsening of macroeconomic situation in New Zealand. The Fiscal balance moved from a surplus of 1.6% of GDP in 1972 to a deficit of 6.5% of GDP in 1984, and at least in part as a consequence, current account deficits became persistent (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1).Over the course of 1970s the rate of unemployment from less than 1% to 7% by 1998. Although the world was going thru the same phenomena but inflation proved to be more persistent in New Zealand.

The “reform period” from the mid 1980s dissatisfaction and underperformance of New Zealand economy prompted the government to come back with comprehensive economic reforms. Thru prudential fiscal policy and monetary policy focused on reducing inflation, the government began dismantling the complicated system of protectionist barriers that has sheltered a large proportion of New Zealand producers. Basically the reforms were aimed at macroeconomic stability and microeconomic efficiency. Hence emerged transformed “New Zealand” economy the most open market-based in OECD. Service sector emerged as a considerable contributor to GDP, conversely, the proportion of GDP generated by the industrial sector has declined over this period. The growth in primary production has been accompanied by substantial product diversification.

Since 1990s New Zealand has been witnessing increase in its economic growth rate. Growth over the 1990s occurred in the absence of increased fiscal spending or a significant improvement in terms of trade. The main drivers have been private sector investment, consumption and net exports. However the economy again faced turbulent times. Two consecutive drought, negative impact on foreign trade from the Asian financial crisis and the influence of past firm monetary policy all culminated in a short domestic recession in early 1998 (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1).

Monetary Policy of New Zealand

What is monetary policy?

Monetary policy is the process by which the government or monetary authority of a country controls the supply of money, availability of the money and the rate of interest in an economy (RBNZ, 2007). It is a tool used by Reserve Bank to keep control over inflation within a specific target band. The main instrument of monetary policy is OCR (Official Cash Rate) which the New Zealanders directly encounter as they borrow money at retail interest for mortgage loans, personal loans, credit cards, or when they save in banks. The retail rates of interest are directly related to OCR set by Reserve Bank. Other ways in which a common man encounters monetary policy is thru its effect on inflation and economic activities. Recent monetary policies have contained inflation within narrow limits very effectively. It also helps in preventing large swings in economic growth and employment (Reserve Bank of New Zealand: Bulletin Vol. 70 No.2).

Developments in Monetary Policy

Earlier in mid 20th century when government regulatory played a vital role in the economy the monetary policy was used to enhance growth, reduce unemployment, and keep prices stable. During 1960s and 1970s the world was facing high inflation thus started inflation targeting by most of the nations. The experience suggested that inflation could be reduced by controlling the money supply. During 1980s the period of liberalization New Zealand effectively opened the way for inflation-control policies and NZ pioneered a further monetary policy step – a specific target band.

As per the Policy Targets Agreement (PTA) inflation is measured by the All Groups Consumer Price Index (CPI) published by Statistics New Zealand. CPI records the change in price of weighted “basket” of goods and services purchased by an “average” New Zealand household. The percentage change of this index is typically referred to as “CPI Inflation” (Reserve Bank of New Zealand: Bulletin Vol. 70 No.2). What all goes into the basket of goods and services is periodically reviewed by the Statistics using data obtained from its annual Household Economic Survey. The PTA signed between the government and Reserve Bank of New Zealand requires the Reserve Bank to keep inflation between 1-3% target range and this task has to be accomplished without unnecessary instability in output, interest rates and the exchange rates (RBNZ (2007) Explaining New Zealand’s Monetary Policy).

Since 1999 Reserve Bank has been setting the OCR or in other words has been setting the wholesale price of borrowed money. Through OCR the RBNZ (Reserve Bank of New Zealand) is able to influence the wholesale price of money and via banking system and financial markets influences a range of factors that can help keeping inflation under control. Most of registered banks hold account with Reserve Bank which is used as settlement accounts for numerous day to day transactions of individuals. These transactions at the end of the day result in debit for few banks and credit for others. The Reserve Bank pays interest on settlement account balances and charges interest on overnight borrowing at rates related to the OCR. The most crucial part is that Reserve Bank sets no limit on the amount of cash it will borrow or lend at these interest rates. Hence no bank can offer a significantly higher rate of interest for a short term loans than the OCR, because the other bank can then undercut the interest rate using credit from Reserve Bank. Similarly banks cannot lend at rates significantly lower than OCR. Hence market rates generally are around the Reserve Banks OCR level. OCR influences the domestic interest rates and the other factor which influences the interest rates is international borrowing by financial institutions. Movement in overseas rates can also influence the interest rates even if OCR has not changed. When Reserve Bank increases the OCR the relative value of the NZ Dollar in comparison to other currencies tends to increase and vice-versa. This is because of the demand for NZ Dollar will fluctuate based on interest earning investment for Foreign Investors in currency (RBNZ (2007) Explaining New Zealand’s Monetary Policy).

The Impact on Economic Activity

Interest rates and exchange rates have a huge impact on demand. For example if the Interest rates increase people tend to take less loans and will tend to save more as the interest earning will be high. So people will spend less on goods and services and the economy activity will slow down. Conversely if interest rates come down people will spend more and demand more. Same goes for Exports also, if our exchange rate is high then the foreign currency prices of our goods and services will be high and this will impact our Export. Conversely our imports will be cheaper as the Dollar rate is high, this will increase demand for imported good and demand for domestic goods and services will decrease. Hence increase in exchange rate will also reduce the Economic Activity.

GDP = C + I + G + ( X – M )

C= Consumption of goods and services (Spending by Consumers)

I= Investment made by firms

G= Government spending

X= Exports

M= Imports

Monetary Policy Process in New Zealand

OCR

Interest Rate

Exchange Rate

Economic Activity

Trading Partner Inflation

CPI Inflation

Expectations

CPI Inflation

Transmission mechanism of New Zealand monetary policy

To summarize the monetary policy, OCR is high, hence wholesale short term rate and wholesale long term rate is also high, bonds and equity prices are down and floating mortgage and variable loan rates are high, this has a direct impact on house prices which are relatively low, exchange rate is high, which make business activity and business investment low, over all house consumption is low, as exchange rate is high imports are high and exports are impacted, domestic output is also low, non tradable inflation is also low, hence overall the inflation is expected to come down (Reserve Bank of New Zealand: Bulletin Vol. 63 No.1).

Fiscal Policy

What is Fiscal Policy?

Fiscal Policy is the use of government expenditure and revenue collection to influence the level of economic activity (Sullivan and Sheffrin, 2003). The two basic and main elements of fiscal policy are government expenditure and government taxation (revenues). Governments in particular Reserve Bank Governors use Fiscal policy of influence aggregate demand in a particular economy, so as to influence price stability, employment status and overall economic growth. Fiscal policy puts a lot of emphasis on transparency thru enabling responses from monetary policies.

Types of Fiscal Policy

Fiscal policy can be said to be of three types (Sullivan and Sheffrin, 2003);

Neutral stance of fiscal policy – This implies to balanced economy. Results in large tax revenue. Spending by the government is fully funded by tax revenue and the budget has a neutral effect on the level of economic activity.

Expansionary stance of fiscal policy – When government expenditure is in excess of government taxation or revenue.

Contractionary stance of fiscal policy – When government spending is lower than government revenues.

Many world economies have enacted FISCAL STIMULUS PLANS in response to the on ongoing global economic recession. These economies or Nations have used a combination of government spending or expenditure and tax cuts to provide a booster to the staggering economies. Most of these plans are based on Keynesian Theory that deficit spending of governments can replace some of the demand lost during a recessionary period and will prevent waste of economic resources which are lying ideal by a lack in demand.

New Zealand Fiscal Policy

As already the Revenue for the Government was in excess of expenditure made, the income tax slab was increased to 39% for individual tax payers. Hence people started looking for options to save taxed and one of the option which came out was Investment in property as the interest rates were low and income from Sale of property was not taxed (there was no Capital Gains Tax). The interest paid for the housing loan was being adjusted against the Income. This resulted in Housing prices to rise because of high demand. OCR running high, bond market is running high, inflation is high, and NZ Dollar because of overseas demand goes up. This puts pressure on exports and import goes up.

AD = C + I + G + ( X – M)

OCR = RR = Money Supply Increases

Demand for Foreign Currency is high and Value of NZ$ increases.

The Nett. Result is GDP is down, employment is down, inflation is down.

Impact of Monetary and Fiscal Policies followed by government of NZ

Like many economies of developing world, New Zealand was also hit by the recent financial crisis and acted by altering the monetary and fiscal policy. Treasury maintains control over the fiscal policy of the crown, including proper management of State Owned Enterprises (SOE’s) while Reserve Bank thru its Governor controls the OCR and reserve requirements of banks thru the monetary policy.

As part of New Zealand’s monetary policy, the Reserve Bank of NZ controls the Banking system primarily thru the Official Cash Rate (OCR), and also sets reserve requirements for the banks (RBNZ, 2007). OCR has had a large drop during 2008-09 from 8.25% to 2.5% over a short period of nine months. The Reserve Bank expressed to keep its policy on OCR to historically low rate until middle of 2010 and still continues based on pressure from CPI inflation, subdued credit growth and weak business spending.

Sheer nature of the New Zealand economy and the size of purchase by the Government of NZ have a huge impact on the GDP. Government spending is close to 35% of its GDP, consistent with the Treasury’s goal of increasing productivity and improving the lives of New Zealanders (Peters and Wilson 2009).

In periods of recession, like 1999-2000 or 2008-09, the government increased its spending as a percentage of the GDP in order to compensate for the decreased spending by consumers. We can also say that New Zealand Government was following the Keynesian view which suggests that a recessionary period should be countered by increase in government spending as the same is caused by decreased demand by consumers.

According to the 2009 Fiscal Strategy Report, the treasury has an aim to cut down on the dents to a prudent level; to ensure a stable economic environment, and a public sector that produces quality good (Federal Reserve Board, 2006). To achieve these goals, Treasury will be looking at long term debt as net debts to evaluate the strength of the financial position, review the level of long term debt and forecasts to include the effects of the 2008-09 crisis on the levels of National Debt. Reduce the allowances from the 2010 budget which has been planned and delay tax cuts and investment fund payments until the economy stabilizes.

Problems / Issues with the Policies

Tighter monetary policy of New Zealand as explained above with higher OCR led to higher rate of interest. This attracts global investors to find it suitable for investment in NZ. Investors from developed countries have been attracted to New Zealand dollar financials assets because of the return associated to the Bonds. The two Bonds issued are Eurokiwi and Uridashi. Uridashi Bonds for Japanese retail investor and account for almost half of the Total 55 Billion in offshore issuance. The offshore issuance of Bonds has an impact on the economy and fiscal system. Issuance of Bonds is source of Capital inflow to NZ financial system. These bonds facilitate financing of current account deficit by providing the local banks with cost effective mechanism of converting overseas borrowing into NZ Dollars. Bonds tend to depress swap rates over a period of time thus enabling the bank to offer mortgage loan at relatively low fixed interest rates. This has reduced the effect coming from increased in the OCR relatively. Issuance of these Bonds has raised demand for NZD (NZ Dollar) which is currently witnessing the currency at high levels against USD, EURO and Japanese Yen (Reserve Bank of New Zealand: Bulletin, Vol. 68, No. 3).

The deficit rose to $ 15.16 Billion over a year most of which was funded by a $ 13 Billion increase in net debt over the year, and most of that $10 Billion increase in Bank borrowing (Fallow, 2006). Increase in inflation saw mortgage rates increase, at this time Reserve Bank of NZ announced that it will not consider a drop in interest rates until May’2009. Rather the Governor increased rates five times since early 2007. Thus interest costs increased for mortgage loans, pushed exchange rates and aggravated the inflation issue. These measures were taken to reduce inflation as such.

These control measures had an adverse effect on common people making it difficult for them to make their ends meet forcing them to cut on spending. Series of business failure and job losses or job cuts accompanied by pressure on living costs of household lead New Zealand into recession (Braddock, 2008).

RBNZ increased OCR to 7.5% in order to tackle the issue associated with rising Housing Rates. High housing prices give consumers the confidence to spend and borrow more exacerbating inflation pressures and debt problems. Housing price inflation continued to stay at 5% rather than average 2% (Peters and Wilson, 2009). Despite receiving adverse feedback and worrying results RBNZ Governor continued with his strategies of extortionate interest rates and pushing exchange rates higher putting extreme pressure on exporters and making them go out of business and thus resulting in bankruptcies and job losses. Asset price inflation made business rates higher (Louisson and Twose, 2006).

The government at this point hired huge super class of well-heeled policy advisers and consultants to ease out situations (O’Sullivan, 2007). Government could not clamp its own spending which was one of the major contributors for the inflationary pressure on the economy.

The government introduced a new tax system of increasing GST and lowering the top tax bracket (Epstein, (n.d)). The system was more biased and favoring investment in housing rather than encouraging investment in domestic businesses which would have created jobs and incomes. People from high income group and working class invested highly in housing and later claiming rebate in taxes from the levels which they paid earlier (Fallow, 2006). Local banks borrowed from foreign markets and lent these investments to local market who in turn used these funds to buy houses which did not contributed to the economy at any stage. From 2002 the banks had overseas assets of $ 29 Billion and liabilities of $69.3 Billion, resulting in net deficit of $40.3 Billion. In recent quarters the banks had increased this deficit to $ 119.2 Billion (Peters and Wilson, 2009).

The Newly elected government headed by Prime Minister John Key moved in to impose the full burden of the economic breakdown on the backs of working people. In an effort to stabilize the economy it cut down on government spending also.

The worry as of now is that the outstanding value of these Bonds (Eurokiwi and Uridashi) is larger than the New Zealand government bonds outstanding and on par with total New Zealand dollar government securities on issue.5 Secondly as banks have access to cheaper funds they tend to lend this to New Zealanders to buy houses, cars and household appliances in massive shopping spree. This is ideally funded by overseas lenders. This is profitable for the financial institutions as they have access to cheaper funds from overseas with an effectively very low risk of exchange rate as the Bonds have to be paid in New Zealand Dollars only. Offshore issuance of NZD Bonds is likely to continue for as long as the conditions which have fostered it are sustained. If the credit demand is strong and foreign investors are keen to buy NZD because they can fetch better rates then offshore bond issuance is likely to continue. Conversely if the credit demand slows down and swaps rate falls, or interest rates offshore rise, or the risk perception in mind of investors rises based on the account deficit which NZ is carrying then issuance of Bonds is likely to fall. But in the current scenario the OCR is running at 3% as the latest announcement made by Reserve Bank on 16th September’2010. Hence things are under control, in case the OCR is raised and this can fuel the borrowing and lending further which is currently the most difficult question faced by Governor of RBNZ (Reserve Bank of New Zealand).

Conclusion

In the current circumstances the monetary policy of NZ is very tightly run to control inflation, money supply is reduced and interest rates are high, hence people are consuming less and are not looking for investment options (Demand has dampened), the inflation is under control currently with high interest rates the demand by overseas investor for NZ Dollar is on the increase and the NZ demand has risen, as the Dollar has appreciated the Imports have become cheaper and the demand for domestic goods and services have reduced. This has reduced inflation further but on the other hand exports are losing competitiveness in overseas markets because of the exchange rate, putting pressure on the exporters on margins. This has impacted the GDP and eventually we can say because of these monetary and fiscal policies the economy went into recession.

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