Download Government Policies: - Eg 1

Government Policies: - Eg 1
The Government has many policies that help to guide them make decisions on various matters that
relate to running the country. The policy relating to managing money in the economy is called
Monetary Policy. Monetary policy is defined as the action taken by the Reserve bank of New
Zealand, with the intention of influencing interest rates through the money supply. Before 1989, the
RBNZ used monetary policy to attempt to achieve economic growth, full employment and low
inflation. But the aims conflicted with each other and in 1989 the RBNZ created the Reserve Bank Act
1989. This was designed with the purpose of clarifying monetary policy and its objectives,
responsibilities and accountabilities. Now price stability is the sole objective of the new act. The
aims of full employment and growth were left to other means. This is done in order to achieve price
stability by limiting inflation. Inflation is an increase in the average price level. The government uses
monetary policy to achieve price stability for the economy. The government decides on monetary
policy, but the RBNZ are responsible for administrating the policy and making it work. The RBNZ
attempts to lower inflation by using a number of policy tools including: The Official Cash Rate (OCR),
Open Market Operations (OMO) and Moral Suasion. Interest rates are influenced by the OCR
through the money supply. The OCR is the difference between the interest rate banks have to pay
for borrowing money from the RBNZ through their settlement accounts, and the interest they
receive for having money in their settlement accounts. Settlement accounts are accounts held at the
RBNZ by registered banks to settle their accounts at the end of the day. The RBNZ have The Policy
Target Agreement (PTA) with the government to keep the rate of inflation between 1-3%, this is the
current acceptable rate of inflation set by the government. If inflation is too high or there are
inflationary pressures, then the RBNZ will increase the OCR. This action is known as a Tight Monetary
Policy or Contractionary Monetary Policy. If the OCR increases, then the level of money supply will
decrease, so there will be less money in the economy. The graph below (on the left) shows money
supply decreasing, shifting the MS curve to the left, causing an increase in the interest rates.
Investment and consumer spending will also decrease, due to less money in the economy. Savings
will increase as households will save more and spend less. This will lead to Aggregate Demand
decreasing (as shown by the graph on the right). If AD decreases, the price level will decrease which
will reduce inflationary pressures.
Interest Rates: MS2
MS
PL
R2
Ple1
R1
Ple2
AS
MD
AD1
AD2
Qe2
Qe
Ye2 Yf Ye1
The long-term effects of Aggregate Demand decreasing are a negative flow-on effect of tight
monetary policy. The level of investments and consumer spending will decrease due to tight
monetary policy, which can have a negative effect on the economic growth. Growth will also
decrease because of less consumption. Less spending on commodities will cause firms to reduce
production, and less investment leads to less buying of capital goods, so less production. Because
capital goods are not being replaced, productivity may decrease and employment may fall. This will
cause Aggregate supply to shift to the left (as shown below). This will cause the price level and
output to increase and employment to decrease.
PL
AS2
AS
Ple2
Ple
AD
Ye2
Ye
Trade can be impacted in the short-term by exports decreasing, as firms cost of production increases
through increased interest payments. The exchange rate will appreciate because since the New
Zealand interest rates are higher overseas, investors are more likely to save money in NZ causing the
interest rate to appreciate. Exports will become less competitive as they become more expensive
due to the higher exchange rate, so exports will fall. Imports will become cheaper as the exchange
rate appreciates, which will cause production to fall as NZ producers become less competitive. This
causes the balance of trade to become worse. If inflation is controlled, the exchange rate may fall in
the long-run. If the inflation rate is less than overseas countries then NZ will eventually become
more competitive, leading to an increase in exports and a decrease in imports. This may cause the
balance of trade to improve in the long-run. The model below shows the NZ$ appreciating shifting
the NZ$ demand curve to shift to the right.
NZ$/US$
SNZ$
Ep2
DNZ$2
Ep
DNZ$
Qe
Qe2
Q
The government could introduce an Employment scheme in order for more people to be employed.
This will create more jobs, which will raise the employment level, minimising the negative effect of
employment decreasing. Production may also increase because with more jobs and workers, more
production can happen. The government could also introduce supply side policy. These are policies
that encourage producers to increase productivity, with the purpose of increasing Aggregate Supply
(AS). Supply side policy could be implemented by things such as changes to investment and
infrastructure, increase in research and development and/or company tax cuts. These methods of
supply side policy help keep the inflation level between 1-3%.
Price stability is a desirable objective of the government because inflation is bad for the economy.
High inflation can have a negative impact for the producers and households in the economy because
of the increase in the cost of production for producers and the cost of living and purchasing power
for households. Also the real wage and savings will decrease impacting households, while for
producers the business confidence and exports will decrease. The cost of production will increase
because of the increase in the price level of the goods and services, and the decrease in purchasing
power. Purchasing power is the number of goods and services that can be bought with one unit of
currency. During inflation, the Purchasing power will decrease because the real wage decreases.
Firms will now have to pay more money for the same amount of goods. Household’s savings will
decrease because the purchasing power has decreased, and so the cost of living will increase so
households are more likely to spend more and save less.
Current Economic Situation:
According to an article by Alex Tarrant, Price stability is maintained with the current OCR rate of
2.5%. The recession triggered a risk of deflation, but was prevented by the RBNZ, who created major
tax cuts to the OCR in order to increase aggregate demand. The decrease in the OCR causes a
decrease in interest rates and savings, but an increase in consumption and investment. If interest
rates decrease, households’ disposable income will increase as interest rates decreasing causes
mortgage and loan payments to also decrease. If households’ disposable income increases,
consumption is likely to increase, as households have more money to spend. An increase in
consumption will cause Aggregate demand to increase. The AD model below shows Aggregate
Demand increasing, causing an increase in the average price level and output.
AD Model:
AS
PLe2
Ple
AD2
AD
Ye
Ye2
OCR cuts have also have reduced business loan repayments to 2.5%, they now have higher profits
that can be used for investment in capital goods. Capital goods will increase the productive capacity
of firms, and as they become more efficient, cutting their costs of production. This will allow them to
produce higher output with the same level of input, which will result with an increase Aggregate
Supply (as shown in the AS model below) causing an increase in output (from Ye to Ye2) and a
decrease in price level (from Ple to Ple2).
AS Model:
AS
AS2
PLe
Ple2
AD
Ye
Ye2
Because of the decrease in the OCR, NZ’s interest rates decrease. This means that overseas investors
will receive lower interest on their investments, and so may seek to invest elsewhere instead. This
will cause the exchange rate of the NZ$ to depreciate as the demand for NZ$ decreases. This is
shown in the Forex model below.
NZ$/We
SNZ$
Ep
DNZ$
Ep2
DNZ$2
Qe2
Qe
Exports will become more competitive overseas as they receive higher returns because of the NZ$
depreciating. This will mean that the NZ economy can either increase efficiency, production or lower
the price level. Though the depreciation of the NZ$ will cause imports to decrease and cause the
cost of production to increase, due to the increase in the price of raw material needed for
production. Because of the increase in cost of production, producers will increase the price level of
goods in order to keep profit levels up. The balance of trade is currently insufficient, but with the
OCR at 2.5% will slowly increase with the depreciation of the NZ$ and increase in NZ exports price
competitiveness. Increased exports will increase growth and the balance of trade will increase as
export sales exceed import payments.
By using supply side policy, the economy will become more productive, by increasing Aggregate
Supply and can successfully get the economy out of a recession without increasing the price level. If
producers invest in capital goods, productivity will increase to meet the demand from the
government. With the investment increasing in capital goods, productive capacity will increase
causing the cost of production to decrease because firms can now increase output with the same
amount of input. This will increase AS, as the firms can now decrease price level. Goods and services
become cheaper and price stability will be maintained. An increase in productivity and Aggregate
Supply will create jobs, causing employment levels to increase. Households’ disposable income will
increase as employment increases. With disposable income increasing, consumption will increase
causing Aggregate Demand to increase. Productivity will increase due to AD increasing. With supply
side policy creating efficiency in the economy, the price level of goods decreases, employment in
households will increase and price stability can occur.
Another good policy that will help the economy get out of a recession is Fiscal policy. Fiscal Policy is
government decisions on spending and revenue, to achieve economic goals. Expansionary Fiscal
Policy is when the government spending is more than revenue. If the government increases
spending, Aggregate Demand will increase causing growth to also increase. An increase in growth
will cause the AD curve to shift right. This will lead to more income, which will cause consumption to
also increase. If consumption increases sales will increase, causing firms to increase production. GDP
will increase leading to more growth. The government can increase government spending by
increasing transfer payments for families. This will increase the household’s disposable income
which will cause consumption and growth to increase.