Download The Business Cycle and Interest Rates

Interest Rates and
the Business Cycle
The Official Cash Rate - OCR
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The OCR is an interest rate set by the
RBNZ
The RBNZ can influence interest rates in
the economy through the OCR
The OCR
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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
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The RBNZ announces that the OCR is 2.5%
What interest rate do banks pay the RBNZ for
loans?
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Banks pay 2.75% for loans from the RBNZ
What interest rate does the RBNZ pay banks for
deposits?
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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.
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The C + I + (X – M) component of AD (GDP)
Investment
OCR effects……
Net Exports
Consumption
How the OCR effects spending (C)
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An increase in the OCR leads to…..
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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…..
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a decrease in interest rates
it becomes less attractive to save
cheaper to borrow
Spending will rise
How the OCR effects Investment (I)
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An increase in the OCR leads to……
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an increase in interest rates
more expensive to borrow
Less attractive to invest
A decrease in the OCR leads to…..
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a decrease in interest rates
more attractive to invest
cheaper to borrow
OCR and the exchange rate (X – M)
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When the OCR rises, (overseas) investors will place
their money in our banks.
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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.
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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?
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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?
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“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
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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
Recession
Recovery
Boom
Trough/Depression
Time
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Boom
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Rising interest rates
High eco activity
“Full” employment
Great optimism
Businesses operating at capacity
Peak (Turning point)
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Trade Cycles
Eventually rate of growth must slow down. Even if economy is still
growing it is now doing so at a decreasing rate
Recession
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Rising unemployment and business failures
Savings may increase as people fear unemployment
Business activity slows down
Trade Cycle
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Depression (Trough)
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Unemployment stabilised
Low level eco activity
Excess capacity
Interest rates low
Low consumption , low saving
Eventually some major piece of capital equipment will need replacinginjection of investment lead to recovery
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Recovery
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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:
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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
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Time
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)
 BA––Negative
Positive
Change
in
Growth
a
b
Output
Gap.The
Theeconomy
economyisis
Gap.
trying to produce
a
producing
below the
level of GDP
thatofis
sustainable
level
above the sustainable
output
resources
growth(some
path of
the
are
idle). Demand
economy
(using for
resources
less than
resourcesisfaster
than
the
supply
therefore
they
can replenish).
general
Demand
price
for level
resources
will
exceeds
supply
drop
causing
therefore or
price
level
disinflation
deflation.
and inflation will
occur.
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A. AD increases
causing inflation
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B. AD decreases
causing disin/deflation
Governments use of OCR
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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.