New Zealand Monetary Policy, Essay Example

New Zealand’s Monetary Policy and its Effectiveness in a Time of Financial Crisis

Introduction

This paper posits to examine New Zealand’s monetary policy, and it’s effectiveness in a time of financial crisis. It will provide insight on measures the Government of New Zealand employs to micro-manage economic trends using monetary policy. Monetary policy is sustained through actions such as raising the interest rates, or changing the quantity of money the bank reserves (Casu et al, 2006). However, if the supply and cost of money is not regulated, then both are detrimental for economic development of the economy. This process by which monetary policy outcomes affect gross domestic product (GDP) in real terms, aggregate demand, and price levels is expressed as monetary transmission (Meltzer, 1995). Monetary transmission mechanism means the general conceptual structure, whereas the channel of monetary influences means the means by which the monetary turbulence influences the goal variables (Pierce & Tysome, 1985).

The Monetary Policy in New Zealand

There is great international support, for the universal view that the most favorable monetary policy framework is illustrated by (1) operational sovereignty of the central bank (2) an objective of price stability and (3) an unambiguous accountability of the central bank for accomplishing the objective (Svensson, 2001).  Monetary policy objectives must be consistent with the wider economic objectives and must also be restricted to objectives which are feasibly obtainable through monetary instruments (Amano, et al, 1999). There are no less than four channels by which New Zealand monetary policy seems to be impacting the country’s economic activities. These are: (1) Direct exchange rate channel to CPI inflation (2) Real interest rate channel to aggregate demand (3) Credit channel to aggregated demand (4) Exchange rate channel to aggregate demand. It is imperative to note that, these channels of transmission function with unstable lags which depend on the degree of the general economic development.

Channels 1, 2 and 4 are typically accepted by monetary economists. Channel 1 being most obvious in a comparatively open economy whereby the exchange rate has an impact on the prices of exportable and   importable. The third channel relies on the effects of bank lending or balance sheet, instigated by changes in interest rates. In the event of rise in interest rates instigated by monetary policy, the balance sheet channel works via a decrease in the household or firm balance sheet strength as equity reduces notwithstanding rising interest rates. Consequently, investments reduce while credit margins enlarge. The bank lending channel works by means of a decline in banks’ capacity to lend in an environment with unsatisfactory substitutability among bank credit and other related forms of credit (Svensson, 2001).

Inflation targeting

In light of the above analysis, The Reserve Bank Act 1989 obligates New Zealand’s monetary policy to be aimed exclusively at creating price stability. By specifying a solitary objective and granting the Reserve Bank political autonomy to pursue it, the Reserve Bank Act minimizes the probability that price stability may be forgone in favor of for other policy goals. Several provisions in the Act require accountability and transparency and at the same time, enhance the Bank’s integrity. Price stability, in this context, refers to maintaining a rate of inflation that ranges between 1% and 3% in the medium term. Price stability is supposed to grant a setting for constructive and sustainable economic growth by minimizing risk and uncertainty linked to inflation. Price stability in the policy-stipulated inflation target has been a characteristic of the New Zealand economy for almost two decades (Archibald, 2001).

The Policy Targets Agreement (PTA).

The Reserve Bank of New Zealand Act 1989 mandates the New Zealand Reserve Bank to bring about stability in the universal level of prices. A new PTA is usually negotiated each time a new Governor is chosen or re-appointed. The Act entails that the PTA ought to set out precise price stability targets. The PTA is only modified by agreement between the Minister of Finance and Governor (section 9(4)). Consequently, neither party has the mandate to enforce unilateral changes. It is noteworthy to mention that, under the Reserve Bank Act, the government retains the power (section 12) to overrule the PTA. This can only be done by directing the Reserve Bank to employ monetary policy for a dissimilar economic goal in general for one year duration (Reserve Bank of New Zealand, 2007).

The PTA comprises of four sections. The first section authenticates that, the Reserve Bank is obligated to conducting monetary policy. Its objective is sustaining stable universal level in prices. The second section stipulates that the Reserve Bank’s inflation target shall in the medium term be 1 to 3% on average. This is defined in relation to the All Groups Consumers Price Index (CPI). Section 3 stipulates that, in case external actions push inflation below or over its medium-term trend, the Reserve Bank ought to react consistently with attaining its medium-term targets. The fourth section illustrates how the Reserve Bank will implement and be responsible for its decisions. This incorporates providing clarifications for any breaches in inflation, or anticipated breaches. These clarifications should appear in the Bank’s quarterly Monetary Policy Statements. This section also articulates that, as the Reserve Bank implements monetary policy to accomplish price stability, the Bank should seek to circumvent avoidable instability in interest rates, output, and the exchange rate. Price stability, as stipulated in the Reserve Bank of New Zealand Act 1989 and the PTA, safeguards the value of the citizens’ savings and incomes (Reserve Bank of New Zealand, 2007).

The Monetary policy, on its own, cannot create rapid sustainable economic development, but, by bringing about price stability, it facilitates a predictable environment against which households and businesses can formulate the most valuable decisions (Grimes, 2000), and hence contribute to exploiting sustainable economic development for New Zealand. Additionally, monetary policy designed towards price stability facilitates reduction in boom-bust industry cycles. This means that, in the event that the economy weakens, inflationary pressures plummet and monetary conditions can be alleviated. This would promote the economy and employment to develop again (Reserve Bank of New Zealand, 2007).

Banking Regulation

However, notwithstanding the vulnerability of banks in New Zealand to foreign ownership, the banking sector in New Zealand was mostly intact by the latest global financial meltdown. In particular, there was no crisis funding requested from or granted by, the state. While banks in New Zealand were exposed to the pressures on international wholesale markets in general, this was more applicable in terms of the cost of finances in the global markets rather than general accessibility of finances to New Zealand banks in those particular markets. The higher cost of money was eased by guarantees granted by the New Zealand government regarding bank debt. The Reserve Bank also implemented several modifications to its liquidity operations (Putnis, 2010).

The Official Cash Rate (OCR)

The Reserve Bank, however, does not have direct control over the money supply. Financial institutions in New Zealand have no compulsory reserve ratios. Under the OCR approach, the Reserve Bank has noteworthy authority over short-term interest rates, and therefore, can affect the creation of credit in the economy. As an alternative of fixing reserves, the Reserve Bank permits the reserves to adjust to the preferred OCR.  The OCR is the interest rate at approximately which banks in New Zealand may borrow suddenly from the Reserve Bank in the event they have a deficit in settlement cash, and the interest rate earned on settlement cash balances suddenly. Settlement cash is then permissible to adjust to accomplish the declared rates. Thus, an alteration in the OCR can be anticipated to create a largely corresponding modification in the whole interest rate framework of the economy. Consequently, this creates an impact on spending, savings, borrowing and investment decisions, and, eventually, on inflation (Reserve Bank of New Zealand, 2007).

Conclusion

The monetary policy framework in New Zealand is a major example of a framework that can be replicated in several other countries seeking monetary policy reforms. It is vivid in this paper that monetary policy in New Zealand aims at controlling interest rate and accessibility of loan able resources for investment through the central bank’s regulation of the supply of money (Ahmed, 2003). The New Zealand monetary policy outcomes, impact on the GDP through its control on investment and consumption decisions of business households, and financial intermediaries.

References

Ahmed, S. (2003). Sources of Economic Fluctuations in Latin America and Implications for Choice of Exchange Rate Regimes. Journal of Development Economics, 72, 181-202.

Amano, R. Coletti D. & Macklem T. (1999). Monetary Policy Rules When Economic Behavior Changes, Monetary Policy Under Uncertainty, Reserve Bank Of New Zealand Workshop Proceeding.

Archibald, J. (2001), ‘Independent Review of the Operation of Monetary Policy: Final Outcomes’, Reserve Bank of New Zealand Bulletin 64(3):4-14

Casu B, Girardone, Claudia, Molyneux & Philip (2006), Introduction to Banking. Prentice Hall, (ed.), Ed. First, England: Pearson Education, ISBN 100-273-69302-6;

Grimes, A. (2000), ‘Submission to Independent Review in Operation of Monetary Policy’, available on official website: www.monpolreview.govt.nz

Meltzer, A.H. (1995). Monetary, Credit and Other Transmission Process. Journal of Economic Perspectives, 9, 3-10

Pierce, D.G. & Tysome, P.J. (1985). Monetary Economics: Theories, Evidence and Policy, London: Butterworth

Putnis, J. (2010). The Banking Regulation Review; Law Business Research. Retrieved June 1, 2011 from             http://Www.Russellmcveagh.Com/Doclibrary/Public/Bankingregulationreviewnzchapter.Pdf

Reserve Bank of New Zealand, (2007). Fact Sheet, Retrieved June 1, 2011 from  http://www.rbnz.govt.nz/monpol/about/0072140.html

Svensson, L. (2001), Independent Review in Operation of Monetary Policy in New Zealand: Report to Minister of Finance, Wellington.