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Reserve Bank of New Zealand’s Monetary Policy Essay

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The current monetary policy of the reserve bank of New Zealand operates by considering the use of interest rates and the sale of government securities. Monetary policy means varying the price and supply of money circulating. It is more flexible than fiscal policy since changes can be made at any time. In addition, the effects are less obvious. The two monetary measures are designed to reduce total spending by raising the cost of borrowing and limiting the availability of loans. The money supply comprises mainly bank deposits and monetary controls are intended to regulate this major form of money (Baumol W, 1992). Controls are applied by the reserve bank of New Zealand.

The reserve bank uses open market operations that are the use of special deposits and directives. This is aimed to reduce investment and consumption by making finance more expensive and difficult to obtain. Open market operations consist of selling or buying government securities by the reserve bank on the market. If the bank sells securities, buyers pay using a cheque drawn on the commercial banks. The balances of the commercial bank at the bank, will, therefore, be reduced and if the reserve assets ratio is to be maintained, then bank advances must be reduced (Waud R.,1997).

Funding is an aspect of open market operations. It means lengthening the age structure of the national debt by issuing less short–term debt that is the sale of treasury bills through the discount houses and more long-term or funded debt. In this way, the reserve bank can alter the banks’ opportunities to purchase liquid assets, because treasury bills are easily converted into cash. Thus, if the bank wishes to decrease the money supply, the sale of treasury bills is restricted by converting the desired amount of short-term debt into funded debt. Consequently, the banks must seek alternative liquid assets to reduce deposits( McTaggart D Finlay C & Parkin M. 2003).

A drawback to the effectiveness of this process is that the banks may maintain their liquidity by increasing their holdings of commercial bills. These bills are bought from discount houses and are just as liquid as treasury bills (Baumol W, 1992).

Special deposits:- The drawback can be overcome to some extent by using special deposits as a form of control. The central bank can call for special deposits equivalent to a given percentage of the commercial banks’ total deposits. These special deposits do not count as part of the liquid assets and so, to raise them, the banks have to call in some part of other advances. Issuing directives open market operations and calls for special deposits are insufficient in themselves to achieve full control over bank advances. For example, instead of reducing their advances, the banks may prefer to sell their investments. Therefore, the central bank may supplement its action by issuing directives to restrict loans (Waud R. 1997).

Reserve bank of New Zealand rate is used to influence rates of interest and hence, the cost of borrowing. Technically, the bank rate is the minimum rate at which the central bank is prepared to re-discount bills of exchange brought to it by members of the money market. However, the chief importance of bank rate rests in its function as the sheet of the anchor of interest rates throughout the country. Changes in the bank rate influence other rates of interest. When the bank rate is raised, borrowing becomes more expensive and demand for loans is reduced, thereby reducing purchasing power. Conversely, a reduction in the bank rate will lead to an expansion of bank deposits. The resulting fall in overdraft rates will encourage borrowing while saving will be discouraged because of the lower rate of interest paid on savings (Otto, G.,2007).

For example, if announces changes in reserve amount requirement, it will have many economic impacts on the part of the commercial banks and the economy as a whole. The change of the reserve requirements will affect the supply of money and operations of the bank. The reserve requirements increment for banks is intended to reduce there supply of money in circulations thus reducing funds available for lending out. This measure is intended to reduce total spending by raising the cost of borrowing and limiting the availability of loans. Money supply comprises mainly deposit therefore transferring some money from the commercial bank to the Federal Reserve is reducing money available. The economic impact in this case will be inflation will come down and reducing money for spending there will be slow in growth (Otto, G, 2007).

The banks will react to such a measure by selling their investments to provide funds for continual lending. The bank may also raise the interest for deposit to attract new customers and increase the lending rate. When the reserve bank announces the changes in a discount rate there will be a reduction in borrowings reducing the amount of loans available for the borrowing as well raising the cost of borrowing. Changes in the bank rate influences other rates of interest, when the discount rate is raised, borrowing becomes more expensive effectively reducing demand for loans, the effect in the economy is reducing the purchasing power of people. The announcement by the Federal Reserve Bank that the discount rate will be raised will mean that borrowing will be very expensive thus the supply of money will also reduce (Waud R ,1997).

For successive working of bank rate, several conditions have to be satisfied:

  1. Efficiency of bank rate in controlling credit requires a closer relationship between the bank rate and other interest rates in the money market.
  2. Not excess reserves. The necessity for commercial banks to approach the central bank for rediscounting is an important factor in determining the successive working of the bank rate. But commercial banks will not need to approach the central bank when they have ample liquid resources at their disposal( Otto, G. 2007).
  3. The successive operation of the bank rate policy presupposes an elastic economic structure so that changes in credit condition should lead to corresponding changes in wages, rents, production, trade, etc. (Waud R. 1997).

The bank has many options to counter this pending reserve bank announcement. They will be required to sell some of their investments and assets to generate cash inflows to assist in generating sufficient funds for reserves. The bank also can borrow from other banks through the federal funds market or they can borrow from the federal bank reserve. These options have advantages and disadvantages and some of the advantages and disadvantages of selling investment include (Waud R (1997):

  • The assets and investments of the bank will reduce and other and other sources of income will effectively reduce.
  • The bank’s balance sheet will improve because the bank balance sheet is normally made of deposits, savings, current accounts, money at short call, treasury bills, liquid assets, and investments (Hahn, E, 2002).

Borrowing from federal will have many advantages and disadvantages; one of the advantages is that the company’s reserves will improve however the company’s liquidity ratio will be win question. The cash ratio and liquid ratio are the most important ratios in the bank therefore borrowing will reduce the liquidity ratio of the bank (Elkington J. 2001).

Borrowing from the federal funds market will mean that the bank will increase obligations through interest; this may affect the profitability of the bank. However the bank will have enough cash improving the cash ratio of this bank (Waud R. 1997).

Inflation targeting:-The causes of inflation are complicated but can be explained by two kinds of forces affecting the level of prices, namely, demand pull and cost push:- Basically, inflation represents a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output (Hahn, E, 2002). In such a situation, the rise in price level is the natural consequence. Now this excess of aggregate demand over supply may be the result of more of one force at work. For example, consumers might be spending a greater proportion of their income; income themselves may have risen; or cheap and easier credit facilities might have been used to finance a spending boom (Baumol W. 1992).

If inflation is mainly induced by rising costs of production, it can be described as a cost –push inflation. We can visualize a situation where, even though there is no increase in aggregate demand, prices may still rise. This may happen if costs, particularly the wages- costs, go on rising. Now as the level of employment rises, the demand for workers also rises so that the bargaining position of the workers becomes stronger. To exploit this situation, trade unions ask for an increase in wages rates which are not related to increases in productivity or the rise in the cost of living. The employers in a situation are likely to concede to higher wages claims (Elkington J. 2001).

As labor costs are often one of the main costs of production, firms may be compelled to raise the prices of their goods and services, to cover the addition to the wage bill. However, the price rises will lead to a further round of wage demand as people endeavor to restore the buying power of their incomes. In return, further price increase will result and the chain of events will repeat itself in an inflationary primal of prices and incomes (McTaggart D Finlay C & Parkin M. 2003).

It should be mentioned that a cost- push inflation may be attributed to increase in cost other than wages. For example, increases in raw material prices may cause to rise. However, increase in wage rates unaccompanied by increase in out –put per man – hour are best known cause of rising costs (Elkington J., 2001);. Inflation can be caused through the following five factors acting singly or in combination:

  1. Increase in money supply unaccompanied by proportionate increase in the output of goods and services.
  2. Increase in the community’s aggregate spending, which naturally leads to greater demand for the economy’s output and raises its price.
  3. If for any reason, such as famine and drought, abnormal industrial unrest, the volume of production falls.
  4. Excessive and undue speculation and tendency to hoarding and profiteering on the part of producers and traders.
  5. Rise in wage rates and other costs.

ESSAY 2

The changes in PTA will have much impact on consumption and investment and this will depend on whether it is an increase or a decrease. An increase will result reduction in consumption and decrease inflation( McTaggart D Finlay C & Parkin M. 2003). It effects will be effects on ability to save: the increase in the interest rate will reduce the amount that can be saved, but the reduction in real investment brought about by the reduced saving may be offset by increased government investment.

Effects on desire to work: many people may feel that it is not worth while to work overtime if the earnings can not meet their needs.

Effects on desire to save: the increase in the interest rate in some cases may increase the desire to work to maintain savings at the previous level.

Effects on enterprise: the increase in the interest rate of profits may make the entrepreneurs unwilling to undertake risk, and so it may check enterprise.

Diversion of resources: the increase in the interest rate will make some commodities to divert economic resources and the production of other goods (RBA ,2008).

When the interest rate is increased there will be an increase in the cost of live. This will reduce the quantity demanded and consumed in the market. The demand curve for the changes appears as follows.

Picture one

In the graph, D0 is the original demand curve if there is an introduction or increase of interest rate in the market, demand will reduce to D1. When demand reduces to D1 price will not remain the same, it will also change to P1 to create an equilibrium price at which the new demand D1 intersects the supply curve SS1. As a result of the increase in the interest rate, equilibrium amount demand and supply will also fall to OP1 (McTaggart D Finlay C & Parkin M(2003).

A rise in prices is harmful to the consumers’ interests. They have to pay more for everything that they buy. Their incomes do not go as they could go before.

The workers suffer. Their wages do not buy as much as they could buy before. It means their real wages have gone down. But because during the times of rising prices, there is a great trading and manufacturing activity, the workers gain in the continuity of their employment, and more jobs are created (Elkington J., 2001).

Suppose a reserve bank opts to increase the lending rate and at the same time increase the cash ratio by commercial banks it will require banks to take measures by increasing rates which customers borrow thus affecting the credit creating process. In this case banks will many options to counter this reserve bank actions. They will be required to sell some of their investments and assets to generate cash inflows to assist in generating sufficient funds for reserves. The bank also can borrow from other banks through the federal funds market or they can borrow from the federal bank reserve (RBA ,2008). These options have advantages and disadvantages and some of the advantages and disadvantages of selling investment include (Baumol W, 1992).

  • The assets and investments of the bank will reduce and other and other sources of income will effectively reduce.
  • The bank’s balance sheet will improve because the bank balance sheet is normally made of deposits, savings, current accounts, money at short call, treasury bills, liquid assets, and investments.( Stonecash, Gans, King,1995).

References

Baumol W, (1992); Economics principles & policies; Australia, edn, Harcourt Brace Jovanovich.

BLIX, Marten, 1995,” Underlying Inflation- A Common Trends Approach,” Bank of Sweden Working Paper No.23.

Elkington J.(2001); The Chrysalis Economy, Capstone, oxford.

Hahn, E, (2002); “Core Inflation in the Euro Area: An Application of the Generalized Dynamic Factor Model,” Center for financial Studies Working Paper. (Frankfurt Center for Financial Studies).

McTaggart D Finlay C & Parkin M (2003); Economics, Pearson education Australia.

Otto, G (2007), Central Bank Operating Procedures: How the RBA Achieves Its Target for the Cash Rate, The Australian Economic Review, Vol.40, No.2, pp.216-24.

RBA (2008), About Monetary Policy, Web.

Stonecash, Gans, King,(1995); Principles of macroeconomics, 3rd Edition, Asia Pacific Edition.

Waud R (1997); Macroeconomics; Pearson, Longman.

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