Analyzing the Fiscal and Monetary Policy of New Zealand

New Zealand is a small island country located off Australia. While it has a developed economy, it is subject to volatile fluctuations in GDP growth, due in large part to its dependence on trade and exports for much of its GDP. Additionally, the government takes an active role in the economy with large social programs, state-owned-enterprises, and involvement in healthcare. By evaluating different factors of the economy, we can surmise whether or not this is a good investment location for a new manufacturing plant. We will look at fiscal and monetary policy, GDP figures and components of GDP, trends in these components, New Zealand’s trade and its trading partners, and the exchange rate between USD and NZD as key determinants in our investment decision.

Fiscal and Monetary Policy

Like many economies in the developed world, New Zealand was hit by the recent financial crisis and acted by altering its monetary and fiscal policy. Due to the joint structure of the New Zealand Treasury and Reserve Bank, the Treasury maintains control over the fiscal policy of the Crown, including management of SOEs (state-owned enterprises) while the Reserve Bank controls the OCR (official cash rate) and reserve requirements of banks – the monetary policy.

The Treasury’s role in fiscal policy and its response to the financial crisis of 2008-2009

According to the 2009 Fiscal Strategy Report, the Treasury will focus on bringing down debt to a prudent level; ensure a stable economic environment, and a public sector that produces quality goods. In order to achieve these goals, the Treasury will look at long-term debt as net debt to evaluate the strength of its financial position, review the long-term debt level forecasts to include the effect of the 2008-2009 crisis on the national debt level, reduce the allowances from the planned 2010 budget, and delay tax cuts and investment fund payments until the economy stabilizes.

Due to the nature of New Zealand’s economy, the size of purchases by the government has a large impact on the overall GDP. New Zealand’s 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. As the chart to the right shows, in a period of recession, such as 1999-2000 or 2008-2009, the government increased spending as a percent of GDP to compensate for decreased consumer spending. This suggests that New Zealand follows a Keynesian view that a recession should be countered by increased government spending as the recession is caused by decreased consumer demand.

Monetary policy and change during the 2008-2009 financial crisis

As part of New Zealand’s monetary policy, the Reserve Bank of New Zealand controls the banking system primarily through the Official Cash Rate (OCR), but also sets reserve requirements for the banks. The chart to the right shows the OCR since 1999. Of particular interest is the large drop in the OCR during the 2008-2009 crises. The OCR changed from 8.25% to 2.5% over nine months. The Reserve Bank has expressed its policy to keep the OCR at a historic low rate until the middle of 2010 based on pressure from CPI inflation, subdued credit growth, and weak business spending.

Potential for more public debt issuances

The Treasury has made clear that it is concerned about the forecasted debt levels moving forward. While the Reserve Bank believes some debt increase is necessary to keep the New Zealand dollar from depreciating too much, both institutions believe the debt needs to be adjusted to be less than 20% of GDP. This would mean the government is pursuing a plan to pay down debt after the crisis abates.

Adam Link is an avid follower of the financial markets and constantly looking for the next arbitrage opportunity. He has written on topics ranging from debt markets to Internet start ups to complex financial transactions. His passions include his company, Liekos Group (found online at [http://www.liekosgroup.com]), and traveling when his schedule allows.

Fiscal and Monetary Policy

Imagine you are listening to the radio around the year 1900 and there is news that the economy is going to enter into a recession. Chances are that sooner or later you will not have a job, and there isn’t going to be nearly as many goods available because of lack of production. The only thing of any value will end up being the money in your checking and savings accounts, so the only choice you have it to run to the bank and get hold of that money. The problem: every other person who just heard that announcement is thinking the same thing, and now there’s going to be a run on the bank, or even worse, a bank panic. This was a serious dilemma prior to the year of 1913 – the year the Federal Reserve Bank was established – because there was no way to ensure the economy would remain stable. Although bank panics were not an everyday thing, it was something that citizens had to worry about more than they do today. When the Federal Reserve Act of 1913 was set in place, however, two policies were enabled to monitor and help control the stability of the economy: to this day they remain a very important part of our government and these courses of action are known as monetary policy and fiscal policy.

To fully understand the purpose of monetary and fiscal policy, it is important to look at the structure behind them. The basis of these policies comes from the Federal Reserve. The “Fed” is a fairly simple system to understand: it is the central bank of the United States. This central bank is broken down into districts; the Board of Governors being the most recognized, but also included is the Federal Open Market Committee. Today the head chairman of the Board of Governors is Benjamin Bernanke, and he oversees all the actions that are taken.

The Federal Reserve is the only bank with the power to control a run on the banks or a bank panic. It holds the money available to lend to smaller banks as a last resort in bad economic times. Therefore, the Federal Reserve plays a huge part in controlling the money supply of the US. When the “Fed” was established, so was monetary policy. In the book Macroeconomics by R. Glenn Hubbard and Anthony Patrick O’Brien, monetary policy is defined as “the actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives.” These certain objectives include maintaining a stable economy, increasing economic growth, keeping unemployment at a satisfactory low, and keeping prices of goods and services stable in order to minimize the chances of inflation.

The Federal Reserve uses three separate tools of monetary policy to maintain the money supply. These tools include open market operations – controlled by the Federal Open Market Committee – and the discount rate and reserve requirements, which are controlled by the Board of Governors. Open market operations are a tool used by the FOMC to increase the money supply through the buying and selling of Treasury securities. The trading desk at the Federal Reserve Bank in New York is designated to buy these securities and the sellers deposit them into banks. These deposits increase the reserve of the bank which in turn increases the total money supply because there will also be an increase in loans and checking account deposits (Hubbard/O’Brien). The FOMC also has the power to decrease the money supply by reversing the operations of that same process.

The branch of the “Fed” which controls the other two tools of monetary policy is the Board of Governors. One tool, the discount rate, is defined as “the interest rate the Federal Reserve charges on discount loans (Hubbard/O’Brien). If a bank needs to increase the money available in their vault, otherwise known as their reserve, they turn to the “Fed” for the money and this loan is known as a discount loan. However, unless the Federal Reserve has become the last resort in the case of a recession, discount loans are not typically taken out by banks.

In certain instances, such as the case of Black Tuesday when the worst stock market crash hit the United States, discount loans did not save the economy. It was not until after the Great Depression when the run on the banks caused a severe bank panic that Congress established deposit insurance. In other words, prior to the Federal Deposit Insurance Corporation, a person was neither assured that the money they held in the bank was safe nor that they would be able to retrieve it if the economy were to fall into a recession.

The third tool of monetary policy which is also controlled by the Board of Governors to help manage the money supply is reserve requirements. It is a rare occasion for the Fed to change the reserve requirements though. In essence, changing the reserve requirements entails the banks to make “significant alterations in holdings of loans and securities” (Hubbard/O’Brien). Although it is not a common course of action, it is still purposeful. When the Fed decreases the reserve requirements, it allows the banks to use the excess money to loan out as opposed to holding in the vault. Conversely, if the Fed chooses to increase the reserve requirement, the banks will have less money to lend out. Either way, though, the Fed is makes the change based on the assumption that it will help the economy. All of these tools of monetary policy are followed through with the intention of meeting the objectives stated previously. On the other hand, fiscal policy also plays and important role in helping to maintain a stable economy.

Fiscal policy is defined as “the changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives” (Hubbard/O’Brien). Fiscal policy is similar to monetary policy in terms of what it attempts to achieve, but varies because of the way it tries to do so. Changes in taxes and spending are controlled solely through the federal government.

A better understanding of fiscal policy can be explained through the ideas of John Maynard Keynes. His theory came about after the Great Depression and said if the governments were to spend more money in times of economic decline, then it would soon stimulate the economy. He argued that through the excessive government spending, incomes would rise and so would purchases of goods and services. Eventually, this would stabilize the economy and take the country out of decline and into a state of economic growth. His theory was proved when President Franklin D. Roosevelt took action during World War II and spent an excessive amount of money which ending up in economic growth, as Keynes had said it would (What is Fiscal Policy?).

More recently, as of the 1980s, the main goal of fiscal policy has focused on reducing the budget deficit that has skyrocketed since World War II. Because of such things as new technology and foreign trade opportunities economic growth has been happening automatically, and the deficit only continues to rise (What is Fiscal Policy?). The War in Iraq has also caused the deficit to steadily increase, and George W. Bush is currently under pressure to find a way to decrease it. Although the overall goal of fiscal policy is to achieve broad goals of the economy, it now focuses on smaller goals as well.

Monetary Policy

Monetary policy is a set of measures taken by Central Bank of the government to stabilize the economy (strengthening the national currency, accelerating economic growth, lowering prices, and so on). It is part of the macroeconomic policy, carried out by using various methods and tools, depending on objectives.

In developed economies monetary policy has to serve the function of stabilization and maintaining proper equilibrium in the economic system. But in case of underdeveloped countries, the monetary policy has to be more dynamic so as to meet the requirements of an expanding economy by creating good conditions for economic growth. Monetary policy can be strategic, intermediate and tactical. Under strategic or primary goals the following tasks are very important.
- Increase of employment among the population;
- Normalization of the price level;
- Containment of inflationary processes;
- Acceleration of economic growth;
- Increase in production volumes;
- Alignment (balancing) of the balance of payments of the state.

By contrast intermediate goals are realized by changing the interest rates and the amount of money in circulation. In this way, it is possible to adjust the current demand for the goods and to reduce (increase) the supply of money. The bottom line is to influence the level of price policy, attract investment, increase employment and increase production. At the same time, it is possible to maintain or revive the conjuncture in the money (commodity) market;

Tactical goals are of short-term nature. Their task is to accelerate the achievement of more important – intermediate and strategic objectives:
- Monitoring the supply of money;
- Control of the interest rate level;
- Control of the exchange rate.

Types of Monetary Policy
Each country chooses its own kind of monetary policy. It can vary, depending on external conditions, the state of the economy, the development of production, employment and other factors. The following types are distinguished:

1. Soft monetary policy (its second name is “cheap money policy”) is aimed at stimulating various sectors of the economy by regulating interest rates and increasing the amount of money. At the same time, the Central Bank performs the following operations: – Makes transactions on the purchase of government securities. All operations are conducted in the open market, and the proceeds are transferred to the banks’ reserves and to the population’s accounts. Such actions allow increasing the amount of money supply and improving the financial capacity of banks. As a result, the interbank loan is in great demand;
- Minimizes the rate of bank reservations, which significantly expands the lending opportunities for various sectors of the economy;
- Reduces the interest rate. As a consequence, commercial banks gain access to more profitable loans terms. At the same time, the volume of loans extended to the population on more favorable terms and the attraction of additional funds in the form of deposits.

2. Rigid monetary policy (its second name is “expensive money policy”) is aimed at imposing various restrictions, restraining the growth of money in circulation with the main goal – restraining inflationary processes. With a strict monetary policy, the Central Bank performs the following actions:
- Increases the limit of bank reservations. In this way, a reduction in the growth of the money supply is achieved;
- Raises the interest rate. For this reason, commercial structures are forced to stop the flow of borrowing from the Central Bank and to limit the issuance of loans to the public. The result is a suppression of the growth of money supply;
- Sells government securities. At the same time, transactions are made on the open market due to current accounts of the population and reserves of commercial credit and financial organizations. The result is the same as in the previous case – a decrease in the volume of the money supply.