Understanding the economy requires a basic knowledge of the key flows that influence economic activity. How do interest rates affect households and businesses? How does government policy influence GDP? Forming a view on these and many other policy questions requires some knowledge of the economy’s structure.
The two institutions that have the greatest effect on the economy are the Reserve Bank (RBNZ) and the government. The RBNZ has the most influence on economic activity. By raising or lowering interest rates the RBNZ can control economic activity. The government sets the agenda for medium to long-term economic growth by putting in place the necessary economic institutions and frameworks. The Governor of the Reserve Bank, will influence how the economy performs within the context of the economic infrastructure, but the government has the ability to alter that infrastructure.
A basic model of the economy
Those influences are easier to understand if we have a simple model of how the economy works in mind.
Imagine a bathtub full of water, where the water level represents the level of employment or economic activity.
There are two drains on the bathtub: taxes and savings. The government collects taxes and then uses it to fund a lot of other activities like health, education, justice, social welfare, etc. The government can control how much it spends through its annual Budget.
Savings are invested either by households or by businesses. So we could put our savings towards a house, or we could it put in the bank. The bank would then lend it to businesses to invest. That comes back to the economy.
Now comes the trade-off: if the economy falls below the ‘full employment’ level there is unemployment. If it rises above that level then there is inflation. Both of these are undesirable; we don’t want mass unemployment, nor do we want very high inflation.
How much of the taxes and savings coming back into the economy depends on two key agencies: the government and the RBNZ. By controlling fiscal and monetary policy respectively they control the ‘taps’ that fill the bathtub back up. The government decides, for example, how much to tax and how much to spend. On the savings and investment side the RBNZ’s key instrument is the interest rate.
The key thing to realise is that the government and RBNZ cannot simultaneously reduce inflation and increase employment, so they face a trade-off between the two. If they were to try, then the two ‘drain’ and ‘tap’ mechanisms would be fighting each other and get us nowhere.