Economics provides us with frameworks for examining a wide variety of real life problems and issues, and tools to measure and assess what will happen under different circumstances.

Monetary policy

Monetary policy is comprised of the actions taken by the Reserve Bank of New Zealand (RBNZ) to influence interest rates. Through that mechanism, the RBNZ also influences the money supply, exchange rates, economic activity, employment and inflation. The RBNZ changes monetary policy to meet its goals of price stability while avoiding undue volatility in the economy and the exchange rate.

The RBNZ’s main tool is the Official Cash Rate (OCR), which is the interest rate for overnight transactions between banks. This strongly influences, but does not dictate, the movement in interest rates for mortgages and deposits.  The RBNZ meets every six weeks to assess economic conditions and decide the appropriate level of the OCR.

Why the RBNZ pursues monetary policy

The RBNZ is required to maintain price stability under the Reserve Bank of New Zealand Act 1989. The Policy Targets Agreement requires the RBNZ to maintain inflation, as measured by the annual increase in consumer prices, between 1% and 3% on average in the medium term. The RBNZ is allowed to look through short term volatility associated with policy changes (e.g. an increase in the GST rate in October 2010) or price shocks (e.g. oil price increases in global markets). The RBNZ pursues price stability along with economic, exchange rate and financial market stability.

The inflation tradeoff

In an economy, policy changes are about tradeoffs. With inflation the tradeoff is with unemployment. The Phillips curve, pioneered by New Zealand economist Bill Phillips, showed that when inflation rises unemployment falls and vice versa.
High levels of inflation are undesirable. However, if inflation is reduced by choking economic growth, this will lead to a rise in unemployment. Mass unemployment is also undesirable. Hence the RBNZ is charged with the delicate task of balancing inflation and unemployment.

The impact on the economy

When the RBNZ seeks to cool inflation, it raises interest rates. This essentially reduces the demand for goods and services relative to supply, which contains prices. The reduction in demand works through a number of channels. First, saving is encouraged by higher deposit rates. Second, borrowing and investment is discouraged through the higher cost of borrowing. Together, money is reallocated from consumption to saving and investment is reduced. A higher interest rate will also typically lead to an appreciation in the exchange rate. This reduces exports as each unit of exports now earns the New Zealand producer less. So a rise in the interest rate leads to a reduction in consumption, investment and exports. As activity reduces, so does employment, wage growth and inflation.

When the RBNZ seeks to stoke the economy and inflation, it reduces interest rates. It encourages consumption over savings, and borrowing for investment. A lower exchange rate will also support exports. These will result in higher economic activity, employment, wage growth and inflation.

In practice the linkages take varying lengths of time to influence behaviour. Interest rate changes typically take one to two years to achieve the full impact on economic activity and inflation. So the RBNZ has to look ahead in formulating monetary policy, often based on forecasts and judgement.

The lag between OCR changes and the impact on the economy depends on a range of factors. For example, during 2007-2009, the RBNZ raised the OCR significantly, but the impact on the economy was slow. The main reason was most mortgage holders were fixed for two years or more. So while mortgage rates rose, the impact on borrowers was small, until they refinanced their fixed mortgages.  

Further information

A full run down of monetary policy as well as a full history of interest rates can be located from the Reserve Bank: