- Economic Growth – more GDP
The recessionary state of New Zealand’s economy has resulted in an increase in Government expenditure that has been financed primarily by borrowing with an aim to increase growth (GDP) / reducing the negative growth.
The reasoning behind this policy relates to Keynesian theories developed during the Great Depression of the 1930’s that states essentially the only way to come out of a recessionary climate “is to run a budget deficit by increasing government expenditures in excess of current tax receipts. The increase in government expenditures should be sufficient to cause the aggregate demand curve to shift to the right from AD1 to AD2 (see figure below), restoring the economy to the natural level of real GDP (GDP growth)”. The multiplier effect also come into play here as any increase in Government expenditure has a multiplier effect on aggregate demand i.e. In the figure below the government need not spend the difference between Y2 and Y1 to drive up the aggregate demand from AD1 to AD2, consequently leading to an increase in GDP.
Classical economists however point out against the effectiveness of this policy by arguing that “When the government pursues an expansionary fiscal policy, it finances its deficit spending by borrowing funds from the nation's credit market. Assuming that the money supply remains constant, the government's borrowing of funds in the credit market tends to reduce the amount of funds available and thereby drives up interest rates. Higher interest rates, in turn, tend to reduce or “crowding out” aggregate investment expenditures and consumer expenditures that are sensitive to interest rates.” This consequently results in mitigating the multiplier effect of government expenditure to a certain extent and hence it can be argued that GDP growth will not be exactly as proposed i.e. Fiscal policy may not affect the economy as strongly as predicted. This also has an impact in raising inflation which is discussed in the next point below. [9, 13]
The other aspect that needs to be considered is that “High levels of government debt may be costly if large injections of debt financed government expenditure crowd out private sector spending by driving up real interest rates and exchange rates and relative prices.” This could consequently lead to higher inflation in the present period. [6]
Figure 2: Combating a recession using expansionary fiscal policy [13]
- Price Stability (Inflation: 1 – 3%)
As mentioned above inflation becomes a significant factor with implementation of expansionary fiscal and monetary policy (reduction in OCR). Monetary policy has a significant impact on inflation. An Expansionary Monetary policy results in lowering the interest rate (OCR) as previously mentioned that in turn increases the quantity of goods and services demanded at any given price level, hence contributing to shifting aggregate – demand to the right.
In a climate of recession, where money supply is limited, Inflation is not a significant factor in the decision making of the NZ government or the RBNZ Governor; on the contrary increase in inflation is seen as positive sign of growth in Recession as it indicates an increase in demand. This is further evident by the recessionary climate resulting in a drop in inflation as quoted “Inflation is set to plunge over the next year, starting with a 0.5% fall expected for Q4 2008. Retail spending is expected to be down significantly for November, as weak core sales were amplified by lower spending on fuel (petrol prices fell by 16% in the month). Car sales could see a technical bounce after plunging by 14.5% in October, but they will remain at very depressed levels.” The above quote underlies the fact that in the current environment an increase in inflation will be seen as a positive sign.
The expansionary fiscal and monetary policy pursued presently fare well in a recessionary climate, however if they are pursued over a long period of time, then they could lead to creating an inflationary gap (See figure below). An inflationary gap occurs when aggregate demand exceeds supply. This can thus result in “Overheating the economy” i.e. Actual GDP exceeds Potential GDP and leads to a significant Trade deficit and unemployment as well. [4, 7, 17, 21, 22]
Figure 3: Inflationary Gap [20]
The aim of this objective is to keep the level of unemployment in check. A recession is accompanied with an increase in unemployment. The figure below describes the situation prevalent in New Zealand today where due to a recession; unemployment has increased, due to primarily a drop in aggregate demand.
Figure 4: Keynesian AD / AS Model [23]
The impact of the expansionary fiscal and monetary policy as mentioned above results in increasing aggregate demand thus essentially resulting in people demanding and consuming more, which results in people buying more goods and services that consequently results in reducing unemployment as demand exceeds supply as opposed to the current scenario (see figure) and thus resulting in more people being employed to meet demand. The impact of this expansionary policy may / will lead to an increase in inflation; however in the short run there exists an inverse relationship between unemployment and inflation as can be seen in the figure below. [20]
Figure 5: Philips Curve describing Inverse Relation of Inflation and Unemployment [23]
Please note that will be always be a certain percentage of the population that will be unemployed at a particular point in time due to various external factors E.g.: Cyclical employment, Switching / Moving between jobs etc. [11]
- More equal distribution of income
This policy essentially targets at reducing economic disparity. The distribution of income determines the type of economic activities and amount of saving, which relates to price, consumption and employment [3]. Expansionary Fiscal and Monetary policy aim to bring equal distribution of income by reducing unemployment, a primary contributor to increasing economic disparity. Please note that in New Zealand as well as most other countries with an Open Market economy, it will never be possible to equally distribute income.
- Reduce the Current account deficit
Current account deficit is “the broadest measure of the gap between what New Zealand earns from the rest of the word through trade and investment and what the rest of the world earns from it” [1]. Thus it measures the difference in value between our exports and imports.
New Zealand’s current account deficit for the fourth quarter was $3.8 billion that was significantly down from previous quarters with its peak in last June at $4.7 billion, falling to $4 billion in September and $3.8 billion in December. This deficit is further expected to reduce due to the recession leading to lower demand (cutting imports) and the expansionary fiscal and monetary policy causing interest rates to fall (reducing the cost of servicing foreign debt). The primary contributor for reducing this deficit can be attributed to an increase in value of exports, however, “the improvement in exports was all in prices - export volumes fell nearly 2 per cent”. This essentially describes the lack of demand in New Zealand’s export markets due largely to the recession causing lower demand for goods exported from New Zealand. [1]
“For a small open economy such as New Zealand, the most important reason for the downward slope of the aggregate demand curve is the exchange rate effect”. This quote underlies the importance that exchange rate has in the overall context of putting New Zealand on the road to recovery. The exchange rate as well as other factors (discussed below) consequently affects New Zealand’s balance of payment. [24]
Exchange Rate Effect
The expansionary fiscal and monetary policy have primarily resulted in aiming to / increasing the money supply as is evident by the sharp drop in the OCR in recent months as mentioned above. This results in increasing the supply of money relative to demand, leading to a drop (weakening) of the currency. The lower rate primarily means it is cheaper to borrow money that stimulates business investment and results in increasing employment. This also contributes to an increase in exports as price of exports reduces due a weakening currency. The above point is further outlined in the figure below that describes the relation existing between interest rate and money supply. [14, 24, 25]
Figure 6: Demand for Money Curve [25]
Balance of Payments
Balance of payments records the value of New Zealand’s transactions in goods, services, income and transfers with the rest of the world and the changes in New Zealand’s financial claims on assets and liabilities to the rest of the world. This is essentially composed of three accounts as mentioned below:
The Current Account as mentioned above measures the difference in value between our exports and imports, services trade (tourism) and international investment income. The seasonally adjusted current account deficit was $3,772 million in the December 2008 quarter, $236 million smaller than the September 2008 quarter deficit of $4,008 million that can be broken into the three things that contributes towards the deficit. [18]
The narrowing of the deficit in the latest quarter was mostly due to an increase in exports of goods, partly offset by an increase in imports of services. The increase in exports can be attributed to the expansionary fiscal and monetary policy resulting in the weakening of the New Zealand dollar. [18]
The services balance had a deficit of $511 million in the December 2008 quarter, that can be attributed partially to the drop in the number of tourists and the total number of days spent in New Zealand that can be attributed largely to the recessionary climate prevalent all over the world. [18]
The December 2008 quarter income deficit of $3,199 million is $58 million smaller than September 2008. This can attributed to a drop in earnings for foreign investors due to lower interest (drop in OCR) earned on New Zealand assets. This can be attributed to the expansionary monetary policy by the RBNZ. [18]
Capital account measures the value of assets transferred by migrants into, and out of New Zealand as well as purchase and sale of intangible assets. The capital account balance was deficit of $167 million in the December 2008 quarter, a reduction of $30 million from the previous quarter. [18]
The financial account relates to the foreign direct investment, portfolio investment, movements in reserves and net errors and omissions. A surplus in financial accounts indicates that current account deficit is being financed from the savings of foreigners. The overall result of this was $2.5 billion outflow of financial capital, reducing net liabilities. This can be attributed significantly to the drop in OCR due to expansive monetary policy leading to banking sector transactions reducing overseas debt security liabilities. This relates to retail debt instruments called Uridashis & Euro-Kiwi dollars denominated in New Zealand dollars and paying New Zealand level interest rates that had the banks slurping up cheap money overseas as interest level was very low in other OECD countries (E.g. Japan & Belgium) and with New Zealand on the contrary having one of the highest interest level, it made perfect sense on the part of these investors to invest in these bonds. The current expansionary monetary policy and the recessionary climate prevalent around the world have however made these investors jittery of their expected returns leading to drop in their investments. This has consequently led to New Zealand banks facing serious risks of shortage of funds as they “get upwards of a third of their funds from overseas sources“[15]. This is further highlighted in the quote from Statistics NZ in the Net Errors and omissions that states “The cause of the residual lies in the financial account – not the current account or capital account. As a result of this, the financial account for the December 2008 quarter must be viewed with caution.[18]” This essentially underlies the significant impact of an expansionary fiscal and more importantly monetary policy in the overall balance of payment. [15]
Thus overall exchange rate and balance of payments have already been significantly impacted by the expansionary fiscal and monetary policy and will face further impacts as these policies are pursued.
Thus before I conclude one must note that the Expansionary fiscal and especially monetary policy do not always have the impact that they are intended to achieve. This is all the more evident when we analyze the effectiveness of monetary policy in giving direction to the economy over the last five years.
In the year beginning around 2003, Japanese investors (ordinary people – mum and dad) started taking a liking to Uridashis as they were offering up to 7% interest as opposed to 0.1 % interest from their bank deposits, this consequently led to Japanese investors investing heavily in Uridashis that consequently frustrated bollard’s attempts in reining in the New Zealand dollar to help export earnings and the wider economy. This was summed up by Reserve Bank and Treasury officials going to Japan in early 2006 to tell investors not to buy the stubbornly buoyant New Zealand dollar and also resulted in a spokesman for Dr. Michael Cullen quoting “One of the purposes of the talks with Japan's central bank and uridashi issuers, including the World Bank and Asian Development Bank, was to make sure that the risks associated with uridashis are better understood given that we have been talking about the imbalances in the economy and where the dollar is in its cycle" [16]. This however did nothing to stem the tide and Japanese investors continued investing that in turn resulted in artificially inflating the kiwi dollar and also helping to fuel the housing boom. Thus it is evident that monetary policies do not always have the desired effect and it is only due to the recessionary climate gripping the world along with drop in interest rates that have resulted in Japanese investor losing some interest in Uridashis. [5, 16]
Thus in conclusion an expansionary fiscal and monetary policy is perhaps the only viable way by which the New Zealand Government and RBNZ can stimulate demand in this climate of recession affecting the entire world. There are bound to be certain costs associated with implementation of this policy that includes inflation and also the possibility that future generation will in all likelihood be paying for this expansionary policy by means of an increase in taxation of income and services. This was more aptly described by Keynes who once said, “In the long run, we are all dead.” essentially implying that if one was to follow Classical economists then it will take a long while before we do manage to come out of a recession. [13]
References
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- Economics Course Book