Re-thinking interest rate policy: Asking for submissions.

Note: Other posts in this discussion are available under the tag “inflation debate“.

So Trevor Mallard is suggesting that New Zealand “re-thinks” its interest rate policy.

Now his statements that the currency is a “one-way bet” is thinking that is associated with the NZX, while his statement that higher interest rates may have caused the housing bubble is the thinking of Berl – they both stem from submissions to a monetary policy review by the Parliament’s Finance and Expenditure Committee.

In fact, at the time I wrote about both of them, here for NZX and here for Berl. Overall, I felt that both of these organisations were completely wrong – which is why I’m so troubled that the current government has decided to follow their ideas.

Now given that I have discussed this business before I would like you guys to leave some comments saying what you think about the monetary policy framework and how you think it could be improved. I will then write some posts discussing the issues raised. Hopefully some people actually comment to this post :p . Please please please, write what you think 🙂

Note: I am not going to comment on this post, although I will be reading all the comments and thinking about them. Furthermore, and other blog members may comment. Feel free to say whatever stuff you feel about inflation and policy on it, and I will try to pull it all together later on.

Links to other posts discussing this issue can be found under the flap:

Rates blog: Initial response (*) (ht Bryan Spondre); Rates blog Email exchange with Dr Cullen (*); further opinions (*)

Inquiring mind: Initial response (*) (ht Adam Smith); further discussion (*)

Homepaddock: Initial response (*)

Kiwiblog: Initial response (*)

NZ Herald Articles: Initial response – with some insightful comments by Bill English! (*)

“We think it is just the wrong time to throw the framework away, because the only reason the Reserve Bank can look through oil and food prices and let inflation rise is because they believe inflation expectations are anchored well below 3 per cent.” – that is exactly right … in my opinion 🙂

27 replies
  1. Bryan Spondre
    Bryan Spondre says:

    I have posted a couple of charts here. It is interesting to note that has the RBNZ has increased the OCR from 5% (2004) through 8.25% that the growth in housing loans has declined.

  2. adamsmith1922
    adamsmith1922 says:

    I am pleased you have picked up on this, as when I saw the reported remarks I was very concerned.

    Whilst not pleased at times with the way the RBNZ has operated I am at the same time concerned that what has essentially been a bi-partisan approach in this area looks like it is being abandoned, purely for short term electoral relief. In this regard it is I suggest symptomatic that it was Mallard who made the comments rather than Cullen.
    From what I read in the DomPost he said:-

    “For a number of years … inflation has been driven by increased domestic demand that stems from a buoyant housing market, fuelled by cheap foreign capital attracted by a stable economy and relatively high interest rates.

    “Now we have inflation challenges driven by record high international prices of food and oil. In both cases the tools available to the Reserve Bank have not been able to address those problems.

    Surely Mallard is not meaning to suggest that the RBNZ can address and resolve the issues of food and oil pricing, by altering the RBNZ policy settings. That is simply absurd, yet it is a construction that can be placed on his remarks. Certainly, Winston Peters in the past has seemed to imply that.
    The idea that Labour might seek to campaign on such a basis is appalling.

    Neither am I convinced by the first part of his remarks on cheap foreign capital seduced by relatively high interest rates, that seems to be a nonsense remark.

    Surely one of NZ’s problems is that we have a current account deficit which is propped up by inward funds invested high attracted by the Kiwi dollar interest rates.

    It is my view that one of our difficulties is that for too long we have focussed on the export of essentially raw product rather than value added product, Fonterra being a case in point as is the meat industry and forestry. In addition our productivity is low compared to elsewhere exacerbated by issues over work force quality.

    This is compounded by a tendency for business owners to sell out at a certain point rather than develop their businesses.

    There is a cultural tendency in NZ to think of business as evil.

    I realise that I am not on thread here, I suppose it is because I think that part of the issue is not so much monetary policy settings as cultural/value settings – where we have a society where sportsmen are valued more highly than creators of wealth, and business success is denigrated.

    There are probably some things that could be done concerning tax treatment of property investment, but given the extent to which many have as their sole source of retirement savings property that risks causing major problems.

    I suspect that creating a more welcoming climate for new investment, especially in certain sectors through sunrise industry legislation, such as that used by SIngapore, may assist especially if targeted at say agriculture.

    Overall, I would be extremely worried if Labour was proposing a weakening of the stance on controlling inflation, when I suspect that over the last 9 years ‘real’ growth has probably been rather less than they would have us believe after taking account of inflation.

    After all :-

    RONALD REAGAN once described inflation as being “as violent as a mugger, as frightening as an armed robber and as deadly as a hit-man”.

    Sorry if I have rambled

  3. Eric Crampton
    Eric Crampton says:

    If we’re going to combine the inflation target rule with anything, we ought to combine it with a money rule such that the RBNZ could allow an external shock to pass through while being disciplined against using that as an excuse for ramping up the printing presses at the same time. Tyler Cowen wrote on this back in 1991 in a piece for the NZBR: “The Reserve Bank of New Zealand: Policy reforms and institutional structure”. He’s there talking about the oil price shock that hit with the first gulf war, but it’s perhaps prescient.

    Combining the price rule with a monetary base rule provides additional checks upon the danger of inflation and irresponsible monetary policy. A central bank which decided to inflate would then be violating two different mandates rather than one. Furthermore, combining a monetary base rule with the current price rule would increase Reserve Bank credibility and lower expectations of inflation. Nor are the powers of the Reserve Bank restricted in any disadvantageous fashion. A Reserve Bank serious about fighting inflation should not be interested in increasing the monetary base more than three percent a year.

    Combining a price rule with a money rule would prove particularly useful when negative real shocks occur. If an oil price shock hits the economy, for instance, it is desirable (and probably inevitable) that the price rule will be relaxed to some degree. When a money rule is present, the price rule can be relaxed without removing all constraints upon the behaviour of the Reserve Bank.

    Relaxation of the price rule would imply that the Reserve Bank should not tighten to prevent the oil price shock from translating into a higher price level. At the same time, continued maintenance of the monetary rule would imply that the Bank’s discretionary latitude could not be used as a pretence or excuse for increasing the money supply. If the negative real shock does occur, the Bank might be subject to governmental pressures to inflate and stimulate the economy. An institutionalised monetary base rule would increase the Bank’s ability to resist such pressures.

    The latter constraint is particularly important because the Policy Targets Agreements mechanism has not yet been seriously tested. Price movements have followed a downward trend since the Reserve Bank Act was passed, and the oil price shock from the Gulf crisis was short-lived. If pressures to stimulate the economy were to increase, the additional constraint of a monetary base rule would contribute to macroeconomic stability.

    Supplementing the price rule with a money rule would also prove useful because the size and scope of real shocks cannot always be identified clearly. A money rule would prevent the Bank from inflating and claiming that real shocks were responsible for the resulting increase in prices.

    In the Bank’s defence, monetary growth has been a lot lower lately than it has been, but M3 is still running at 5% Y/Y. The real shame is that we didn’t have much lower non-tradeable inflation over the last few years such that the RBNZ could accommodate the current external shock without letting inflation expectations become unhinged.

    Adding in other non-inflation related targets would be an exceedingly bad idea. Now, I don’t think they’ll actually go through with it: I’d be surprised if they could pull that together before the election. But what’s more important is that it really points to that the current government welcomes the highly inflationary outcomes that have been produced by Alan Bollard. There is zero chance they’ll hold him to account for presiding over a large increase in inflation relative to his predecessor or for that the Bank now seems to view the medium term as being about a decade. They’ll happily take his assurances that the current inflation is due to external pressures and ignore the significant increase in non-tradeable inflation over Bollard’s tenure as compared to the period under which Brash was subject to the 1-3% rule. It’s just another signal to Bollard that he’s entirely on the right track by whittling down the RBNZ’s credibility as an inflation fighter.

  4. Eric Crampton
    Eric Crampton says:

    On the other hand, there’s some chance that a change in the PTA would be for the better. The RBNZ seems to have been ignoring the PTA of late and instead acting in accordance with what Mallard/Winston are suggesting anyway. If the PTA were changed to reflect current practice, then perhaps there’d be less credibility lost and it perhaps would be easier to credibly convey a shift in policy if National ever decided to have the Bank go back to inflation targeting.

    If credibility consists in doing what one says and in saying what one is doing, then changing the PTA to reflect what they’re currently doing might not be all for the bad. Just depends on one’s assessment of whether it’s easier to call RBNZ to task for failing to meet the current agreement (when nobody wants them to meet the current agreement and nobody will hold them to account), or whether it’s easier to draft a new PTA later on that re-emphasizes inflation.

    I’d still think it a bad idea to re-write the PTA. But there’s maybe a 10% chance that the above story is the correct one.

  5. Peter Cresswell
    Peter Cresswell says:

    Hi Matt,

    Thanks for the invitation to comment.

    Following Brian above … and given my own degree is in architecture, not finance … I will offer the thoughts as I understand them of various economists of the Austrian School.

    My first observation would be to point out that when a politician raises the prospect of changing the Reserve Bank criteria just a dozen weeks or so before an election, then it should be obvious the primary driver is not good economics — especially when it comes from Trevor ‘Look At My Big Stadium’ Mallard.

    Keep that in mind with everything Mallard says on this or any other subject.

    There are two relevant aspects to the “one way bet” that is NZ currency — one good, one not so good.


    First of all, the present arrangement is at least predictable. Well, moderately predictable. Investors and users of capital still need to take account of how Alan Bollard is feeling on any particular morning, but at least the criteria on which he makes his decisions are clear, and widely understood. On this basis, any good investment is a one way bet. This clarity is a good thing, and should not be sacrificed just to be seen to be “doing something.”

    But there is a serious positive feedback loop that shows the economic thinking on which the Reserve Bank Act is based is flawed, not least in its bogus pursuit of ‘price stability.’ The flawed macroeconomic model insists that raising interest rates lowers price inflation, but as with all government meddling once the law of unintended consequences kicks in we find that raising interest rates simply makes our currency more attractive to short-term overseas investors, leading to the inflow of credit and the creation of various bubbles (including housing, most recently) that politicians use as excuses for more meddling.

    The credit is not easy in the sense of being low interest, but it is (or was) very easily available, and at a cost that borrowers thought was affordable.

    The collapse of two-dozen finance companies since shows that many borrowers were wrong, and that the effect of this ‘easy’ credit was not investment for productivity, but malinvestment. BUt that is always the case with the counterfeit capital created by central banks.

    Rather than change the economy to fit the model, as the various calls for the likes of a capital gains tax require, why not let economic thinking actually refelct the way people behave.

    Any meddling for either ‘economic growth’ or ‘price stability‘ is flawed. It’s this meddling that got us into trouble in the first place — it assumes the central banker knows what to do to promote growth, and assumes too that the law of unintended consequences won’t kick in again, whatever arrangements might made to avoid the present problems. The irony is that it’s the pursuit of price stability that has led to rampant instability.

    The fact is that there is no free market in money, and this the basic reason for most of the problems being attribute to markets — a further irony is that it was so called ‘free marketeers’ who introduced the nationalised money which has created all the problems.

    As economist Larry Sechrest points out,
    Mark this well. Central banks are the source of both inflation and business cycles. Tragically, many people seem to believe that both inflation and boom-bust cycles are somehow an intrinsic part of a market economy. They thus turn to the central bank to solve the problems that the central bank itself created. I might add that the very existence of a central bank introduces into all markets pervasive “regulatory risk” that would not otherwise exist. That is, market participants expend real resources in an attempt to forecast—and then cope with—the manipulations of money, credit, prices, and interest rates undertaken by the central bank. It all sounds frighteningly familiar.”


    It’s often assumed that with the introduction of the Reserve Bank Act and the Stabilisation Act and so on, and the explicit pursuit of price stability since then, that inflation itself has been tamed, and all that’s needed now is a little tinkering with the mechanism by which inflation is kept down.

    This whole conclusion is erroneous, since in order to hold the prices of an ever-changing nominal “basket of goods” stable, the local currency (measured by M3) has been inflated by about eight percent annually since 1988, leading to serious problems with the exchange rate, and problems for producers, exporters, home-owners and prosperity overall, and the rampant rise of malinvestment.

    For a number or reasons, the pursuit of price stability is itself seriously flawed. One of the most serious flaws is that it kills price signals stone dead — and since it’s price signals that are the means by which economies are coordinated, what you’re destroying is the very means by which markets clear. Bad move.

    It’s this vain pursuit of price stability that is the real issue, however the means by which it’s pursued are tinkered with. If commodities go up for good market reasons, or housing, or food, then squelching prices across all sectors to kill rises in just one makes no sense. And trying to squelch prices rises in the likes of oil and food, that are caused by overseas pressures wholly outside the local jurisdiction, is just insane. Even if you were successful, which is unlikely, what you’re squelching is not inflation but price signals. Not good.

    The fact is, that in pursuing this illusion of price stability while ignoring (and in fact exacerbating real inflation), our wealth is still being stolen, and we are being set up for some serious future problems as the whole price system unravels. MA Abrams explains: “In an economically progressive community (that is, one where the real costs of production per unit are falling and output per head is increasing), any additions to the supply of money in order to prevent falling prices will be hidden inflation; and in a retrogressive community, (that is, one where output per head is diminishing and real costs of production are rising), any contraction of the supply of money in order to prevent rising prices will be hidden deflation. Inflation and deflation can occur just as well behind a stable price level as when the price level is rising and falling…”

    Further, this economic model assumes that inflating the money supply will have no effect on inflation. But this is absurd. Inflating the money supply is inflation.

    At bottom, that’s what all this tinkering with nationalised money is all about — a means whereby to avoid the truth that inflating the money supply is a way of trying to get something for nothing, and there’s some way whereby to avoid the consequences of that delusion.

    There isn’t.

    What’s becoming urgent is not mere tinkering, but a serious rethink of the basis on which the money supply was nationalised, and how the nationalised money is managed. Here’s two simple steps:

    1) Stop inflating the currency.

    2) Let interest rates float.

    That’s as much of a medium-term prescription as you need. The long-term prescription calls for completely free banking.

  6. adamsmith1922
    adamsmith1922 says:

    Some further thoughts are we suffering from the impact of poor quality government spending. In the last 9 years the quantum of spend has rocketed, but would anyone say that the value received for that spend has materially improved. I doubt it, this must surely contribute to the domestic inflation level.

    In addition, will not the introduction of the ETS cause considerable economic adjustment, including a rise in unemployment which will drive an increase in benefit payments requiring more taxes from an already burdened private sector?

  7. Jamesey
    Jamesey says:


    From what I understand the intent of the price stabilising measures used by the Reserve Bank isn’t to control the actual price of goods and services, but a) to stop them from being “set” as workers are signalling that they are willing and able to pay the new price and b) to stop a perpetuating cycle of inflationary pressure as workers demand higher wages to offset increased costs, though I agree with Austrians that its an inadquate solution to the problem.

    People claim that the low inflation rates demostrate the effectiveness of the “inflationary targeting” monetary policy, but thats just pure reductionism.

    They’re completely neglecting other factors such as the dramatic fall in the price of oil that began in the mid 1980s and the lack of job security that has come about as a result of the restructuring of the world economy.

    Something that Alan Greenspan frankly admitted in his 1996 testimony to the Senate Banking Committe.

    “the situation is unique. Given the degree of job insecurity in the high-tech economy, there was “[a]typical restraint on compensation increases.” In 1996, even with a tight labor market, 46% of workers at large firms were fearful of layoffs–compared to only 25% in 1991, when unemployment was much higher

    The reluctance of workers to leave their jobs to seek other employment as the labor market tightened has provided further evidence of such concern, as has the tendency toward longer labor union contracts. For many decades, contracts rarely exceeded three years. Today, one can point to five- and six-year contracts–contracts that are commonly characterized by an emphasis on job security and that involve only modest wage increases. The low level of work stoppages of recent years also attests to concern about job security.

    Not to mention the deflationary effect that China’s entrance into the world economy had until recently, in production of raw and processed goods.

    Matt Nolan, made an interesting point on another thread when he said, “I also dislike asymmetric information which leads to sub-optimal trading. However, wouldn’t the best response to this be to promote education and information revelation.”

    Isn’t that precisely the intent behind the OCR adjustments? Why the need to set the price at all? As I said in that thread, the actual price makes no difference as long as the individual perceives that their return on investment will be substantially in excess of the price of their loan. If the monetary policy isn’t about controlling the money supply, then why use interest rates as the only tool to control inflation?

    “In an economically progressive community (that is, one where the real costs of production per unit are falling and output per head is increasing), any additions to the supply of money in order to prevent falling prices will be hidden inflation; and in a retrogressive community, (that is, one where output per head is diminishing and real costs of production are rising), any contraction of the supply of money in order to prevent rising prices will be hidden deflation.”

    Um thats a fairy tale land that has absolutely no relevance to today.

    Its entirely possible for an enterprise to exprience increasing in per head production and an increase in the costs of production, because most enterprises are reliant on external inputs in order to operatate. Whilst it may be rational on an individual basis to increase production so as to offset the extra costs through volume, on an economy level it would be supremely irrational, because that would merely depress prices.

    The perspectives of the Austrian School and the monetarists betray their fundamental misunderstanding of how the monetary system actually works.
    There is actually an inverse causal link between prices and money supply. People RESPOND to higher prices by either using their savings or tapping into credit lines through banks or credit cards, both of which increase the money supply circulating in the economy and “set” the new price level. Its this signal that indicates to firms that people are willing to pay extra for the goods and services.

    “The reversal of causation is very important, and also inherently straightforward logically. If a firm faces an increase in the price it has to pay for a key input (say oil), then it dips into its Line of Credit and instantly increases the money supply.

    Ditto a shopper who buys an extra (even if less expensive) plasma tv–or has to fork out more money than planned for a new car, let’s say. He/she dips into the unused portion of the credit card limit.”

    If economists don’t recognise this fundamental flaw in their theory, expect another repeat of Paul Volcker’s “controlled disintegration” in the not too distant future.

    Perhaps eventually the prices will adjust as it encourages other firms attracted by the high price to increase production, but theres a lengthly time lag before that happens and it doesn’t take into account monopoly dominance or any other factors that could restrain production.

    In finishing, a single fiscal instrument is obviously and will prove demonstratively, an inadequate tool in controlling inflation, if not actually counterproductive.

    Of course you can expect inflation when you have virtually uncontrolled monetary expansion coupled with an inadequate investment in productive capacity.

    Whats needed isn’t fiscal control, but a) the better management of the housing market, which is not only has a considerable contribution into the living costs, is the cause of substantial monetary growth, but also distorts efficient investment allocation. I’d recommend the implementation of a graduated land tax combined with generous depreciation rates on plant and building, minimum level of required deposits, and ringfencing capital gains, a result hopefully would steer investment away from land speculation into more productive avenues.

    My boss met with a property developer today who said that improvement on land are a zero sum game, because they yield about 3% a year, but they also depreciate at the same level. He said the value is actually in the land, which as a rule appreciates by an average of 10% a year. Why should they receive a return merely because they have the claim ownership of land and yet aren’t adding any real value or producing anything? Its a question that was asked by the classical economists like the French Physiocrats, John Stuart Mill, and Adam Smith. Their solution was by imposing a ground-rent on the value of unimproved land. Various States in Australia still do it and New Zealand did prior to the reforms of the 1980s.

    and b) to counteract inflationary pressures through the encouragement of policies and measures that increase the efficiency of material and energy use to counteract the effects of inflation.

    We must recognise that price levels are highly inelastic, because they suffer from time lags, real constraints, or require considerable demand destruction before they adjust, whilst money supply is highly elastic, because all you need is a bank that is willing to loan you money or to have not yet exceeded your credit card limit.

  8. Bryan Spondre
    Bryan Spondre says:

    “Perversely, any attempt to push down the Official Cash Rate unnaturally would undermine foreign investor confidence in New Zealand. We need that confidence. Every 90 days foreign investors choose whether to let us keep NZ$60 billion in debt we owe. That is four times our total export receipts over those 90 days. If they are worried about our ability to keep inflation down they will pull that money out. That will cause the New Zealand dollar to collapse and inflationary pressures to rise.”

    Bernard Hickey

  9. Simon
    Simon says:

    Perhaps we should ask ourselves a slightly different question, if curbing inflation to between 1-3% is the sole target of the reserve bank, why is it that our economy requires interest rates much higher than the prevailing international rates to keep inflation to a similar level as our international competitors ?

    Presumably there are structural factors at work here, but one could argue that if inflation could have remained in the target band at an internationally competitive level of interest rates then perhaps the currency would not have appreciated as far as it has.

  10. Jamesey
    Jamesey says:


    Great point.

    This post at the Von Mises Institute answers Simon’s question rather admirably.

    “The most aggressive experiment in monetary policy ever conducted is now under way. Japan is printing yen in order to buy dollars in such extraordinary amounts that global interest rates are being held at much lower levels than would have prevailed otherwise.”

    A blogpost on the Council on Foreign Relations website also rebutts the common belief that its the U.S. government whose responsible for the massive international monetary growth.

    The author claims that subsequent to the recent rate cuts there hasn’t been a substantial change to the size of the FED’s balance sheets, which indicates that most monetary growth has occured in the U.S.’s trading partners who are trying to prevent the appreciation of their currencies against the Green Back.

  11. bryanspondre
    bryanspondre says:

    Yes we are very vulnerable to the actions of otherseas investors ( the Japanese housewives and Belgian dentists).

    “This potential for an exodus known as the “Uridashi Tsunami” is one of the factors behind fears of a sharp slide in the New Zealand dollar and a subsequent rise in wholesale interest rates, as foreign investors would demand a higher risk premium to finance our current account deficit of around NZ$13 billion a year or 7% of GDP.”

    A couple of related charts here.

  12. Jamesey
    Jamesey says:

    I’m inclined to believe that its more and more likely everyday that will happen, especially with the current state of retail and the real estate market. And theres always the potential for the commodity bubble to burst, especially as the high prices are encouraging other countries to expand their dairy industries. Canada, Wisconsin in the U.S., the Americas, and even China. Especially when you take into account the inflated land prices here.

    Hope everyones prepared for a rough ride ahead.

  13. Simon
    Simon says:

    Bryan – I understand the phenomenon of the carry trade i.e overseas investors moving money over here (and thereby increasing the exchange rate) to benefit from the increased interest rates available within NZ. However isn’t this a result of the higher interest rates rather than a cause ?

    If this is so, it brings me back to my original query, what makes our economy so special that we require much higher interest rates than the US,UK, Australia to keep our inflation rate within the same range as these countries.

  14. Jamesey
    Jamesey says:

    “If this is so, it brings me back to my original query, what makes our economy so special that we require much higher interest rates than the US,UK, Australia to keep our inflation rate within the same range as these countries.”

    I think the high interest rates here stem from that fact that New Zealand has one of the highest employment rates, yet one of the lowest productivity rates in the OECD, so whilst on an individual basis the workers here aren’t as productive as others in other OECD countries where theres been more investment in capital, whilst also having a stronger bargaining position, because of our high rate of employment. Not to mention that New Zealand is one of the few countries with such a strict monetary policy, where the Reserve Bank is constrained to having only one instrument their arsenal.

  15. Paul Walker
    Paul Walker says:

    I have a very simple view on monetary policy. We have one instrument, the interest rate, and one objective, inflation, and thats about it. If we want the RB to deal with more objectives then they need more instruments, and its not clear what they are. The Brash idea of the petrol tax only changes a relative price not the price level, so I’ve never really understood that idea. Also its not clear to me that we should ask the RB to do more than worry about just one objective anyway. What if they had two objectives which require different levels of the interest rate? One objective would have to take priority, which amounts to having one objective. As to the RB considering the exchange rate I think there are a couple of problems here. One even if the RB intervenes in the market it can’t do it forever, so the best it can do is change the exchange rate for a short time and then the rate goes back to the market level. So whats the point? Second the exchange rate is a price and like all prices it can only do its job of signaling relative scarcity if its price in determined in a free market.

  16. Paul
    Paul says:

    What is inflation? My understanding of inflation and the monetary policy that is used to control it seems way different from that outlined here. Probably because I have not studied economics for long enough.

    So this is what I understand:
    The I in CPI stands for ‘index’, not ‘inflation’. The CPI is an index that tells us how much prices have changed across a standardised basket of products that are purchased by consumers. Hence: consumer price index.

    Changes in the CPI are used as shorthand for the amount of inflation because when there is x% inflation there is expected to be an equal x% general increase in prices. This doesn’t say what inflation is. I will come to that.

    But the problem with that index is that it is a standardised basket of products. It assumes the mix of products stays relatively constant. To be a useful comparison over time it needs to keep a pretty constant mix. The problem is that the weighting of products in the economy is constantly changing, not least because of relative price changes. For example, the amount of petrol purchased is changing as the price rises relative to everything else.

    I think you rightly say that the amount of money in the economy, adjusted for velocity, is a measure of money supply.

    And I think you are right to say that if money supply increases, prices can be expected to increase, all other factors being equal. My understanding is that inflation is a measure of the increase in the money supply, and rising general price levels is the result of inflation.

    My understanding of monetary policy as a way to keep prices under control, is that it works as follows: increasing money supply leads to rising prices, so to prevent rising prices we take money out of the hands of those who spend it, namely consumers. To take money out of the hands of consumers we raise interest rates, which reduces the amount of money consumers have available for discretionary spend. This works really well if everyone in the economy is exposed to variable interest rates, which was the mostly case when monetary policy was first used to control inflation. The speed at which a change in interest rates can drive a change in spending is influenced by how quickly that change in rates sucks money out of the hands of consumers and businesses.

    (And as an aside, the cost of controlling prices is borne by that portion of society for whom changes in interest rates causes immediate change in the amount of money they have available to spend. And to avoid that cost most of those who can have switched their borrowing to fixed interest rates over longer periods of time. And the result is that for interest rate changes to impact on prices it now takes a greater amount of change in rates, and a longer time, to suck the requisite amount of money out of the economy, and the cost is felt by a smaller group).

    Now along comes an increase in the world price of oil. Prices of oil rise at the pumps. Everyone is exposed to the price of oil, and more money is spent on that oil. What happens to the supply of money in our economy? It gets reduced because the money is sent overseas to buy the oil. So a rise in the price of oil has the same inpact on money supply as a rise in the interest rate.

    So by my definition of inflation, a rise in the world price of oil is deflationary in New Zealand because it reduces money supply.

    Of course, it makes the CPI rise by the weighted average of the price change for petrol times the proportion that petrol makes up of the basket of goods.

    Similarly rises in the price of imported food and other products does the same thing. But only to the extent that it is driven by remittances that reduct the money supply in the hands of NZ consumers.

    Offsetting this to some extent is the world price of milk and other agricultural produce that we export. That brings more money into the NZ money supply, but the impact of that (both the size and how long it takes) is impacted by what the people who receive that extra money decide to do with it. What are the farmers doing with their windfall gains? Are they spending up large providing additonal employment within NZ, or are they socking the money away in the bank, paying off debt, etc? My guess is it is a bit of both, but with a slowing economy and falling confidence, these naturally conservative people will be salting a good proportion away for the rainy (or very dry) days ahead. So rising agricultural export prices and rising fuel and food import prices will not have an equal and offsetting impact on the economy.

    So the upshot of all this? Rising import prices are probably having a greater deflationary effect than rising export prices are offsetting, in terms of the money supply. But a high indicator of inflation, CPI, suggests (incorrectly) that interest rates should be high. High interest rates are the wrong answer.

    Of course, it is not all that simple. If we lower interest rates our exchange rate will probably fall, and those imports will become even more expensive in local terms. So someone needs to do the sums to work out the magnitude of that change. Lower exchange rates would help exporters to get busier, putting more money into the the hands of consumers. Not a bad result.

    I am sure the real economists out there will be able to tell me why my understanding is all wrong. I look forward to more comments.

  17. MLemus
    MLemus says:

    There is obviously a lot more to figure out about this issue, but you made some really good points. I will definitely be checking here more often. Thank you.

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  2. […] Without too many substantive criticisms of our view of what inflation is (yet) it seems that we can move on with our discussion on “re-thinking monetary policy“. […]

  3. […] 2008 Thank you for all the insightful and intelligent comments (and posts on other blog) on the Re-thinking monetary policy post. Now that you guys have put down the important issues that we have to look at with monetary policy […]

  4. […] Now as I said the status quo is not perfect. The question is whether one can find a better solution. The Visible Hand in Economics is canvassing that issue. […]

  5. […] 07 2008 Hi all. Good to see people commenting on re-thinking interest rate policy here, I am going to give it another day for people to make comments (as I am waiting for some specific […]

  6. […] The Visible Hand In Ecnomics is troubled by this and is calling for submissions on it. […]

  7. […] this post at The Visible Hand in Economics also. If you have any thoughts, from an economics perspective, on this issue, please add them to […]

  8. […] Read the rest of this great post here […]

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