Sunday, April 11, 2010

Unit 9 – Money, Inflation and Interest Rates

The chapter introduced the main two kinds of financial institutions; financial markets, which includes bond and share markets and financial intermediates, which savers can indirectly provide funds to borrowers in means such as banks.

Recently in New Zealand there have been a number of new law changes that will affect the market of loanable funds. The first initiative was the introduction of kiwisaver, a saving policy encouraging New Zealanders to save part of their income for their retirement or for buying first time house. The kiwisaver will have an effect on the loanable funds because it will increase the supply of funds available and therefore the interest rate will drop as equilibrium is found again after the supply curve move to the left.

Another new law which was passed in 2010 is to increase GST from 12.5% to 15% for all goods and services and lower the business and top tax rate from 38% to 33%. In doing this it will move the loanable fund curve to the right as the tax on investments will be less therefore creating extra demand, however with GST increasing to 15% it may lessen consumption of the public and therefore increasing savings, which would move the supply curve to the right. Therefore it is unpredictable whether the interest rate will increase or decrease or stay the same as both curves will move to the right. However, the about of loanable funds will increase, which might have appositive effect for New Zealand as it may correlate to more investments in capital.

Also the in the last three years the government has announced large budget deficits. In a closed economy this would move the supply funds to the left i.e. decreasing quantity of loanable funds available and increasing interest rates.

The above three law, taxation and government deficits will have a definite effect on New Zealand. However, as New Zealand is a open economy some of these effects will be mitigated by the availability of cheap loanable funds from overseas. Loanable funds from overseas have decrease because of the GFC and that was notable in the margins between the official cash rate and the banks interest rates. The Margin noticeably increased during the GFC as banks struggled to obtain cheap credit from overseas.

The Reserve Bank of New Zealand (RBNZ) has similar polices in controlling the inflation rate of New Zealand. The RBNZ uses the official cash rate (OCR) to control inflation to between 1% and 3%. One of the main causes of inflation in New Zealand is the residential property market. This is a major source of investment for New Zealanders. The housing prices in New Zealand increase significantly between 2002-2008, as shown in the figure 1.



As can be seen the OCR has an effect on the housing prices in New Zealand. When the OCR increase it increases the interest rates that people can borrow at. When the cost of borrowing increases the amount of people willing to borrow to buy houses decrease. When borrowing decreases on the houses it moves the demand curve in the property market to the left and therefore decreases the quantity of the houses sold and also reduces the price of houses sold. Also people who already have mortgages when the OCR increase, feel the affect because when the OCR increases, interest rates increase which means the repayments mortgagees have also increase. If mortgagees are spending more of their income on their mortgage repayments, they have less income available for consumption, which means that the products they cut back on will move the demand curve to the left for those products and therefore putting pressure on the price of the products to decrease for equilibrium to be found again. However this effect from mortgagees is normally a delayed effect because most mortgagees are fixed into term of 1,2 or 5 years. Therefore as can be seen from graphs above the increase in OCR did have some effect initially however much of the effect was not notice until 2007/2008 where house prices crashed dramatically. Since then the OCR has been decreased to 2.5% to try and stimulate economic growth in the New Zealand economy.


The lastest RBNZ policy was enforced in the early 1990’s. And as shown in figure 3 the inflation has been kept pretty steady around 1 to 5% (compared to before 1990 where inflation was as high as 19%. Therefore, it could be inferred than the RBNZ policy is working. Some interesting things to note in inflation is some of the large peaks. One of the main causes in the 1970’s was the increase in oil prices because of the oil crisis. As consumption of oil is relativiely large in the New Zealand economy a small increase can be felt through many industries. Because oil is used for transport, power, etc and therefore an increase in oil prices can dramatically increase inflation. Oil increases around 2005/2006 can also be notice on this graph of inflation with a small peak in 2005/2006.

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