Amanda Z

Inflation Targeting

New Zealand was the first pioneer to Introduced inflation targeting with the passage of the
Reserve Bank of New Zealand Act in 1989, and its revolution in central bank governance
influenced the whole world during 1990s. The Innovative monetary policy reforms were
remarkably introduced by the Labour Party, which was elected in July 1984. The election of
the Lange/Douglas Labour Government radically changed New Zealand’s economic policy
framework, and it realized the importance and necessity of the change of its monetary police
to keep the stability of price level. According to the Labour Government, the monetary
policies included: import controls were phased out and tariffs drastically reduced; export
subsidies were abolished, all price, wage, dividend and rent controls were removed; the
company tax rate was reduced from 48% to 33%, the top personal tax rate was cut from 66%
to 33%, and a Value Added Tax was introduced; many government trading enterprises were
privatized; the banking sector was substantially liberalized. The Reserve Bank used monetary
policy in order to maintain price stability. The targets were bounded by formal agreement
between the minister of finance and the central bank, so the monetary policy with strong
commitment to keep the stability of consumer price index (CPI), which was the measurement
in New Zealand to reflect the price level on consumption. In order to maintain a healthy
economic growth, New Zealand intended to maintain a rate of CPI inflation between 0 and 2
percent.

In out discussion, the background and history of New Zealand before1984 gave us some hints
that why the government should tighten the monetary policy on price inflation through the
minister of finance. The survey show the inflation was markedly higher than the average in
other OECD countries, and the record show the inflation was a serious problem to affect the
economic system during the period from 1970 to 1984 in the OECD. When we looked at the
data during the period, the inflation was driven at least in part by the rapid raise in
international oil prices in New Zealand and other part of the world. More likely, the lack of
strong and tightened monetary policy was a major factor to lead the inflationary problem. At
that moment, the central bank did not have independence authorized by the government, and it
was all about political purposes. The best-known example was 1981: the central bank
repeatedly warned the Minister of Finance during that year, and the inflationary pressures
were built and accumulated. The central bank urged the Minister of Finance, as well as the
Prime Minister, to authorize a tightening of monetary policy. However, the Prime Minister
was facing the election late in that year, and he did not want to jeopardize his chances of
winning that election. As a result of loose monetary policies, the inflation continued to build.

In order to understand why New Zealand imposed strong commitment on inflation by its
tightened monetary policies, we can apply the theory to illustrate the advantage from price
stability, which is better than inflation or deflation. Price stability provides a healthy economic
environment for economic growth because investors and producers are able to interpret and
predict the future market growth by looking at the economic information. Price stability
reduces the management risk and uncertainty when investors and producers make decision on
investment and production.
When the inflation is a big problem in the economic circumstance, investors consider the
money currency is losing its buying power when the prices on goods keep rising. Investors are
thinking how to treat their money to gain the maximum return on market, and they don’t want
to deposit money in saving institution because the interest rate is not high enough to cover the
losses if they invest money in market. The nominal interest rate is shrinking on saving
institution, and it drives the real interest income to decline when the inflation is involved.
Therefore, investors would like tot take out their money to purchase investing assets in order
to get optimal return on market. In this case, real estate is a good market to invest for investor
because the prices on properties, such houses, are sparkly high and keep rising to the next
level. As a result of the prediction, the demand on housing increase and it does not fully
enhance the production capability in market. The housing bubble is formed by the soaring
prices and the bubble will be burst one day. The inflationary pressure continues to build when
investor predict and expect in his way. If the housing bubble burst, lots of investors’ wealth
will decrease, and then the consumption on other goods will decrease as well. Economic
downturn leads a severe problem for everyone.

When consider the effect of inflation on production, volatility of inflation affects the
producers to interpret the demand and supply on consumption. Mostly, producers would like
to produce more goods when the prices on particular products rise. The demand on those
particular goods increases, so the profit will be maximized if producing more. However, if the
prices increase because the inflation is involved, producers cannot interpret if the demand of
the goods increases. Therefore, producers lose track to predict the future production and the
management risk and uncertainty occur. The resource allocation cannot be performed
accurately on production plan. In this kind of condition, costs of production will be higher
than as usual in price stability.

On the other hand, if prices are stable, investors and producers are able to make decision on
their investment, saving, consumption decisions, resource allocation, and production with less
management risk and uncertainty. The market is healthy to make the transaction effectively
and efficiently with less risk. That is the major reason the central bank of New Zealand
intended to maintain low inflation in its economic system and target inflation rate between 0
to 2 percent.

The Reserve Bank uses monetary policy in order to maintain price stability. Price stability
exists when prices overall are stable in trading. At present price stability is defined as keeping
the inflation on average between one and three percent in an agreement set out between the
Minister of Finance and the Reserve Bank Governor, called the Policy Targets Agreement
(PTA). The Reserve Bank of New Zealand influenced short-term interest rates, including
floating mortgage interest rats, by adjusting the Official Cash Rate. As we know, the Reserve
Bank had the opportunity to adjust the Official Cash Rate eight times a year to influence the
short-term interest rate of borrowing in order to keep the inflation down.

The Official Cash Rate influenced short-term interest rates in following way. The Reserve
Bank set the interest rate 0.25 percent below the Official Cash Rate for the private banks, who
deposit the money into central bank after the announcement of Official Cash Rate.
Furthermore, the Reserve Bank provided overnight cash loan to private banks by charging
interest rate 0.25 percent above the Official Cash Rate. The Reserve Bank did not have the
limit to take in and lend out between private banks at 0.25 percent above or below the Official
Cash Rate.

By doing this, the Reserve Bank can stabilize the short-term interest rate. The commercial
banks cannot offer the short-term loans higher than the Official Cash Rate because other
banks can use the credit line authorized by the Reserve Bank instead of paying higher price
from commercial banks. On the other hand, the commercial banks will not lend short-term
loan to other bank below the Official Cash Rate because the same commercial bank can lend
money to the Reserve Bank at the Official Cash Rate to receive higher interest, at least at the
level of Official Cash Rate Level.
As a result, the Reserve bank is able to influence the short-term interest rate by adjusting the
Official Cash Rate in order to stabilize the price level and maintain low inflation.

Work Cite

“Monetary Policy Challenge: Monetary Policy.” The New Zealand Reserve Bank Official
Site. 24 Oct. 2007. Web. 18 Apr. 2010.
Fischer, Andreas Lyi. “Inflation Targeting: The New Zealand and Canadian Cases.” Reviews.
N.p., 20 Feb. 2004. Web. 18 Apr. 2010.