Stagflation And Gloomy New Zealand Economy

Stagflation and Gloomy New Zealand Economy

Lecturer: Mr.Gamini Jayasuriya Module Name: 4.703 World Economy

Student Name: Patel Shaurin B. Student Number: 20080541 MBA: 83 Assignment Due Date: August 27, 2008.

(Word Count: 2575 Including References)

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Table of Content 1. Introduction………………………………………………………....... 2. Stagflation and New Zealand Economy…………………………….. 3. What can be done in this situation......................................................

4. Conclusion…………………………………………………………….. 5. Bibliography…………………………………………………………..

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Introduction: The country’s economy depends on the various factors like government, savings, consumers, investments, businesses and overseas sectors.

(http://www.amosweb.com/images/CFIm001w.gif)

The above diagram shows how the economy works. There are three Macroeconomic Sectors; Business, Household, & Government. There three Macroeconomic Markets; Financial, Resource, & Product. The goods and services are produced by firms which are being consumed by households. Households save money in banks; banks lend that money to business for investment in new businesses and create new jobs. When consumer is spending more firms invest more, government receives more tax revenue, which shows economic expansion in country. When consumer spends less, then firms do not invest in businesses much more and in result the circular flow of economy starts to slowdown. The import from foreign firms is the leakage in the flow because the country has to pay money through currency exchange to the foreign country, and the export is the income which country receives through the selling of goods to the foreign country.

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There are three macroeconomic factors to determine the development of any economy of a country. They are •

GDP ( Gross Domestic Product)

•

Inflation

•

Unemployment.

(http://www.investopedia.com/email/) GDP shows growth of economy by measuring it against the base year. It can also give insight that is the country is heavily dependent on the foreign investments or not. It shows the economic growth. Negative economic growth is called ‘Recession’. GDP is also related to inflation in the country. Inflation plays major role in the country’s economy because it shows the general price levels of goods and services. If the inflation rises then country’s purchasing power decreases, standard of living decreases, it affects adversely to the country. By negative economic growth in the country the rate of unemployment rises. To curb the rising inflation country’s authorities raise OCR and when the country is suffering from slow economic growth, when firms are not investing in businesses then to encourage the economic growth and encourage firms to invest more in businesses the authorities cuts the OCR. There is economic cycle for any country’s economy. The below is the cycle of economic expansion, its peak, and economic recession. It is shown with time and real output.

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(http://www.financialsense.com/Market/cpuplava/2007/images/0314.h1.gif) Every country faces the peaks falls in their economies. When economy is expanding it goes to peak level and when there is lack of resources like labor, infrastructure, higher production and lower demand then economy settles its way with the true economical situation. The present period is not good for domestic (NZ) as well as global economies. Talking about problems with New Zealand economy it is facing economic stagnation and rising inflation. The current situation could be defined as economic ‘Stagflation’.

Stagflation and New Zealand Economy: It is state of economy when the economy is struggling with its demand supply problems which result in inflationary problems and the country is slowing down because of scarcity of resources, decline in consumer spending, decline in new business investment confidence, factory output tumbles, unemployment rises, interest rates at higher level, etc. Under such economic condition economy is facing rising inflation on one hand and on 5

other hand it faces economic recession. It could be caused by some specific reasons like if a country is importing commodities from other countries e.g. oil then is the price of that commodity rises that country has to increase the price of relative products which makes production less profitable and results in slowdown in economy. Secondly the damage could be done by inappropriate macroeconomic policies of the country, like central bank cause inflation by printing and circulating huge amount of money in the economy and government can cause stagnation by putting more rules for goods and labor market. Figure:

(http://www.harpercollege.edu/mhealy/ecogif/asad/asfedec.gif)

A shift of AS to the left shows decline in supply which will reduce output of firms and the price will go upwards as the supply decreases. This would cause more unemployment, slow down in economic growth rate and push inflation or prices upwards because the AS (supply) is decreased. This inflation could be called "cost-push" inflation. It is inflation 6

caused by decrease in AS curve. The situation will result in situation of “Stagflation” as decrease in output, increase in unemployment and rising inflation coupled with the slump in economy. It is inflation caused by higher input costs, lower supply and growth in emerging economies which led the growth in the export of food items, milk, cheese, etc items which can be a factor for pushing food product prices higher. New Zealand imports oil so unexpectedly rise in the oil prices pushed the cost of food products by 2.2%, transportation cost rose by 4.9%, production cost also increased. The rise in Energy and Food prices are the main perpetrator for rise in Inflation. As there is rise in the food products the situation could be ‘Agflation’. (http://www.raboplus.co.nz/binaries/Inflation,%20agflation,%20stagflation%20%20what%20it%20means%20for%20investors_tcm36-49873.pdf)

So the current situation is situation of “Stagflation” as far as New Zealand economy is concerned. Higher inflation means companies under allow for reduction and twist economic situation. The rise in oil prices was due to the rising demand from the emerging economies like China, India, etc. The production by OPEC was pretty flat it wasn’t increased as the demand increased in developing countries.

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The oil price move was a little bit technical move as by the move marginal buyer of the oil is not out of the market and the demand and supply is going to settle again. The oil prices rose about 50% ($147/bbl) in last one year which pushed product prices higher which resulted in higher inflation rate despite the economy is facing downturn. But we can see the oil prices have fallen consistently in the last one month as the increase in the oil output by OPEC and slowing demand in the world’s largest developed economies.

(http://www.anz.co.nz/about/media/liabrary/mf/mf20080721.pdf)

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The above graph shows how the inflation changed with the growth or downturn in economy in New Zealand from year 1995 to 2008. As we can see the circle in the graph which shows rising inflation but the GDP growth is being going into recession. As we discussed above the rise in inflation is being driven by the rise in the commodity prices globally. The fall in US dollar could be one of the factors that led the commodity prices up as the dollar was down the demand and supply adjusted with that rise. As per the data available the NZ economy is going in recession from current levels. It is expected that the calendar year growth could be around 0.3%, which shows the negative economic growth. The country is facing offshore headwinds and a massive de-leveraging process across households the recovery looks tough. Consumer spending has been declined

as

the

retail

sales

over

recent

times

have

been

declined.

(http://www.anz.co.nz/about/media/library/mf/mf20080728.pdf) The unemployment rate for June quarter was 3.9%. Which risen from 3.7% in March. And there are no signs of cooling off of unemployment. However the country gained the 27,000 new jobs in recent weeks from the 29,000 jobs it lost in the recent months.

What can be done in this situation? There are various options for the policy maker to choose from. It depends on what the policy makers want to decide about the economy, it remains million dollar question. There are mainly five policies a policy maker could choose from. All the policies the authorities take they are for stabilizing the economy. Either authority is trying to bring full employment and economic growth or want to reduce the inflation.

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Fiscal Policy: In this policy government manage economy through implying taxation, spending or borrowing. The long run recurring behavior of this policy is that the level of debt falls when the country enters in the boom phase of its business cycle. It is long run policy; it has some time leg to be effective.  Fiscal contraction policy:

(http://www.harpercollege.edu/mhealy/eco212i/lectures/ch8-17.htm) The goal here is to curb inflation in the country. If a country wants to adopt this policy then it has two ways. The government budget under fiscal policy is balanced. i.e. G=T. Means Government is totally funded by the tax income it receives. But under the contraction fiscal policy the situation is like ~ G
Reduced government spending. Or

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-

Increase in taxes.

The use of the policy would shift the AD to left. Means reduction in aggregate demand by increasing taxes so that the consumer will spend less and government’s budget deficit will improve or reduce the government budget for better budget surplus. But is has some drawbacks like is consumer will spend less then economy will start slowing down, and in the situation of negative economic growth it will take economy into further deep slowdown in economy. It will decrease inflation but it will increase unemployment and effect of depression in depth. So, For New Zealand it would not be good policy to use otherwise the economy will go in further deep recession.  Fiscal expansionary policy: The policy involves the government to push the economic growth by spending more on services, infrastructure, etc. or by cutting down taxes to boost economic growth. Traditionally it was used to curb unemployment, increase economic growth.

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(http://www.culturaleconomics.atfreeweb.com/111%20114%20MBB%20Macro%20Grap hics/Macro/Fig%209.1Expand%20FP.jpg) The increased government spending or reduced in taxes would increases from AD0 to AD1. So, AD curve would shift to the right side. This would increase real GDP, reduce unemployment but on the other side increased money on the hand of consumer will raise consumer spending and hence increase inflation/price level from P0 to P1s. The policy increases the government’s budget deficit or government has to borrow aggressively to help the economy. (http://en.wikipedia.org/wiki/Expansionary_fiscal_policy) But it can not be used in the New Zealand, as the country is facing situation of rising inflation already and economic growth is also slowing down.

Monetary Policy: The policy is course of action taken by government, central banks, etc. which controls

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-

Supply of money

-

Availability of money

-

Cost of money (Interest rate).

The benefits of the policy would be -

Stable economic growth

-

Price stability

-

Exchange rate stability.

(http://www.chr.up.ac.za/ggp/coursematerial/2006/good_gov/Goodgovernance_MPFP.pdf )

 Contractionary monetary policy: It is used to decrease supply of money as the policy is controlled by the Finance department of any country or Central bank. When money supply has increased in the economy and there is rising inflation authorities take action to combat rising inflation.

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(http://www.harpercollege.edu/mhealy/eco212i/lectures/ch8-17.htm) The main objective is to curb the inflation. For that central bank raises inflation rate which increases the cost of money which results in decrease in money supply in the economy. The action results in shift of AD curve to the left side which shows reduction in demand of money because of high borrowing cost for money. By this way they get control on inflation but the economy slows down further and unemployment rises.

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(http://www.rbnz.govt.nz/keygraphs/Fig7.html) The above shows changes in OCR in the past years in New Zealand. Currently the OCR is 8% but it is 0.25% lower that its high of 8.25% which shows the higher borrowing cost for the business to invest in businesses. By this was the country was pretty well managing inflation but it caused in slowing down economic growth. So this policy could be better to curb inflation but not enough to give economy to boost up.  Expansionary monetary policy: The policy is used to increase the flow of money in the country. It can be done by any open market operation e.g. Govt. buys bonds from market and in return supplies cash in the market. Monetary policy affects the monetary variables such as price variables and interest rates.

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The above graph shows the use of expansionary monetary policy effects on the economy. After implementing expansionary monetary policy the AD curve shifted right side from AD1 to AD2 which shows economic expansion or growth in real GDP, reduction in unemployment. The price level or inflation in the economy will take toll as there is increase in money supply in the economy. It can be done by making lower Credit Reserve Ratio for banks so that banks can give more money to the people and hold fewer amounts in assets. Central bank could allow more risk taking lending to the people of the country by the banks. It can also decrease the interest rate or official cash rate so that borrowing cost reduces and investors can borrow money and invest in economy. The flow of money becomes easy as reduction in interest rate. New Zealand recently reduced the OCR by 25bps to give some relief to economy. RBNZ thought saving the economic is first job then curbing the rising inflation. Because as the

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oil prices went down from its high of $147/bbl to around $117bbl in last one year the inflation will go down as it was mainly because of the rise in the oil and manufacturing prices.

Conclusion: By all the above discussion I hereby conclude that, in such a difficult economical situation no policy option can give relief to the economy. Because there are three major macro economic sectors: Government, Public and Businesses. They are the biggest spender in the economy if they start spending less then the economy will react negatively. The inflation plays a crucial role in macroeconomic measure of economy. The GDP and Unemployment are also important factor in macro economy. In the situation as the inflation rises and economic growth slumps, the policy makers can not do much for economy. All options have their own limitations as discussed. The economy runs on people’s expectations. As if people think that the house prices are too high they will stop buying houses and certainly the house prices will fall as everyone thinks house prices are too costly, which will certainly hammer the economy, because consumers are not spending so much. So we can say that economy is run by the “People’s rational expectations” as said by Keynes, a famous economist. So in the situation of stagflation the “Do Nothing Policy” would be the best policy to follow, leave everything on the economy do not interfere the economy will sort it out itself. As we saw above that when there is recession the economy goes in to trough to recovery phase, so economy will recover it self from the problems.

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Bibliography: 1. Investopedia, GDP, Retrieved on August 24,2008 from http://www.investopedia.com/email/ 2. Amosleb, Circular flow image, Retrieved on August 24,2008 from http://www.amosweb.com/images/CFIm001w.gif

3. Financial sense, market ,Retrieved on August 24,2008 From http://www.financialsense.com/Market/cpuplava/2007/images/0314.h1.gif 4. Harper College, Stagflation, Retrieved on August 24,2008 from http://www.harpercollege.edu/mhealy/ecogif/asad/asfedec.gif 5. AMP Capital Investors, Inflation, Agflation, and Stagflation- What it means for investors, Retrieved on August 25,2008 from http://www.raboplus.co.nz/binaries/Inflation,%20agflation,%20stagflation%20%20what%20it%20means%20for%20investors_tcm36-49873.pdf 6. ANZ, Economic Report, Retrieved on August 25, 2008 from http://www.anz.co.nz/nz/ 7. Culture Economics, Macroeconomic, Retrieved on August 24,2008 from

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http://www.culturaleconomics.atfreeweb.com/111%20114%20MBB%20Macro%20G raphics/Macro/Fig%209.1Expand%20FP.jpg 8. ANZ, Market Focus, July 2008, Retrieved on August 24,2008 from http://www.culturaleconomics.atfreeweb.com/111%20114%20MBB%20Macro%20G raphics/Macro/Fig%209.1Expand%20FP.jpg 9. Wikipedia, Fiscal policy, August 2008, Retrieved on 24,2008 from http://en.wikipedia.org/wiki/Expansionary_fiscal_policy 10. Monetary and Fiscal policy as tools for good governance, Retrieved on August 24,2008

from,

http://www.chr.up.ac.za/ggp/coursematerial/2006/good_gov/Goodgovernance_M PFP.pdf 11. RBNZ, Key Graphs, August 2008, Retrieved on August 25,2008 from http://www.rbnz.govt.nz/keygraphs/Fig7.html 12. Boyes W., Melvin M., 2005, Economics, 6th Edition, Houghton Mifflin Company, Boston, New York.

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