How Government and Economic issues interact
THERE ARE MULTIPLE SIGNS OF A HEALTHY ECONOMIC SYSTEM. AN ECONOMY THAT IS IN A HEALTHY STATE OR ENTERING ONE WILL DISPLAY SIGNS SUCH AS INCREASED SPENDING BY CONSUMERS AND FIRMS, HOUSING MARKET STABILITY, INCREASED PRODUCTION, DECREASES IN UNEMPLOYMENT/INCREASES IN EMPLOYMENT. ANY ONE OF THESE SIGNS CAN INDICATE THAT AN ECONOMIC SECTOR IS RECOVERING AND COLLECTIVELY CAN INDICATE THAT THE ECONOMIC SYSTEM AS A WHOLE IS RECOVERING. IN CONTRAST, AN UNHEALTHY ECONOMIC SYSTEM WILL SHOW SIGNS OPPOSITE TO THAT OF A HEALTHY ECONOMIC SYSTEM: UNEMPLOYMENT, DECREASED PRODUCTIVITY, FLUCTUATIONS WITHIN MARKETS, DECREASED CONSUMER CONFIDENCE - JUST TO NAME A FEW INDICATORS.
Government economic policies are set and remain in place to prevent such things from happening. The economic policy objectives’ purpose is to sustain a healthy economic system, and quash unhealthy signs that could damage the economy. The New Zealand (NZ) Government’s primary economic policy objective is to maintain price stability within the NZ economy, predominantly by keeping economic inflation between 1-3% on average over the term. NZ’s price stability objectives are defined by the PTA (Policy Target Agreement) which was constructed by The Reserve Bank of NZ and the NZ Minister of Finance to affirm the primary economic goal of maintaining price stability. The Reserve Bank of NZ implements economic policy solutions such as the OCR (Official Cash Rate) to maintain inflation between 1-3%. The NZ Government also implements the ‘supply side policy’, a policy that encourages increases in producer productivity, which leads to an increase in aggregate supply (AS). Supply side policy is generally implemented by changing/reducing regulations (i.e. producer/company tax cuts). This method of supply side policy helps to maintain price stability of inflation between 1-3%.
The objective of price stability aims to balance the general price level within the economy. Price stability is the primary NZ policy objective because of it’s desirable effects on the economy, such as enabling people to recognise changes in relative prices (i.e. prices between different goods/services), without being baffled by changes in the overall price level, which allows them to make well-informed consumption and investment decisions. Price stability will also aim to avoid decreases in productivity and consumption, which could compound problems surrounding inflation, as well as aiming to decrease major fluctuations in inflation/deflation, which will reduce the impact if such does occur. Furthermore, price stability will greatly contribute to financial stability within the NZ economy, as well as aiding the NZ economy to grow steadily and sustainably. Price stability is a primary NZ Government policy objective because if inflation exceeded 3%, the NZ economy would not be able to grow at a sustainable rate. Competitiveness with other countries would decrease, resulting in NZ’s highly dependable exports to also decrease. The housing market would also wildly fluctuate, resulting in investment in real estate, of which isn’t desirable to the NZ government at the rate of which it would happen at 3%+ inflation.
Without price stability, inflation is almost certain to occur within the NZ economy, impacting households and producers. The primary impact that inflation will have on households is that the real value of the households’ savings will decrease, because as the general price level rises the households’ savings can’t keep up with inflation, thus the households’ purchasing power is decreased. Furthermore, household/consumer spending will decrease - as well as consumer confidence - which results in decreased consumer demand and consumer standard of living as households can’t keep up with inflation and afford to purchase as many goods/services. Inflation will also negatively affect producers, primarily because costs of production (C.O.P) will increase, resulting in less revenue for the business as well as increased prices of that producers good/service. Furthermore inflation will also cause unforeseeable problems, because the economy is unpredictable and unable to be forecasted, which will result in decreased investment by the producer.
The NZ Governments’ goal of employment and stability of income is ensured by keeping inflation within desirable margins, from it’s economic policies. With the policies, consumer confidence and purchasing power will not fluctuate strongly and increased producer productivity will result in employment. Because of this, the NZ Government will employ these policies, because of the positive effects from price stability. The NZ economy OCR of 2.50% (as at 25 July 2013), will ensure that price stability within the NZ economy is maintained.
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When a reduction to the NZ OCR (such as the result from the 2008 Global Recession) is made, consumers and producers are left with a higher disposable income. Consumers will spend this higher disposable income, increasing consumer spending and AD (Aggregate Demand) as illustrated in the graph where the AD curve shifts to the right from AD to AD1, increasing Real GDP as well as the Price Level. This will increase the Price level (from PL to PL 1) so that inflation does not fall below 1%.
Without the Government Policies in place to ensure price stability within the NZ economy, inflation would be sure to occur. A major flow on effect of inflation on the NZ economy would be the impact of lower interest rates. A reduction in the OCR he interest rates, and as a result foreign investors will invest elsewhere, creation a cash withdrawal from the NZ economy. Lower interest rates cause the exchange rate to fall to E1 because there will be a decreased amount of overseas investment in NZ currency (the NZ Dollar), thus decreasing the demand for the $NZ from Qe to Q1 (shift left), as shown in the diagram opposite. This will make exports more competitive, increasing the NZ economy’s competitiveness. This means NZ exporters will receive a higher amount of $NZ when they exchange export receipts, thus resulting in an increase in exports. Increasing exports will will result in imports costing more $NZ, decreasing the demand for imports, therefore decreasing the level of imports. With imports falling and exports rising, the balance of trade will improve for the NZ economy. Because NZ exports will become more competitive, the exports will receive a higher return on due to the decreased value of the $NZ. This will enable NZ producers to bring export more of their product and increase productivity/efficiency.
Currently, the OCR set by the Reserve Bank of 2.50% is improving the NZ economy. Although, as the OCR has decreased from around 8% during the Global Financial Crisis, depreciation on the $NZ has occurred, as well as a decrease in interest rates . This depreciation (as shown in the diagram above) has meant that sales on imports have increased, resulting in increased costs of goods and services as producers/firms still try to turn a profit. Subsequently, the OCR is improving the NZ balance of trade, as it results in an increase in NZ export competitiveness and depreciation of the $NZ. Furthermore, export sales currently outweigh import payments which further improve the NZ balance of trade.
The NZ Government’s implementation of supply side economic policy will result in a more productive and efficient NZ economy because of the increased AS (Aggregate Supply), and will aid recovery of the NZ economy without causing an increase in price level. A supply side economic policy is an effective way to promote economic growth by lowering restrictions (i.e taxes) for producers to supply goods and services, such as lowering income tax, as well as allowing greater flexibility by reducing regulations. When the government implements supply side economics, consumers will then receive a greater supply of goods and services at lower prices. The ‘Laffer curve’ (shown above) demonstrates supply side economics: the tax rate that will benefit the NZ government the most is between 0% and 100% tax.
The governments supply side policy will maintain price stability within the NZ economy as goods and services become more affordable for consumers. The increase in productivity by producers - supplying more affordable goods and services - will create a demand for more employment, which will work toward the NZ Government’s objective of providing employment. With this increase in employment, households will receive increased income, which leads to more savings as well as higher purchasing power. As households spend this increased income, they demand more from the producers. Therefore, the NZ government will receive an increased amount of revenue due to increased tax as producers’ revenue rise as well as increased income tax as more households/consumers are employed. Thus, price stability will occur within the NZ economy due to Aggregate Demand and Aggregate Supply meeting at the equilibrium point in that economy, consequently meeting the economic objectives of the NZ Government, all due to their economic policies. This dependancy on one-another within the NZ economy is best described by a circular flow diagram:
The NZ Government may also implement a contractionary economic policy in order to reduce Aggregate Demand within the NZ economy as well as maintain price stability if affected by inflation. Implementing this contractionary policy is done so by the Reserve Bank of NZ increasing the OCR of the NZ economy. This will directly increase the value of the $NZ, as well as attracting foreign investment to the NZ economy, but subsequently decrease NZ exports as exporters products have decreased in value. As this is a negative flow-on effect, the NZ Government will implement tax cuts to producers, as well as households in order to keep Aggregate Demand from dropping too low. Allowing such tax cuts means that costs of production will decrease, meaning producers will receive more profit, therefore will keep producing in order to make up for the decrease in exports from the rise in OCR. These tax cuts will reduce the negative effects the Governments’ contractionary money policy will have on imports and exports, as well as the economy as a whole. Consequently, Aggregate Demand within the NZ economy will still change, and is shown as a ‘curve shift to the left’ on the contractionary policy diagram on the previous page. Aggregate Supply will also change, shifting to the right, resulting in a decrease in the price level as well as a decrease in Real GDP (Gross Domestic Production). Eventually, the income tax cuts will mean that consumers will have more disposable income, of which will be spent on goods and services, raising the Real GDP (from Y1 to Y2 as shown on the previous graph). As a contractionary policy is generally placed on the economy during a recession, the tax cuts will create and stimulate economic growth.
In my opinion, I suggest that the NZ Government implement Expansionary Policy as well as Supply Side Policy in order to stimulate growth within the NZ economy. Primarily Expansionary Policy will increase Aggregate Demand, leading to economic growth. Additionally, Supply Side Policy will increase Aggregate Supply, also leading to economic growth. Jointly using these policies will drastically create and stimulate economic growth without dramatically changing the price level and with maintaining price stability, both current objectives of the NZ Government. As a result of this positive economic activity, NZ exports may begin to decrease, but I suggest that exports can continue to grow by altering trade regulations, such as trade agreements within industries or between countries. By implementing my suggestions all together, the NZ economy could grow expansively.
Sources of information:
Book; Economic Issues for New Zealand (NCEA Level 2), Robin Sutton
Article; ‘China’s slowdown may be good for NZ’, Brian Fallow, The New Zealand Herald, Thursday July 25, 2013
Article; ‘Bank Chief hints at tightening’, Brian Fallow, The New Zealand Herald, Friday July 26, 2013