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

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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

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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<T.

- 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

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http://www.culturaleconomics.atfreeweb.com/111%20114%20MBB%20Macro%20G

raphics/Macro/Fig%209.1Expand%20FP.jpg

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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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