What will higher unemployment figures in NZ mean for monetary policy?

Although still low New Zealand’s unemployment figures today registered an increase of 0.1% to be at 3.4%. The labour market is still tight but there are signs that the reduction in job ads and monthly filled jobs are putting less pressure on the market. This may mean that the RBNZ, who sets monetary policy, sees that aggregate demand is starting to ease indicating a less aggressive stance with interest rates. With inflation at 7.2% and still well above the policy target agreement of 1-3%. the RBNZ might increase the OCR this February by 0.5% which is a reduction on the the previous increase of 0.75% on 23rd November. That would leave the OCR at a peak of 5.25% by May. However if high inflationary expectations become the norm the RBNZ might have to become more aggressive in its policy. Below is a mindmap on monetary policy which might be useful for revision purposes.

Source: ANZ Research 1st February 2023

Adapted from: A Level Economics Revision – Susan Grant.

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on Monetary Policy that provides for users with different learning styles working at their own pace (anywhere at any time).
 

Advertisement

Taylor rule and New Zealand interest rates (OCR) at 8%

The Taylor Rule is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. The rule is a formula for setting interest rates depending on changes in the inflation rate and economic growth.

A simplified formula is: r = p + 0.5y + 0.5 (p – 2) + 2
r = the short term interest rate in percentage terms per annum.
p = the rate of inflation over the previous four quarters.
y = the difference between real GDP from potential output.
This assumes that target inflation is 2% and equilibrium real interest rate is 2%

Taylor argued that when:

  • Real Gross Domestic Product (GDP) = Potential Gross Domestic Product
  • Inflation = its target rate of 2%,
  • Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).

If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 1.5%.
He stated that the real interest rates should be 1.5 times the inflation rate.

This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.

New Zealand and the Taylor rule
When the Taylor Rule is applied to the New Zealand economy it suggests an optimal, OCR of more than 8% – see graphic from live gross domestic product (GDP) tracker. A rate as high as this would do significant damage to the economy even if inflation did get down to the 2% target for inflation. Households and businesses would find it particularly hard with incomes being squeezed. An OCR of this level would have an unwieldly impact on households and businesses, squeezing incomes. 

Criticisms of Taylor rule
The theory assumes that only the central bank can affect the equilibrium real rate of interest and there is a closed economy with households that have identical consumption patterns and the same declining marginal utility. However, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy. These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. This almost rules out any fluctuations in the natural rate that might arise from alterations in how individuals discount the future, from how consumption preferences may differ among individuals or alter over time for one individual, or from differences in the distribution of wealth.

Source: Live GDP tracker

How well do we understand inflationary expectations?

In looking at the causes of inflation, textbooks will cover demand-pull and cost-push but not go into much detail about inflationary expectations. If the consumer believes that prices of goods are going to increase this will have an impact on future price levels and the wage demands – a self-fulfilling prophecy.

Higher wages = Higher labour costs = Higher prices

Jerome Powell, US Fed Chairman, has made four 0.75 percentage point hikes in a row is an aggressive monetary policy to reduce inflation. Yesterday’s increase of 0.5% takes the bank’s benchmark lending rate to 4.25% – 4.5%, a range that is the highest since January 2008. He also alluded to inflationary expectations:

“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”

So how do you measure inflationary expectations? Policymakers use surveys at different times to monitor households’ and firms’ beliefs about prices. Furthermore, in order to try and shape consumer expectations central banks are very transparent as to their forecast of inflation and future interest rate changes.

How well do we understand households’ expectations? An article in the IMF Finance & Development (September 2022) looked at a deeper understanding of how consumers think about inflation. There seems to be a disagreement between consumers and policy makers with the former relying on the price change in a few products like coffee and petrol as an overall indicator of a country’s inflation rate. Past experiences —such as living through events such as the 1970’s oil crisis, the stagflation years of the late 1970’s, the Global Financial Crisis 2008, stock market crash of 1987 (Black Monday) etc, can influence peoples understanding of inflation for years to come. For instance if you lived through the stagflation years you are you more likely to be less optimistic about controlling inflation?

Andre et al (2022) recent research set out to see if economic policy (fiscal and monetary) and economic events result in the same expectations by laypeople and experts. They focused on unemployment and inflation and distributed surveys to 6,500 households and 1,500 experts. The survey asked respondents to consider four hypothetical shocks to the US economy:

  • a sharp increase in crude oil prices
  • a rise in income taxes,
  • a federal government spending increase,
  • a rise in the Federal Reserve’s target interest rate.

All respondents were given the current figures for inflation and unemployment and were asked to give their forecast of their movement over the following year after being given news about one of the four shocks. Interestingly laypeople believed that an increase in interest rates and income taxes would increase inflation which is contrary to what economics textbook models show – see Chart 1. The difference of opinion seems to stem from the interpretations of demand versus supply models see Chart 2. The experts used theoretical models and economic toolkits whilst the laypeople were more likely to rely on personal experiences, political views and a different interpretation – i.e. they look at supply-side issues:

higher interest rates = higher costs for firms = increase in prices to maintain profit margins = inflation↑

Experts take the view that it is a demand-side issue:

higher interest rates – higher cost of borrowing for consumers = less borrowing = inflation↓

Central Banks look to make communication more accessible

Central banks are now trying to, not only make communication accessible, but also much easier to understand. For example the European Central Bank (ECB) has built a presence around social media platforms using simpler language to explain the impact of interest rates on inflation.

Economic models depend on ‘rational expectations’ according to which households base their individual decisions—on how much to save, consume, and work—on expectations about the uncertain future state of the economy.

Source: Hall of Mirrors: How Consumers Think about Inflation by Carlo Pizzinelli
IMF F&D September 2022

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on Inflationary Expectations that provides for users with different learning styles working at their own pace (anywhere at any time).
 

US dollar strength a problem in fighting inflation

The US dollar hasn’t been stronger since 2000 – it has appreciated:

  • 22% – Yen,
  • 13% – Euro,
  • 6% – emerging market economies.

The dominance of the US$ has serious implications for the macroeconomy of almost all countries. Although US share of world trade has declined from 12% to 8% the US$ share of world exports has remained around 40%. Therefore imports denominated in US$ into countries have become more expensive and it is estimated that for every 10% US$ appreciation adds 1% to the country’s inflation figure. For developing countries with a high dependency on US$ denominated imports this is particularly worrisome.
Furthermore almost 50% of cross-border loans and international debt securities are in US$ and although emerging market governments have made progress in issuing debt in their own currency, their private corporate sectors have high levels of dollar-denominated debt. As the US Fed continue to raise interest rates with a fourth consecutive 75 basis points rise on 2nd November financial conditions have tightened and the strong US$ only compounds these pressures especially for many low income countries that are close to defaulting on their debt.

What should countries do?
Some countries and intervening in the foreign exchange buying their own currency with US$ reserves – foreign reserves fell by over 6% in the first half of this year to support their currency. Intervention should not be a permanent policy as it could mean a loss of foreign reserves as well as alerting markets to your intentions which could play into the hand of foreign exchange dealers. Monetary policy needs to keep inflation close to its target rate and the higher price of imports should reduce demand and therefore prices but a lot depends on the elasticity of demand for a country’s imports – if inelastic there is increasing pressure on inflation. Fiscal policy should provide some support to those that are most vulnerable without jeopardising the inflation target.

Source: IMF Blog – How Countries Should Respond to the Strong Dollar.

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on EXCHANGE RATES that provides for users with different learning styles working at their own pace (anywhere at any time).

Why has the US dollar got so strong and problems associated?

There has been a lot of talk about global currency’s depreciating against the US dollar but why has the dollar been so strong? In times of uncertainty people gravitate to the US dollar for safety – it is the global reserve currency and the vast majority of global trade is done in US dollars. The uncertainty in the global economy has been due to:

  • The pandemic
  • Expansionary fiscal and monetary policy
  • Supply side problems not being able to keep up with demand
  • Ukraine War which has increased energy and food prices.

From the above there has been strong inflationary pressure in the US especially and this needs contractionary monetary policy intervention – higher interest rates. The US Fed Reserve has increased interest rates ahead of other developed economies.

28th September 2022 – US dollar.

Problems with a strong US dollar
When the US dollar appreciated – see image above – it has a contractionary impact on the global economy. The dollar and US capital markets are far more globally important than the US economy itself – the currency is the world’s safe haven and its capital markets are those of the world. Therefore the exchange rate is crucial when money goes into and out of the US. Also countries worry about the exchange rate in particular when inflation is high – weak currency makes imports more expensive and can feed inflation. For those that owe money in US dollars a weak currency becomes very expensive as they have to convert more of their currency into US dollars – this is prevalent in the developing world. With Fed Chair Jerome Powell determined to bring US inflation down there is the risk of further interest rate hikes which could put economies into recession.

Source: Financial Times – Why does the strength of the US dollar matter? Martin Wolf

For more on Exchange Rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.

Sources:

The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

BoJ still buying bonds as other central banks reverse asset purchases.

Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July.
In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:

FT – Investors crank up bets on BoJ surrendering yield curve controls

How to Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the new bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%

Yield curve control
Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?

Shorting JGB’s
A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.

Source: Online Trading Academy

Sources:

  • The Economist: – BoJ v the markets. June 25th 2022.
  • Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022

Sign up to elearneconomics for comprehensive key notes with coloured illustrations, flash cards, written answers and multiple-choice tests on Monetary Policy that provides for users with different learning styles working at their own pace (anywhere at any time).

Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

  • With the threat of inflation should banks have increased their rates earlier?
  • If they tighten too quickly will that tip their economy into recession and a hard landing?
  • What is the right rate increase for the current inflation figure?
  • How long (pipeline effect) will it take for interest changes to impact the inflation figure?
  • These are the challenging questions that central bankers face in today’s environment.

For more on Inflation and Base Rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

IB/A2 Economics – Macroeconomic policies essay

With the mid-year exams next week here are a couple of mindmaps I produced using OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4. My question would be:

What policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives? (25)

Interest rates and controlling inflation

Excellent video from The Economist. It goes through the impact of raising interest rates in an economy – mortgages, spending patterns, inflationary expectations. Also looks at when interest rates in the US went to 19.5% during the 1980’s. There is a fine line between increasing interest rates too quickly and tipping the economy into a recession or being too slow with the tightening process and letting inflation spiral upwards. The video discusses all these points – great revision for the Inflation topic at NCEA, IB and CIE.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Interest Rates and Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Turkish inflation hits 73.5% but not surprising.

Most economists are in agreement that when there is an increase in inflation the central bank increases the base interest rates in order to reduce spending and encouraging saving. This takes money out of the circular flow and should lead to less borrowing and therefore less pressure on prices.

The Turkish lira dropped by 17% this year with three cuts in interest rates since September. This comes as inflation has climbed to 73.5%. So why would you drop interest rates when you have rapidly increasing inflation? President Erdogan sacked the governor of the head of central bank Naci Agbal who had been hiking interest rates to dampen down inflation – he was the third governor to lose his job in the last two years. Erdogan believes that raising interest rates would raise inflation rather than reduce it and he proceeded to cut rates further which saw an even steeper decline in the lira. An argument for this policy could be that the cheaper exports can drive economic growth.

Source: FT4th June 2022

The collapse of the lira make exports competitive and imports more expensive and in September Turkey posted a current account surplus thanks in large to a recovery in tourist numbers. Turkey relies heavily on imports of raw materials and energy and with the exchange rate falling these have become a lot more expensive. Although Turkish exports should be cheaper, the heavy import component of finished exports makes those goods more expensive so this outweighs the benefits of having a cheaper lira – e.g. in assembling kitchen appliances the price of imports of the component parts make the overall price of the appliance more expensive. This just fuels more inflation. Supermarkets are limiting customers to one item as they know people will stockpile produce with the ever increasing inflation rate.

So with inflation now at 73.5% and and interest rates at 14% this makes real interest rates = – 59.5%. The central bank kept its benchmark interest rate at 14% at its May meeting, extending a pause that followed 5% of cuts last year. This has led to the local population to turn to other currencies – US$ Euro – in order to protect the value of their money. Below is a very good video clip from Deutsche Welle (German World Service) outlining the crisis that Turkey face and how a policy of cutting interest rates has backfired.

The impact of a tighter monetary policy.

Below is a CNBC video on the impact of higher interest rates which is now the case in many developed economies. As post-covid demand surges and supply chain problems exacerbate, inflation has started to impact many economies with higher prices and a cost of living crisis. In order to control this inflationary pressure central banks around the world have been forced to adapt a more contractionary monetary policy which means higher interest rates. The Reserve Bank of New Zealand even gets a mention. Good for revision of the flow on effects in an economy from higher interest rates.

BBC Podcast – How do we stop high inflation?

This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:

BBC – The Real Story – How do we stop high inflation?

The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.

Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.

Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

AS & A2 Economics Revision – Monetary Policy Mind Map

Going over monetary policy with my A2 class and have modified a mind map done by Susan Grant from a CIE Economics Revision Guide. Useful for those who are sitting the June AS and A2 Economics papers.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Monetary Policy. Immediate feedback and trackedresults allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Strong US$ bad news for global recovery

The recent tightening of monetary policy by US Fed Chair Jerome Powell to combat inflation has seen higher borrowing costs and financial-market volatility. The US$ has risen 7% against a series of major currencies since January this year – a two year high. It has always been a safe haven currency and with a rising Fed Rate and market rates even more capital could flow into the US increasing the demand for US dollars and therefore appreciating its value. See mindmap below for the theory behind a stronger currency.

Adapted from: CIE A Level Economics Revision by Susan Grant

A high value of a currency makes exports more expensive but does lead to cheaper imports especially of the inelastic nature. But to foreign economies it does drive up import prices further fueling inflation. For developing countries this is a concern as they are being forced to either allow their currencies to weaken or raise interest rates to try and stem the fall in value. Also developing economies are concerned with the risk of a ‘currency mismatch’ which happens when governments have borrowed in US dollars and lent it out in their local currency. However it is not just developing countries that have had currency issues. This last week saw the euro hit a new five-year low with the US Fed’s aggressive tightening of monetary policy. The real problem for some economies is that they are further down the business cycle than the US so in a weaker position.

“While domestic ‘overheating’ is mostly a US phenomenon, weaker exchange rates add to imported price pressures, keeping inflation significantly above central banks’ 2% targets. Monetary tightening might alleviate this problem, but at the cost of further domestic economic pain.” Dario Perkins – chief European economist at TS Lombard in London

Source: Bloomberg – Dollar’s Strength Pushes World Economy Deeper Into Slowdown. 15th May 2022

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on exchange rates and monetary policy. Immediate feedback and tracked
results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

Inflation – should central banks hold off on tightening?

In New Zealand the recently published CPI figures published yesterday saw the yearly inflation rate climb to 6.9%. The main points to note are:

  • Tradeables inflation (imported) – makes up 40% of CPI – 8.5%
  • Non-tradeables (domestic) – makes up 60% of CPI – 6.0%
  • Housing and household utilities increased 8.6 %,
  • Transport increased 14 %,
  • Food prices increased 6.7 %,
  • Petrol prices 32.3%

The continued rise in domestic inflation means that the RBNZ will probably look at another 50 basis points rise later in the year.

Source: IMF

Ukraine War adds another supply shock – are higher interest rates the way to go?
With a second supply shock and inflation globally on the rise (see graphs) central banks have raised interest rates. However the Russian invasion of Ukraine and the subsequent increase in food and energy prices has asked questions of how central banks should approach monetary policy in what is unusual circumstances. Martin Sandbu in the FT suggest that they should rethink how they look at the operation of an economy. He made 3 main points:

  • Are central banks committed to aggressively increasing increasing rates every time there is a supply shock? This has a huge impact on households and businesses.
  • Do central banks know how their monetary policy works? Higher interest rates reduce aggregate demand and therefore easing the pressure on the supply side. However this is difficult to vindicate in that nominal spending has only just returned to pre-pandemic levels and still fell short in the EU and the UK.
  • These supply-shocks are ‘out of left field’. COVID caused greater spending on durable goods and non-durable goods by 25% and 10% respectively. Services remained depressed.

With the energy shortages arising from the Ukraine War there will be a movement away from production and consumption that use coal, oil and gas. Russian coal is already banned and it is likely that oil and gas will follow. Sandbu asks how monetary policy should approach a supply shock of this nature. If lower interest rates makes it easier to relocate resources then that is the best option for central banks. A tightening of monetary policy would make investments in new capacity both more expensive and less attractive as demand growth slows.

Today there are abnormal circumstances – COVID, Climate Crisis, Ukraine War, supply chain problems. These will mean huge structural shifts which can improve an economy’s productivity and lower inflationary expectations. If there are still higher interest rates productive potential would be reduced which would mean added pressure on inflation. Heading into a time of global supply chain problems monetary policy seems to be less effective.

Source: Central bankers should think twice before pressing the brake even harder – Martin Sandbu – FT 20th April 2022

Teaching Monetary Policy – Every Breath You Take – Every Change of Rate (Fed Funds Rate)

Here is a really funny video by the students of Columbia Business School (CBS) – you may have seen it before but I find it very useful when you start teaching monetary policy and interest rates.

Back in 2006 Alan Greenspan vacated the role of chairman of the US Federal Reserve and the two main candidates for the job were Ben Bernanke and Glenn Hubbard. Glen Hubbard was (and still is) the Dean at Columbia Business School and was no doubt disappointed about losing out to Ben Bernanke. His students obviously felt a certain amount of sympathy for him and used the song “Every Breath You Take” by The Police to voice their opinion as to who should have got the job. They have altered the lyrics and the lead singer plays Glenn Hubbard.

Some significant economic words in it are: – interest rates, stagflate, inflate, bps, jobs, growth etc.