What determines the Neutral Rate of Interest?

Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented.
The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.

OCR > Neutral Rate = Contractionary and slowing down the economy

OCR < Neutral Rate = Expansionary and speeding up the economy

This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be 3% it is the expectation that the RNBZ will increase the OCR to 3%. The graph below shows the difference between the estimated neutral rate and the OCR. Note that:

2008 – positive gap as RBNZ trying to bring inflation under control – contractionary level
2019 – the gap narrows and monetary policy becomes less stimulatory as the neutral of the OCR is likely lower.

What determines the neutral rate of interest in an economy?

Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%.
Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates.
Population growth – strong population growth = larger labour force = larger national output which supports the neutral rate of interest.
Age and life expectancy – higher life expectancy increases the amount that people save during their working years. If consumers buy now rather than later = potentially either lower saving rates and/or higher borrowing = neutral rate of interest rises.
Superannuation / retirement age – burden of funding retirees fall on a smaller working age population. This could require higher taxes which leads to less spending putting downward pressure on interest rates.
Debt – with low mortgage rates, debt servicing have been at record lows. People have therefore borrowed a lot money and now have high level of indebtedness levels. Therefore higher mortgage rates mean that consumers disposable income will be reduced.
Government debt – COVID-19 has led to increased government spending and bigger budget deficits. New Zealand economy is probably as sensitive to higher interest rates and an increase in rates by the RBNZ will be very influential, limiting how far interest rates have to rise. And with households and the Government already loaded up on debt, future borrowing capacity is now reduced, which will put downwards pressure on interest rates too.
Overseas investment – as New Zealand comes a more attractive place to invest it increase the supply of loanable funds to New Zealanders. The investment will also strengthen the dollar which make exports less competitive but imports cheaper. Global capital flows mean that we can’t get too far out of sync with other advanced economies – as long as global neutral rates continue their relentless move south, so too will New Zealand’s.

Outlook
In New Zealand, as in most economies, estimates of the real neutral interest rate have been trending downwards over several
decades. In recent years, the RBNZ indicator suite suggests that the real neutral interest rate has stabilised at low levels. The RBNZ current average estimate for the real neutral OCR is around 0 percent. However, the wide range between the maximum and minimum values of RBNZ estimates demonstrates that there is significant uncertainty about the level of neutral interest rates, particularly since the beginning of the COVID-19 pandemic. RBNZ Monetary Policy Statement – November 2022. P. 30

Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank

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A2 Economics – Liquidity Preference Curve

With mock exams this week here is something on Liquidity Preference – included is a mind map that has been modified from Susan Grant’s CIE revision book.

Demand for money

TRANSACTIONS DEMAND – T – this is money used for the purchase of goods and services. The transactions demand for money is positively related to real incomes and inflation. As an individual’s income rises or as prices in the shops increase, he will have to hold more cash to carry out his everyday transactions. The quantity of nominal money demand is therefore proportional to the price level in the economy. (note:  the real demand for money is independent of the price level)

PRECAUTIONARY BALANCES – P – this is money held to cover unexpected items of expenditure. As with the transactions demand for money, it is positively correlated with real incomes and inflation.

SPECULATIVE BALANCES – S – this is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑.

If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

There is an inverse relationship between the rate of interest and the speculative demand for money.

The total demand for money is obtained by the summation of the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest.

 

 

A2 Economics – Credit Multiplier

When a bank accepts or collects deposits they keep some of the deposit as reserves (0.r is the reserve ratio) and advance the rest. As this money is spent it comes back into the banking system as someone else’s deposits. Some of this new deposit is kept as reserves and the rest advanced. This process continues until the new deposit becomes so small it can be ignored.

The value credit creation multiplier is an indicator of the final change in bank deposits which will stem from the initial change. We can calculate this as 1 / 0.r, where 0.r is the reserve ratio.

In the example below the credit creation multiplier equals 4 (that is, 1 / 0.25). Further we can work out the growth in the money supply (eventual increase in money supply), using the following formula: Eventual increase equals 1 / 0.r multiplied by the initial deposit in the money supply. In our example it is 4 times $100m equals $400m. The example below shows that loans given by one bank then become a deposit in another bank. Of that $75m deposited 25% must be kept in reserve ($18.75) and the remainder can be lent out ($56.25). This process continues through the banking system. We can also calculate the secondary expansion or credit created using this formula: Credit created equals (1 / 0.r multiplied by the initial deposit) minus the initial deposit.In our example it is $400m – $100m equals $300m.

The change in the money supply may not be as high as calculated because of leakages or withdrawals from the credit creation process. Banks tend to lose reserves as the public will not deposit the whole of the loans back. The public may retain some of the loan in the form of cash, or banks may be unable to find creditworthy customers to make advances to, or funds may get diverted into government securities.

Reserves may also be lost to taxation and imports (under a fixed exchange rate). The reasons for the initial increase in bank reserves could be the public banking more notes and coins than they withdraw, or public debt maturing. If a Central Bank buys back (purchases) government securities or other financial assets from the public or financial institutions, then there will be an increase in bank reserves.

Read more at: elearn Economics

Internet Penetration vs Use of Cash

The Economist produced some interesting statistics about how the most digitised countries use less cash and the impact of government in moving towards as cashless society. Most transactions are still carried out with cash but the use of it has fallen:

Use of cash – 2013 = 89% and 2019 = 77%

The graph shows the correlation between Internet users and the % of transactions conducted in cash. Nordic countries lead the way and by 2016 it was estimated that 4 out of 5 transactions were done online. In Denmark the extent of the cashless environment has led the payment app called MobilePay to be the top spot as the most “indispensable” app on smartphones – overtaking Facebook, Messenger etc. MobilePay was launched by Danske Bank in 2013 as a peer-to-peer transfer service.

Italy still had 85% of transactions done by cash with 61% internet penetration. Greece with its significant informal economy still has a very high percentage of cash use as it is very hard to trace.

How do countries promote less use of cash?

• Banks can improve systems that make transfers faster and cheaper
• Firms promoting the use of credit cards with loyalty schemes
• Banning the use of cash on public transport – London and Amsterdam
• Filing tax returns – payments or refunds by Internet banking
• Making goods cheaper if paying by card

Source: The Economist – August 3rd 2019

Money as a store of value: Post-War Germany to present day Venezuela

If you have studied any economics course you will no doubt have come across the functions of money. One of the four functions of money is the store of value.

Store of value
Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant handling costs in accumulating and distributing it.

However in a country which is being ravaged by hyperinflation money as a store value is rather inadvisable due to the fact that the return for putting in the bank will not be greater than the inflation which reduces its value. So what do people do to preserve their savings from hyperinflation? The importance of the function of money is dramatically illustrated by the experience of Germany just after World War II, when paper money was rendered largely useless because, despite inflationary conditions, price controls were effectively enforced by the American, French, and British armies of occupation. People had to resort to barter or to inefficient money substitutes – cigarettes and cognac – as these became stores of real wealth.

Venezuela is a current example of a country which has this problem. Some of the examples of wealth preservation can be seen on the Caracas skyline with the building boom that is taking place. This would usually be indicative of a growing economy but businesses are so worried about preserving their earnings that they are prepared to build white elephants as they see it as a better alternative that all their income being whipped out by inflation. On a smaller scale, eggs seem to be holding their value and are also a useful medium of exchange – it is easier to pay people in eggs as it has value and is much more portable (a characteristic of money) remember post-war Germany with wheel barrows of bank notes. In fact people are more likely to be accepting of eggs than banknotes.

Causes of hyperinflation

As with hyperinflation in Bolivia in the 1980’s, the weaknesses in public finances is the main cause of Venezuela’s hyperinflation. The reliance on a single source of income – oil export revenue – as well as increased social welfare spending left the government short of cash. Their solution was to go to the printers and print more money to pay its bills. This feeds inflation which in turn means that the government has to print more money as tax receipts are eroded by hyperinflation. Therefore more money is created to fill the gap in revenue = inflation increasing.

Hedges

In the 1980’s and 90’s a lot of the middle class in Venezuela kept their money offshore in US dollar accounts. But with capital controls making it hard to transfer large amounts of cash, property seemed to be a viable hedging option. However property was too valuable as an inflation hedge. Car ownership became a store of value in that as well as getting you from A to B it was possible to sell the car for more than it was bought for. Some bought shares so as to deposit money and then sell them for larger amounts of cash. For the low incomes the options are limited but they also lack financial acumen as they tend not to act quickly enough to invest in a broader range of assets and refinance debt when interest rates are low. With hyperinflation the long term becomes the next week.

Source: The Economist – A trunkful of bolivares – July 21st 2018

Spy coin and a poppy

Many thanks for this piece from good friend Jim Frood regarding a Canadian spy coin.
As a limited edition coloured 50 cent coin will go into circulation in New Zealand later this year, to mark 100 years since the end of World War I, one hopes that it doesn’t go the way of a similar Canadian coin in 1974 – see right. The ARMISTICE DAY COIN will feature a red poppy surrounded by a green wreath and silver ferns representing the past, present and future and the three armed forces of New Zealand.

Nicholas J. Saunders in his book: The Poppy A History of Conflict, Loss, Remembrance and Redemption 2013 vividly describes what happened with the Canadian coin. In 2007 in the midst of the war on terror a branch of the US Defence Department issued an alert about ‘spy coins which had appeared in Canada. The Defence Department announced that mysterious coins with ‘radio frequency transmitters’ had been discovered on defence contractors traveling in Canada. Analysis of the coin led to the idea that a transmitter was buried in the poppy inside the coin. The US government then classified all the documents relating to the ‘discovery’! That only added to the affair which Nicholas notes degenerated into farce. The ‘mystery’ was cleared up eventually. If you want to read more about the ‘spy coin’ and the poppy in general, Nicholas’ book is well worth reading.

Cash is a rational birthday present but inappropriate

Here is a clip from Seinfeld that I use when teaching Behavioural Economics. It seems rational that Jerry gives Elaine $182 for her birthday but it really is inappropriate. Cash replaces social norms by market norms and ruins the feelings usually evoked by a typical non-cash birthday gift. The deadweight loss of giving is the loss of efficiency that occurs when the value of the gift to the recipient is less than the cost of the gift to the giver. In this case, economists argue that cash would be a more efficient gift.

India and Venezuela’s battle to purge the shadow economy.

On the 8th November last year India’s Prime Minister, Narendra Modi, announced that all 500 and 1000 rupee notes could no longer be used as a medium of exchange – this accounts for 86% of cash in circulation. These notes could be exchanged for new ones by the end of the 2016.

Why did they outlaw the use of 500 and 1000 rupee notes?

• The main motivation was to remove the country of shadow economy millionaires hoarding of illegal cash. It is estimated that the shadow economy accounts for 20% of India’s GDP.
• Demonetisation increases the use of electronic banking allowing better tracking by tax authorities.
• The printing of new denomination money would hopefully inflate away the value of illegal cash in the shadow economy.
• Encourage people to deposit cash in the bank where it would earn interest
• Greater tax revenue for the government by firms declaring their earnings. This additional money could be used for infrastructure projects as well as tax incentives for companies.

What have been the problems?

• The Reserve Bank of India hasn’t been able to print the new money fast enough to replace the $207bn in rupees. There has been almost no new cash in rural banks and therefore keeping millions of farmers deposits that total $46bn. With limited cash in rural areas prices have collapsed.
• Factories in some cities have closed as employers can’t pay their workers although some have resorted to giving supermarket coupons to keep workers on the job.
• A dentist in an affluent part of Delhi has found a 70% fall in business since the cash ban.
• Outside the major cities cash transactions are very common and not recognising 500 and 1000 rupee notes provides a significant monetary shock for those areas
• Not all the shadow economy can move to a more legal environment with demonetisation and this represents a potential loss of economic activity.
• A shortage of cash has led to small businesses having to shut down.

In the long-run the forced priming of bank accounts and the switch to electronic payments will mobilize more money for lending and taxes.

Venezuela

Venezuela also became a country mostly without cash on December 16, sparking scattered protests and looting around the country as people fumed at having their already limited purchasing power cut off almost entirely.

As the nation’s most widely used banknote went out of circulation, the higher-denomination bills that were supposed to replace the 100-bolivar note had not yet arrived at banks or ATMs. That forced people to rely on credit cards and bank transfers or to try to make purchases with bundles of hard-to-find smaller bills often worth less than a penny each. The government was forced to delay the withdrawal of the 100-bolivar banknote until January 2. The graphic shows the volume of bank notes that are required to make $10m – Venezuela needs 14 sizable trucks to carry the 100-bolivar banknotes.

Source: The Economist – December 3rd 2016

Functions of Money – the easier it is to buy things the more you spend

Money has taken various forms over the ages – whether it be tokens on a tree made of pewter (soft metal which comes from Malaysia) to the stone currency from the island of Yap in Micronesia. There was a problem with the stone currency in that one of the essential characteristics of money is portability and a 5 meter high stone with a hole in it doesn’t fit the bill let alone the wallet. Money that comes in small coins and notes became a much more efficient medium of exchange and facilitates more transactions but it still gives you a sense that you are spending it as your wallet becomes lighter and less bulky.

 

Today the vast majority of transactions are done without cash and there is a tendency not to feel the cost of the transaction, by physically taking money out of your wallet, when paying by credit card. This ease of payment encourages us to spend more. Research has shown that credit cards make people spend 12-18% more, on average, than they would using cash. But lets go further, you  can now wave your card over the credit card terminal with no need for a security pin number or a signature. In fact a smartphone is able to carryout a similar transaction which further erodes the sense of parting with money. I recently received an updated airpoints card from a national airline which enables you to accumulate points that can be redeemed for flights. However reading the letter I was interested to see that the card was also offering me $10,000 credit limit. Credit was also offered from a petrol station and a supermarket card – the means of a deferred payment is a popular function.

For the AS level course remember the following:

The Functions of Money 

There are 4 traditional functions of money.

1. Medium of exchange. 

This is very important in a specialised economy as barter would be very inefficient. It also makes possible a great extension of the principle of specialisation.

The desirable qualities of money are as follows:-

• Acceptable: Must be sure somebody will accept your money for goods & services
• Scarce: Should be, if there’s too much, then no one would value it, hence gold was always good money.
• Portable: Convenient to carry around
• Divisible: Can be divide up into different denominations
• Durable: Money (physical) that can last

 2. Unit of Account

A unit of account is a way of placing a specific value on economic goods and services. Thus, as a unit of account, the monetary unit is used to measure the value of goods and services relative to other goods and services. It thus enables individuals to compare, easily, the relative value of goods and services.  A firm uses money prices to calculate profits and losses: and a typical household budgets its regular expenses daily using money prices as its unit of account.

3. Store of Value. 

Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of  money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant  handling costs in accumulating and distributing it.

4. Standard of Value/Standard of Deferred Payment.

An important function of money in the modern world, where so much business is conducted on the basis of credit, is to serve as a means of deferred payment. When goods are supplied on credit, the buyer has immediate use of them but does not have to make an immediate payment. The goods can be paid for three, or perhaps six, months after delivery.

 

The Indian Cow – illiquid

Back after the Christmas break with an article that I found in the print edition of The Economist.

Cows in India, which number 280m, have been seen as a poor investment when you consider the return the Indian farmer gets. Cattle are expensive to keep and the cost of feed for one cow per year is approximately US$160 a year. Some research has suggested the return on a cow is -64%

So the question The Economist asked is why do households in India buy them?

Households may prefer to produce high-quality milk at home, even if doing so costs more.

Only 7% of Indian villages have a bank branch. That means people lack a formal savings mechanism for their spare cash. And although there are informal ways to save—joining a local savings club, for example, or simply stuffing money under the mattress—owning a cow may be a better option. With the liquid nature of money people find it easier to spend money which they sometimes regret. This is referred to by economists as “myopia”. As the cow is quite illiquid (not easy to instantly turn into cash) it is therefore less myopic which means immediate spending is more difficult.

In future the idea of commitment savings accounts in developing countries has been raised whereby people forgo their right to withdraw funds until they reach a specified level.

Bitcoin interview with Max Kaiser

Thanks to AS student Carlos McCoy for some information on Bitcoin. BITCOIN, the world’s “first decentralised digital currency”, was launched in 2009 and unlike traditional currencies, which are issued by central banks, Bitcoin has no central monetary authority. Instead it is underpinned by a peer-to-peer computer network made up of its users’ machines, akin to the networks that underpin BitTorrent, a file-sharing system, and Skype, an audio, video and chat service. However in today’s environment it does maintain a good store of value relatively speaking when you look at alternative currencies. Below is Max Keiser with some very good points.

Inflation – A thief in your wallet. RBNZ video.

Just published on their website, the Reserve Bank of New Zealand has prepared a short video explaining inflation. The video, featuring the Bank’s Head of Economics, John McDermott, explains how inflation is measured and how it manifests itself in everyday life. It also explains the importance of maintaining price stability. Well worth a look.

Do depositers care about banks being prudent?

The recent LIBOR crisis that hit the headlines last week has shown that once again banks which were once reknowed for their prudence and considered boring have now been replaced by greed and reckless risk-taking. According to the WSJ, in the early years of banking an institution needed to attract deposits from the public and therefore cultivated prudence and integrity and publicised this to potential investors. Lets face it being boring was potentially a selling point for bankers. During the 20th century this changed and you only need to look no further than the pre-crisis advertising in which the rhetoric wasn’t one of care and honesty but a willingness to lend to anyone.

However in today’s environment do depositors care so much about the prudent and trustworthiness of banks? Do they actually benefit from this? When you have a situation that the banks become “too big to fail” and are bailed out by the government there seems to be nonchalant attitude amongst depositors to the integrity of banks. This then means that the banks have little incentive to care either. It seem that banks gain little advantage over their competitors from being prudent. In fact depositors can gain from the banks making risky uses of their money. As the government will guarantee their money they then can profit from higher rates of interest by the banks being prepared to make riskier investments. This has encouraged investors to favour risk-taking banks.

Giant Poster on Money

Found this poster on a guide to money on the xkcd site. It started as a project to understand taxes and government spending, and turned into a rather extensive research project. It goes through from Dollars – Thousands – Millions – Billions – Trillions. The 36″x24″ high-quality poster print allows you to stand back and, all at once, take in the entire world economy. Below is the part on Trillions. To order go to the store.

Inflation: what you need to know

The Guardian newspaper recently produced a useful article about inflation. Although UK based it covers issues such as: stagflation; a historical look at inflation globally (see below); is high inflation good for anyone; why do governments target inflation. Click here for the article.

Global Inflation
The record of the highest inflation globally was long held by Germany in the Weimar Republic years when money was carted around in wheelbarrows. In December 1923 prices were more than 85,000,000,000% higher than a year earlier and the highest denomination bank notes had a face value of more than 1,000,000,000,000 marks. In post-revolution Russia, inflation reached 60,804,000% that year – some economic historians believe the government deliberately stoked inflation to impoverish the better off.

But after the second world war, Hungary suffered the highest inflation ever recorded. In the peak month of July 1946, prices were doubling in little more than 12 hours. Other countries that have seen sky-high price rises include China during the civil war from 1945 to 1949, Greece in 1944, Argentina in the 1980s and war-ravaged Yugoslavia in 1994.

More recently, Zimbabwe made headlines for soaring inflation, with price rises hitting 66,212% in December 2007 – the highest inflation in the world at that time. The highest denomination bank note had a face value of 10,000,000 Zimbabwe dollars.

By contrast, Japan experienced a long period of deflation during the “lost decade” of the 1990s.