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many times do we have to re-learn
what monetary policy can and can't do?
Dr Don Brash
29 October 2012
of the most depressing things that has happened in New Zealand
in recent times was the narrowness with which Winston
Peters’ bill to amend the Reserve Bank Act was defeated a
few days ago – 61 votes to 60.
Mr Peters’ bill was supported not only by New Zealand
First, but also by Labour, the Greens and the Maori and Mana
was depressing because, after more than two decades of low
inflation in New Zealand, with the New Zealand approach to
inflation targeting being copied by almost all developed
country central banks, virtually half the New Zealand
Parliament suffers from the illusion that monetary policy can
increase real economic growth and improve the competitiveness
of the export sector.
find it particularly sad that the Labour Party supports this
The Reserve Bank of New Zealand Act 1989 was, of
course, the product of the reforming Labour Government of 1984
to 1990 – and it was passed without a single dissenting vote
in Parliament (to be fair, Rob Muldoon was in hospital at the
time it was passed).
1999, the Labour Party, by then in Opposition, promised a
comprehensive review of the Act if they won the election that
After they formed a government late that year, they
commissioned that comprehensive review by Lars Svensson, a
highly respected monetary policy academic (and now Deputy
Governor of the Swedish central bank).
And the result?
Following careful assessment of the Act and the way the
Reserve Bank was implementing it, Professor Svensson concluded
that it was world’s best practice.
of the Act make the point that the New Zealand dollar is
over-valued and that the Reserve Bank should be encouraged to
reduce its value.
Most objective observers agree that the New Zealand
dollar is indeed over-valued, and that as a result the New
Zealand export sector, and industries competing with imports,
are facing serious difficulties, with major job losses.
I agree too.
is not the issue.
The issue is what monetary policy can do to rectify
suppose that the Reserve Bank was intent on reducing the
exchange rate and eased monetary policy – either by further
reducing interest rates or by “printing money” – to that
it did this while still insisting that it continued to be
intent on avoiding inflation (which is what Mr Peters’ bill
would have required), it’s doubtful that the exchange rate
would fall much at all, because financial markets would
recognise that the Bank would need to increase interest rates
in the near future to meet its inflation objective.
suppose the Bank eased monetary policy and indicated that it
would not be too worried about a “temporary” or
“small” increase in inflation, the exchange rate might
well fall somewhat – and inflation would certainly increase,
a result both of the direct effects of the exchange rate
depreciation (more expensive imports and “exportables”)
and of the easier monetary policy.
In the very short term, exporters would be better off
as a result of the lower exchange rate.
But as inflation increased in New Zealand relative to
inflation in our major export markets, exporters would soon be
again complaining that the exchange rate was “too high”.
is relevant to exporters is not the “nominal” exchange
rate but the inflation-adjusted, or real, exchange rate.
In Mr Peters’ speech to Parliament introducing his
bill he spoke of the terrifying prospect – which he implied
was anticipated by many observers – of the New Zealand
dollar reaching parity with the US dollar.
But he neglected to note that for some decades during
the post-war period the New Zealand dollar bought US$1.12, and
indeed at one point in the early seventies bought US$1.48.
The reason that those rates would undoubtedly be
calamitous today is that inflation in New Zealand has been
higher, and productivity growth lower, than in our major
while the Reserve Bank’s monetary policy can undoubtedly
influence the nominal exchange rate it can have no enduring
effect on the real exchange rate.
can monetary policy have an enduring effect on employment,
though again the explanatory note which accompanied Mr
Peters’ bill implied that it could. Yes, an unexpected burst
of inflation can reduce unemployment – it does that by
temporarily depressing real wages.
But as soon as workers realise that their wages are
rising more slowly than prices, they take steps to rectify
that situation, and unemployment returns to its previous
In urging the New Zealand Reserve Bank to emulate the
supposedly more flexible monetary policy of other central
banks, the supporters of Mr Peters’ bill appear to have
overlooked the fact that unemployment is higher in virtually
every other developed economy than it is in New Zealand.
reality is that monetary policy has an enduring effect only on
Its best contribution to real economic growth and
employment creation is to keep the price system operating free
from the distortions caused by generalised inflation.
it would be desirable if New Zealand’s real exchange rate
The best and quickest way to achieve that would be for
the Government to further tighten fiscal policy (by cutting
government spending or increasing taxes).
This would dampen economic activity and enable the
Reserve Bank to ease monetary policy without fear of inflation
There would be winners and losers from such a policy
– but of course there are winners and losers from any change
in economic policy, including any depreciation in the exchange
(The harsh reality is that a depreciation of the
exchange rate only works if it effectively reduces New Zealand
real wages, though neither Mr Peters nor the others who
supported his bill were keen to acknowledge that.)
would be reassuring to think that perhaps Mr Peters’ bill
had no serious intent at all – that it was just a device to
suggest to gullible exporters that those supporting the bill
were really really concerned about their well-being; that Mr
Parker has no more intention of changing the Reserve Bank Act
than Dr Cullen did in 1999; and that Mr Peters has no more
intention of doing so than he did in 1996.
more intention of doing so than Mr Peters did in 1996”?
It’s worth recalling that, while Mr Peters campaigned
about the evils of an over-valued exchange rate endlessly
during the 1996 election campaign, he made absolutely no
attempt to change the Reserve Bank Act after he became Deputy
Prime Minister and Treasurer – the minister responsible for
the Reserve Bank Act – at the end of that year.
Hopefully, he is no more serious about changing it now
than he was then.
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