Interest Rates Interest Rates and the Business and the Business

CycleCycle

The Official Cash Rate - OCRThe Official Cash Rate - OCR

The OCR is an interest rate set by the The OCR is an interest rate set by the RBNZRBNZ

The RBNZ can influence interest The RBNZ can influence interest rates in the economy through the rates in the economy through the OCR OCR

The OCRThe OCR How the RBNZ influences interest rates with the How the RBNZ influences interest rates with the

OCR.OCR.

Banks borrow ‘overnight cash’ from the RBNZ.Banks borrow ‘overnight cash’ from the RBNZ. The RBNZ charges interest rates 0.25% above The RBNZ charges interest rates 0.25% above

the OCR for loansthe OCR for loans

Banks also deposit cash with the RBNZ.Banks also deposit cash with the RBNZ. The RBNZ pays an interest rate The RBNZ pays an interest rate 0.25% below the OCR for these 0.25% below the OCR for these deposits. deposits.

Example Example

The RBNZ announces that the OCR is 2.5%The RBNZ announces that the OCR is 2.5%

What interest rate do banks pay the RBNZ What interest rate do banks pay the RBNZ for loans?for loans? Banks pay 2.75% for loans from the RBNZBanks pay 2.75% for loans from the RBNZ

What interest rate does the RBNZ pay What interest rate does the RBNZ pay banks for deposits?banks for deposits? The RBNZ pays 2.25% for deposits by banks. The RBNZ pays 2.25% for deposits by banks.

What is the OCRWhat is the OCR

The RBNZ uses the OCR to effect interest The RBNZ uses the OCR to effect interest rates thus manipulates the level of Spending, rates thus manipulates the level of Spending, Investment, and Net Exports in the economy.Investment, and Net Exports in the economy.

The C + I + (X – M) component of AD (GDP)The C + I + (X – M) component of AD (GDP)

Net Exports Consumption

Investment

OCR effects……

How the OCR effects spending (C)

An increase in the OCR leads to…..An increase in the OCR leads to….. an increase in interest ratesan increase in interest rates it becomes more attractive to save it becomes more attractive to save less attractive to borrow.less attractive to borrow. spending will dropspending will drop

A decrease in the OCR leads to…..A decrease in the OCR leads to….. a decrease in interest ratesa decrease in interest rates it becomes less attractive to saveit becomes less attractive to save cheaper to borrowcheaper to borrow Spending will riseSpending will rise

How the OCR effects How the OCR effects Investment (I)Investment (I)

An increase in the OCR leads to…… An increase in the OCR leads to…… an increase in interest rates an increase in interest rates more expensive to borrowmore expensive to borrow Less attractive to invest Less attractive to invest

A decrease in the OCR leads to…..A decrease in the OCR leads to….. a decrease in interest ratesa decrease in interest rates more attractive to investmore attractive to invest cheaper to borrowcheaper to borrow

OCR and the exchange rate (X OCR and the exchange rate (X – M)– M)

When the OCR rises, (overseas) investors will When the OCR rises, (overseas) investors will place their money in our banks.place their money in our banks. In order for overseas investors to invest their money in In order for overseas investors to invest their money in

NZ they must demand the $NZ.NZ they must demand the $NZ. The $NZ dollar appreciates, which makes exports more The $NZ dollar appreciates, which makes exports more

expensive and imports cheaper.expensive and imports cheaper.

When the OCR falls, (overseas) investors will take When the OCR falls, (overseas) investors will take their money out of banks in NZ and invest their money out of banks in NZ and invest elsewhere.elsewhere. They then sell (supply) the $NZ to buy (demand) They then sell (supply) the $NZ to buy (demand)

another currency.another currency. The $NZ depreciates, which makes exports cheaper The $NZ depreciates, which makes exports cheaper

and imports more expensive.and imports more expensive.

What is happening at the What is happening at the moment?moment? OCR unchanged at 2.5 percent

Date 28 April 2011

The Reserve Bank today left the Official Cash Rate (OCR) unchanged at 2.5 percent.

Reserve Bank Governor Alan Bollard said: “The outlook for the New Zealand economy remains very uncertain following February’s Christchurch earthquake.

“As was expected, business confidence, consumer spending and tourism activity all declined sharply following the earthquake. The OCR was cut as insurance to help limit these adverse effects. Confidence and consumer spending have since shown signs of recovery, but many firms and households remain adversely affected in Christchurch. To date, activity in the rest of the country appears relatively unaffected, with housing market turnover and business investment beginning to increase.

What is happening at the What is happening at the moment?moment?

““Trading partner growth remains robust, helping push New Trading partner growth remains robust, helping push New Zealand’s export commodity prices higher. Along with relatively Zealand’s export commodity prices higher. Along with relatively favourable climatic conditions, the improved price outlook is favourable climatic conditions, the improved price outlook is supporting a pickup in on-farm investment. Higher oil prices and supporting a pickup in on-farm investment. Higher oil prices and the elevated level of the New Zealand dollar are both unwelcome. the elevated level of the New Zealand dollar are both unwelcome. They will have some dampening effect on economic activity.They will have some dampening effect on economic activity.

““Headline inflation is currently being boosted by recent increases Headline inflation is currently being boosted by recent increases in indirect taxes. Annual inflation is expected to settle comfortably in indirect taxes. Annual inflation is expected to settle comfortably within the target band once these tax increases drop out of the within the target band once these tax increases drop out of the annual rate.annual rate.

““Given the outlook for core inflation and continued economic Given the outlook for core inflation and continued economic disruption stemming from the earthquakes, the current level of the disruption stemming from the earthquakes, the current level of the OCR is likely to remain appropriate for some time.”OCR is likely to remain appropriate for some time.”

The Business (Trade CycleThe Business (Trade Cycle

Over time fluctuations in economic Over time fluctuations in economic activity occur. activity occur.

The trade cycle shows us how The trade cycle shows us how fluctuations in the levels of output, fluctuations in the levels of output, employment, income and trade employment, income and trade affect the level of real GDP. affect the level of real GDP.

A Typical Trade Cycle

Time

Real

GDP

Boom

Peak

Recession

Trough/Depression

Recovery

Trade Cycles Trade Cycles BoomBoom

Rising interest ratesRising interest rates High eco activityHigh eco activity ““Full” employmentFull” employment Great optimismGreat optimism Businesses operating at capacityBusinesses operating at capacity

Peak (Turning point)Peak (Turning point) Eventually rate of growth must Eventually rate of growth must slow down.slow down. Even if economy is Even if economy is

still growing it is now doing so at a decreasing ratestill growing it is now doing so at a decreasing rate

RecessionRecession Rising unemployment and business failuresRising unemployment and business failures Savings may increase as people fear unemploymentSavings may increase as people fear unemployment Business activity slows downBusiness activity slows down

Trade CycleTrade Cycle Depression (Trough)Depression (Trough)

Unemployment stabilisedUnemployment stabilised Low level eco activity Low level eco activity Excess capacity Excess capacity Interest rates lowInterest rates low Low consumption , low savingLow consumption , low saving

Eventually some major piece of capital equipment will need Eventually some major piece of capital equipment will need replacing- injection of investment lead to recoveryreplacing- injection of investment lead to recovery

RecoveryRecovery Rise in real GDP slow at first, speeds upRise in real GDP slow at first, speeds up Rehiring of workers as demand increasesRehiring of workers as demand increases Unemployment fallsUnemployment falls Consumption increasesConsumption increases

Start workbook page 56 question 6,7 and page 58 question 12 and 13

The Business CycleThe Business Cycle

A business cycle is identified as a sequence of A business cycle is identified as a sequence of four phases: four phases: Expansion (A speedup in the pace of economic Expansion (A speedup in the pace of economic

activity=higher GDP) activity=higher GDP) Peak (The upper turning of a business cycle)Peak (The upper turning of a business cycle) Contraction (A slowdown in the pace of economic Contraction (A slowdown in the pace of economic

activity=lower GDP) activity=lower GDP) Trough (The lower turning point of a business cycle, Trough (The lower turning point of a business cycle,

where a contraction turns into an expansion) where a contraction turns into an expansion)

The Economy’s Sustainable The Economy’s Sustainable Growth PathGrowth Path

This is the This is the economy’s economy’s capacity to supply capacity to supply goods and goods and services over time services over time without the rate of without the rate of inflation increasing inflation increasing (GDP increases at (GDP increases at sustainable rate sustainable rate which matches which matches increase of increase of resources)resources)

Time

Change in

Growth

A – Positive Output A – Positive Output Gap. The economy is Gap. The economy is trying to produce a trying to produce a level of GDP that is level of GDP that is above the above the sustainable growth sustainable growth path of the economy path of the economy (using resources (using resources faster than they can faster than they can replenish). Demand replenish). Demand for resources for resources exceeds supply exceeds supply therefore price level therefore price level and inflation will and inflation will occur.occur.

Change in

Growth

a

b

B – Negative Output Gap. The economy is producing below the sustainable level of output (some resources are idle). Demand for resources is less than the supply therefore general price level will drop causing disinflation or deflation.

A. AD increases A. AD increases causing inflationcausing inflation

B. AD decreases B. AD decreases causing causing disin/deflationdisin/deflation

Governments use of OCRGovernments use of OCR

The government manipulates the OCR to The government manipulates the OCR to level out the peaks and troughs.level out the peaks and troughs.

When in recovery the government will When in recovery the government will increase the OCR (increasing interest rates) increase the OCR (increasing interest rates) to discourage excess consumption and to discourage excess consumption and investment in order to minimise the peak.investment in order to minimise the peak.

When in recession the government will When in recession the government will decrease the OCR (decreasing interest decrease the OCR (decreasing interest rates) to encourage consumption and rates) to encourage consumption and investment in order to minimise the trough.investment in order to minimise the trough.