stagflation in new zealand 2008

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Stagflation in New Zealand Economy

Code: 4.703

World Economy

Lecturer: Mr. Gamini Jayasuriya

Due Date: 27th August 2008

Prepared by: Keyur Shukla

Student Id: 20080542

Word Count:

Table of Contents:



1.0Introduction…………………………………………………………………………………......

2.0 Current Situation………………………………………………………………………………..

3.0 Justification – Why Stagflation?..................................................................................................

4.0Options to Recover from Negative Growth……………………………………………………

5.0 Recommendation……………………………………………………………………………….

6.0 Conclusion……………………………………………………………………………………...



1.0 Introduction:

The first quarter of year 2008 was nearly over. On 27 th May 2008, a report was produced as a

headline in New Zealand Herald’s Business Page. It was the report of NZIER (New Zealand

Institute of Economic Research) stating that, the forecast for the Real Economic Growth for

the New Zealand’s Economy will be 1.9% to March 2009. It means that it will be 1% down

to the current rate of March 2008. They also envisage that it will be a slow increase in the

Real GDP for the next 4 years. High Interest rates, High Petrol & Food prices will be the biggest

factor affecting slowing down of the Economy. According to the figures of NZIER, the Inflation rate

has increased and the GDP has decreased which shows the rise in Labor price, business intent to raise

prices and Capacity Utilization. http://www.nzherald.co.nz/section/3/story.cfm?

c_id=3&objectid=10512692

http://www.nzherald.co.nz/section/3/story.cfm?c_id=3&objectid=10512692






With the publication of this report in the Newspaper the Economists and the business leaders

of the New Zealand start thinking on the Current situation. They started publishing their

article and study the Circular flow Model of the New Zealand’s Economy. Another report

was published on 5th June 2008 in New Zealand Herald where there was a statement of the

Reserve Bank, “It expects the annual Inflation rate to leap up to 4.7 % in later of this year

which was the highest level in last 18 years.” Than comes Dr. Bollard the Governor’s turn he

said that the Bank would cut OCR later this year in spite of the Inflation. He painted the

depressing picture of the Economy. He later on in his speech confirmed that the New Zealand

Economy is heading towards the nightmare of the 70’s that is STAGFLATION.


2.0 Current Situation:

According to the International comparison of the developed Economic Countries of the

World, the OCR of the RBNZ was floating high as on 5th June 2008 as shown in the below

mentioned figure,





He added that the house prices would be expected to cut to 13%. He further comments that

the New Zealand Dollar will fall faster than assumed. He calls for control in pay expectation

and demands. http://www.nzherald.co.nz/section/3/story.cfm?c_id=3&objectid=10514501

According to 8th out of the 12 economist confirmed this negative economic growth.

According to the report published on the 14th July 2008, the consumer price index roused by

1.4% in the first quarter and the annual Inflation rate was 3.8% which was at the fastest pace

in 2 years. These were the findings of the group of 12 economists of Bloomberg. One of the

Economists named Craig Ebert quotes that, at the end of the year Inflation may touch to 5%

the highest since 1990’s. As New Zealand Institute’s assessment details assumed, 47% of the

firms wants to increase their prices in the upcoming three months.

http://www.bloomberg.com/apps/news?pid=20601081&refer=&sid=aUlqDhMNT17s

So, with all these views of Economists and the statement of the Reserve Bank of New

Zealand’s Governor Mr. Bollard, we can confirm that the situation is of STAGFLATION.








At the end of March 2008, in the report of NZIER, they showed the threat of High Inflation

with headline Inflation to reach 3.9%

Consumer price Inflation is projected to peak at 4.3% in September 2008 and recover back

till March 2010.

http://www.nzier.org.nz/Site/Publications/Consensus_forecasts.aspx





In the report the Average Real GDP was termed to be 1.0% and 2.4% respectively in 2009 &

2010. http://www.nzier.org.nz/Site/Publications/Consensus_forecasts.aspx

They also forecasted that the KIWI dollar will fall on an average to 67.0 and 63.5 on a trade

weighted basis in the two upcoming respective years.








Forecast of total investment is down to 1.4% and 2.5% in the upcoming respective couple of

years.

This is the Current situation which adds towards the justifications of the Stagflation situation.


3.0 Justification – Why Stagflation?

What is Stagflation?

We can simplify these in simple diagram,





“S” factor is the word used by Economist for the Stagflation. It last occurred in 1970s.

Actually Stagflation in the simple word is rise in Inflation and decline in GDP powered by

the forces like Unemployment, price rise, etc.

As we can see it in the above mentioned diagram as the price increase the and the

unemployment increase the AD demand curve and As the supply curve are both shifted

towards the left side hence there is rise in the inflationary gap and the growth is also shifted

towards the left side so it has decreased. It is clear comparison of 2007 & 2008 situation.



Now another thing is why this situation worsened? For answering this question we need to

know the theory of Rational Expectations. This theory was first projected by John F Muth of

Indiana University in early sixties. In this theory he described that there are several

Economic situation happening around but the outcome of that situation mainly depends on

the “people’s expectations”. Furthermore, a famous Economist John Maynard Keynes used

these term and stated that, “It is a wave of Pessimism and Optimism to determine the level of

Economic Activity”. http://www.econlib.org/library/Enc/RationalExpectations.html

Actually People analyze the current situation and express their view, for example, they saw

farmer sawing crops and if the cultivation and harvesting of paddy is less, people expect the

price to go up and they buy as soon as the flock of rice enters the market to sell. So, because

of high demand and low supply the price automatically rise because most of the people

expect that the price of paddy will rise. Hence we can quote it to the theory of Rational

Expectation. This is what people expect and things tend to happen.

Moreover according to the statistics provided by the government the Unemployment rate

after falling throughout 2007, it has seen increase in the first quarter of 2008 by 0.2% to 3.9%

till June 2008. Male unemployment rate rise from 0.4% to 3.9% and Female on the other

hand rise from 0.1% to 4.0%. http://www.stats.govt.nz/NR/rdonlyres/5ED3C518-6FFA-

4F1B-BB07-C3018B412133/0/householdlabourforcesurveyjun08qtrmr.pdf

http://www.econlib.org/library/Enc/RationalExpectations.html

http://www.stats.govt.nz/NR/rdonlyres/5ED3C518-6FFA-4F1B-BB07-C3018B412133/0/householdlabourforcesurveyjun08qtrmr.pdf


http://www.econlib.org/library/Enc/RationalExpectations.html





The above mentioned figure moreover shows the acquiescence issued for residential

buildings from 2004 to first quarter of 2008. We can clearly see the decline in the number.

Major in North Island of New Zealand, Bay of Plenty it declined by 8.8% Waikato by 8.3%

and in Auckland by 7.9%.

This also justify the effect of Stagflation encrypting the economy of New Zealand.

http://www.stats.govt.nz/NR/rdonlyres/5ED3C518-6FFA-4F1B-BB07-

C3018B412133/0/householdlabourforcesurveyjun08qtrmr.pdf







4.0 Options to Recover from Negative Economic Growth:

There are some options to recover from this dangerous “S” i.e. stagflation situation. We will

see it one by one;

Fiscal Policies:

Fiscal Policies are the policies heading towards government spending and taxation. Here AD

that is Aggregate Demand includes expenditure, reserves, net exports, government

expenditure affects AD directly while Taxes affects indirectly by altering the non-refundable

income of the household which alters the consumption. (Economics, 6th

edition, Boyes &

Melvin, 2005 Houghton Mifflin Company, USA) There is a time lag in implementation off

the Fiscal Policies; it is minimum time of 18 months. It is effective in fixed exchange rate.

4.1 Contractionary Fiscal Policy:

Contractionary Fiscal Policy is also known as Restrictive Fiscal Policy in some ways as it

reduces growth rate of Aggregate demand in proportion to aggregate supply. In this Policy



we take aggregate supply unchanging, but aggregate demand is contracted as an outcome of

the higher tax and diminution in government spending. As a result the Aggregate demand

curve is shifted from point of full employment to the point of higher amount of

unemployment. So as a result of this policy, the risk of Unemployment increases.

http://www.colorado.edu/Economics/courses/econ2020/section9/section9-main.html

Hence, we can clearly notice from the graph that this policy controls a bit of Inflation but the

Recessionary gap widens up.

4.2 Expansionary Fiscal Policy:

In this policy the Economy comes under the recession as the Aggregate Demand curve

interacts with the supply to the left of the full employment. To increase up the GDP the

government decreases the taxes and adds to in the Government’s own expenditure. In this

policy there will be a great altitude of output and raise in demand for labour. But on the other





hand the disappointingly the soaring Inflation is likely to be the outcome.


(http://images.google.co.nz/imgres?

imgurl=http://www.colorado.edu/Economics/courses/econ2020/section9/gifs/fig91.gif&imgr

efurl=http://www.colorado.edu/Economics/courses/econ2020/section9/section9-

main.html&h=280&w=280&sz=8&hl=en&start=3&usg=__6vN555KGDK2crVNDmvDnm

wonxho=&tbnid=NkkY4nsOscblYM:&tbnh=114&tbnw=114&prev=/images%3Fq

%3DFiscal%2BPolicy%26as_st%3Dy%26hl%3Den%26sa%3DG)

If we take the example of US regarding this Policy, US tried to cut taxes in 2008, however

the economy is experiencing the falling house prices and a credit crunch. Expansionary

Fiscal policy includes higher Government borrowing and higher spending so it could create

crowding hence it results for private sector to spend less.

http://www.economicshelp.org/blog/economics/impact-of-expansionary-fiscal-policy/

Monetary Policy:

There are two types of Monetary Policies.

1) Contractionary Monetary Policy

2) Expansionary Monetary Policy

Here, Contractionary money Policy is also termed as a Tight Money Policy. And Expansionary

Monetary policy is also sometime called as Easy Money Policy.


http://images.google.co.nz/imgres?imgurl=http://www.colorado.edu/Economics/courses/econ2020/section9/gifs/fig91.gif&imgrefurl=http://www.colorado.edu/Economics/courses/econ2020/section9/section9-main.html&h=280&w=280&sz=8&hl=en&start=3&usg=__6vN555KGDK2crVNDmvDnmwonxho=&tbnid=NkkY4nsOscblYM:&tbnh=114&tbnw=114&prev=/images%3Fq%3DFiscal%2BPolicy%26as_st%3Dy%26hl%3Den%26sa%3DG














Contractionary Monetary Policy:

Contractionary monetary Policy corresponds to a decrease in Money Supply or a FED sale of a

treasury bonds on the open bond market. http://internationalecon.com/Finance/Fch90/F90-1.php

(http://images.google.co.nz/imgres?imgurl=http://internationalecon.com/Finance/Fch90/F90-1-

1.gif&imgrefurl=http://internationalecon.com/Finance/Fch90/F90-

1.php&h=249&w=278&sz=3&hl=en&start=7&usg=__da5FBCh1hzXNu0Mx13GmjGANk-

g=&tbnid=v8e_9gYDk0mUeM:&tbnh=102&tbnw=114&prev=/images%3Fq%3Dcontractionary

%2Bmonitory%2Bpolicy%26as_st%3Dy%26hl%3Den)

Moreover this is also termed as Tight Money Policy hence its main motive is to reduce the

Inflation. But it creates adverse effect and increases the amount of Unemployment. Hence, the

recession increases.

Moreover as the money supply will be contracted, the Interest rate will rise, Investment will fall,

expenditure will fall and net export will fail. People will start investing in the saving schemes

like bond and foreign currency as they earn more interest or more rate of return after due course

of time. http://edwardmcphail.com/intromacro/lecture14/lecture14.html

http://internationalecon.com/Finance/Fch90/F90-1.php

http://images.google.co.nz/imgres?imgurl=http://internationalecon.com/Finance/Fch90/F90-1-1.gif&imgrefurl=http://internationalecon.com/Finance/Fch90/F90-1.php&h=249&w=278&sz=3&hl=en&start=7&usg=__da5FBCh1hzXNu0Mx13GmjGANk-g=&tbnid=v8e_9gYDk0mUeM:&tbnh=102&tbnw=114&prev=/images%3Fq%3Dcontractionary%2Bmonitory%2Bpolicy%26as_st%3Dy%26hl%3Den





http://edwardmcphail.com/intromacro/lecture14/lecture14.html









As we can see in the above mentioned graph, The AD’ curve is shifted towards the left side as a

result of decrease the flow of the Money Supply. The new curve AD is created and as the

outcome of this policy, we can see that the Inflationary gap is start closing, but on the other hand,

the recessionary gap starts widening. Hence the effect of unemployment starts developing.

Expansionary Monetary Policy:

This Policy comes about when the economy is working at the full employment Output. Here in

this policy the augmented money supply put increasing pressure on costs. If this situation is

implemented than sooner or later as shown in the figure, the economy will experience the

happening of Inflation.


With the use of this policy, the injection of the money is made in the circular flow chart, hence

the rate of interest will fall and as a result, the speculation and spending will rise. People will





save less and consume more. They purchase more commodities and services. The prosperity

rises in the business cycle expansion and People also start investing in the financial possessions

as the wealth rises. http://edwardmcphail.com/intromacro/lecture14/lecture14.html

As shown in the figure, A, A’, A” are the supply curve or the augmentation of Money that is

injected in the Economy. As the Injection carry on the Demand Increases and as a result we can

clearly see in the figure the Inflationary gap getting broader. It is correct that it will decrease the

recessionary gap but it will surely increase the inflation in the economy.


Do Nothing Policy:

There is one more policy to have control over the economy in removing the Stagflation. It is

Just Do Nothing. Let the situation remain the same. Let time be the judge. Because in the

Economic cycle there is going to be the Economic Boom & Economic Recession going to

repeat one after the other. History has justified this and many countries have come up with







good outcomes by doing nothing. Do Nothing Policy has worked for many unstable

economies to grow.

As we can see it in the figure, the Economic boom and recession is the continuous cyclic

process, once there is boom, the recession is going to come. Hence this is Do nothing Policy.

Wait for the right time and the time will give you the result. As we all know that golden

saying of Keynes, “Economy is driven by the People’s Expectation”. (Lecturer’s Notes)

When people’s expectation changes the Economy itself will start correcting the path and start

its journey towards the upward direction.

Recommendation:

We have seen the 5 types of different Economic ways that could be implemented at the time

of Negative Economic Growth.

1) Contractionary Fiscal Policy is helpful in reducing Inflation but it creates lots of

Recession which is not good for the Economy.



2) Expansionary Fiscal Policy is helpful in reducing Recession (Unemployment) but it

causes Inflation which is again not good for Economy.

3) Contractionary Monetary Policy reduces Inflation but again proves harmful to the

Economy as it is a cause of Recession.

4) Expansionary Monetary Policy is also helpful in cutting down Recession but if again

causes harm to the Economy by raising Inflation.

5) Do Nothing Policy to me is the best Policy so far I recommend as all the policies have

time lag as this policy also has that but Boom/Recession is a cyclic Process as we seen in

the above diagram, Once if there is Inflationary or Recessionary gap there is going to be

the Economic Boom. If one uses Contractionary or Expansionary policy at the time of

Stagflation, it pays with higher Recession or Inflation. But let time be the judge, which is

the best way to go.

Hence, I Recommend Do Nothing Policy is the Best Policy.

stagflation in new zealand 2008

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