Anthony Byett Economist fxmatters November 2006

1. Money and Monetary Policy Interest Rates Exchange Rates Anthony Byett Economist fxmatters.co.nz November 2006

2. Money and Banking • Definition of money • NZ banking system • Money in NZ

3. ReviewIntroducing a stock into the flow model Money is a stock concept measured at a point in time Income is a flow concept per annum concept Goods & services produced from capital & labour Households Firms Refer Callander 2nd Ed p360

4. Forms of Money Utu, favour exchange Gold, greenstone, cigarettes Notes & coins Transaction accounts access by cheque, EFT-POS, telephone Savings accounts NB some accessible by ATM, telephone Debit cards (as opposed to credit cards) Refer: * The Economist 22-Dec-01 pp85-87

5. Medium of exchange. In order to function it must have the following properties: - acceptable - scarce - portable - divisible - durable Store of value Unit of account Means of deferred payment Functions of MoneyWhy hold money? Refer Callander 2nd Ed p533

6. Money in NZHow much? Recent figures put money = $171 billion I.e. Jun-06 “M3 money supply” reported by RB including $2.8 billion notes & coins remainder were bank deposits Had been $93b in Mar-99 breakdown of this figure to come in following slides

7. Banking in NZInstitutions • Government > collects taxes & borrows money > buys goods & services, pays benefits • Reserve Bank > banker to Government & banks > supervises registered banks > implements monetary policy > issues currency • DMO > Government’s Treasury • Registered banks > accept deposits/makes loans > manage pooled investments > process transactions • Other financial institutions

8. M3 Financial InstitutionsOwners, assets ($b) and S&P credit ratings 1 ANZ National ANZ, Aus 87 AA- 2 WestpacTrust* Westpac, Aus 48 AA- 3 BNZ NAB, Aus 46 AA- 4 ASB Bank CBA, Aus 42 AA- 5 Hong Kong* HK Shanghai 6 AA- 6 Deutsche Bank* DB, Germany 6 AA- TSB NZ trust 3 BBB- Others (3 banks/sub & 2 non-bank) 13 TOTAL (at Dec-05) 251 * Branches Note: Kiwibank ($2.5b) is a bank but not within M3 survey (yet) Source: www.rbnz.govt.nz and www.kpmg.co.nz

9. Balance Sheets of Banks Assets Liabilities + Loans - Deposits + Reserves - Capital (or liquids) NB: deposit is customer’s asset, and bank's liability (as owed customer) Refer Callander 2nd Ed p535

10. NZ “M3” Balance Sheet ASSETS (Mar-99 total=$143b) $b NZD claims (lending) 122 Non-NZD claims 5 NZ Government securities 7 Claims on RBNZ/notes & coins 1 Other assets 9 LIABILITIES NZD funding (deposits) 100 Non-NZD funding 28 Capital 8 Other liabilities 7 Source: www.rbnz.govt.nz or RBNZ Financial Statistics

11. Definitions of money supply LIABILITIES ($billion at Mar-99) NZD funding (deposits) 100 Transaction accounts (net*) 12 Other call accounts (net) 27 Other deposits (net) 52 * the netting involves the deduction of inter-institutional deposits and government deposits Source: www.rbnz.govt.nz or RBNZ Financial Statistics

12. Monetary Aggregates Move from narrow to broad definition of money as per The Economist, Financial Indicators M1 M2 M3

13. Definitions of Money Supply LIABILITIES ($billion at Mar-99) $2 billion NZD funding (deposits) 100 notes & coins held by public Transaction accounts (net) +12 14 = M1 Other call accounts (net) +27 41 = M2 Other deposits (net) +52 93 = M3 Source: www.rbnz.govt.nz or RBNZ Financial Statistics

14. Money SupplyNote that ……. Unexercised overdrafts not part of money supply Debit cards and cheques not themselves money Credit cards accumulate debt to be settled with M1 money

15. Financial Assets and LiquidityMoney just one asset Spectrum of liquidity (See Callander, p536) CashPhysical/human assets NB liquidity may incur opportunity costs • Liquidity • the ease with which an asset can be converted into an M1 asset (i.e. money ) without loss of capital value

16. Money Creation • The creation process • bank asset & liability growth • Limits on natural growth • Daily settlement • Government does not create money • Government flows offset • Money and inflation • Money and growth

17. Where Does Money Come From? Primitive Bankers acted as custodians issued receipts for gold deposits receipts used for transaction purposes Banking Evolved bankers made loans (for interest) by issuing more receipts assumed not all holders of deposits would want gold at the same time  reserves only needed to be a fraction of their deposits (liabilities) Refer Callander 2nd Ed p535

18. Initial Goldsmith’s Balance Sheet See Callander, Fig A.2, p538, Balance Sheet A

19. Goldsmith’s Balance Sheet after Lending Reserves = 20% of deposits Compare Callander, Fig A.2, p538, Balance Sheet B

20. Fractional Reserve Banking A banker holds only a fraction of the outstanding deposits in reserve funds In New Zealand up to mid 1980’s a system of compulsory reserve ratios operated (Reserve Ratio) ‘Prudential reserve ratios’ are used today

21. Banking pre-80s Regulated Reserve Ratios only replaced in the mid-1980s

22. Banking Today Self-imposed liquidity management includes government, bank & corporate securities Minimum capital ratios by regulation

23. Money Creationmore deposits >>> more lending Often associated with government spending Gov’t spends money that it does not have Banks will on-lend (or repay other funding)

24. Money Creationmore lending >>> more deposits More likely the cause today A bank lends money during day (which it may not have) Loan money is deposited in bank Loan becomes “self-funding”

25. Managing Money Growth in NZ • Government issues debt to fund any revenue shortfall (I.e. does not create money) • Long-term: Government Stock issued monthly (approx.) • Short-term: Treasury Bills issued weekly • RBNZ also smoothes daily government flows • through daily and now intra-day settlement • through open market operations

26. The Settlement Process Settlement banks bank with the RBNZ non-settlement banks bank with settlement banks At end of day*, the net daily inter-bank flows are known (* next morning actually) money owed to other banks paid with RBNZ balances i.e. settlement cash if bank has no “cash” tries to borrow from other bank can borrow from RBNZ @ 0.25% over cash target or +0.30% if rolling intra-day bank bill repo Refer Callander 2nd Ed p473

27. Smoothing Settlement Cash • RBNZ conduct daily “open market operations” (OMO) to smooth flows • largely to offset government flows • Too much cash forecast • RBNZ sells T-Bills for cash • Not enough cash forecast • RBNZ lends cash • banks borrow cash using Bills and Bonds as security • actually sell bills/bonds and forward purchase (repo)

28. Does Money Matter? • Remember week 6 and GDP… • The quantity equation MV = PY M= stock of money ($) P= price level ($) V= velocity of circulation (times per year) Y= volume of production (number of “things”) • if velocity steady, money growth will match nominal production growth more money > more output and/or more inflation Refer: * Sherwin, “Inflation”, Economic Alert, Apr-99

29. Price Level AD AD1 AS Inflation Real Output The Output GapLinking money to AD/AS model • More “money” leads to greater aggregate demand • We cannot satisfy all this demand with new products/services • Feeds through to higher prices Refer Callander 2nd Ed p420, Fig 20.6

30. Money and Inflation

31. Money and House Prices

32. Summary • Money typically is bank deposits • Can be created from thin air • Growth constrained by capital requirements • and source of funding • And by government financing with debt • Also volatility reduced by RBNZ cashflow smoothing • Some loose connection between money and inflation/growth exists

33. Monetary Policy

34. Monetary Policy Process NZ monetary policy a three step process: • An inflation target is set by the Reserve Bank Governor (Bollard) & Treasurer (Cullen) • An inflation forecast is formed by the RBNZ • The RBNZ adjusts short-term interest rates to bring the forecast into line with the target • via cash rate target

35. Inflation • In theory, inflation a momentum • the ongoing rise of prices, wages, money supply • In practice, inflation is the change in CPI • goods & services that households consume • weighted according to proportion of spending • Inflation high late 70s, low now • vicious cycle: higher wages, prices & devaluations • tried to contain with wage/price freeze early 80s • eventually moved to independent Reserve Bank • also tight gov’t control, competitive economy, floating exchange rate

36. Inflation

37. RBNZ Act 1989 Part II “The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices” • Inflation target set for term of Governor’s office • RBNZ actions to be consistent with policy target • RBNZ to consult & advise Gov’t (and others) • Governor-General can set another objective for 12 month periods • Policy statements every 6 months

38. The Inflation Target • Contract between RBNZ Governor and Treasurer • Governor appointed to September 2007 • Stability agreed to as CPI inflation between 1-3% p.a. on average over the medium term • Exceptions allowed (if >0.25 was rule of thumb): • terms of trade shock • changes to indirect taxes • natural disaster shock • changes to government levies (see Policy Targets Agreement, September 2002)

39. Consumer Price IndexAs at June 2006 • Annual rate 4.0% • Large contributions from housing & petrol • But inflation? • To what extent will rises be ongoing? • Tradable vs Non-tradable Inflation

40. The inflation forecast • RBNZ forecasts inflation • look at annual CPI forecast out 24 months • in RBNZ model, inflation determined by: • exchange rate movements • international price of exports & imports • unit labour costs • output gap • inflation expectations • influential factors are TWI & unit labour costs

41. Implementation of Policy • If forecast inflation does not match the target • then some policy response is required • Policy signalled via interest and exchange rate forecasts • Policy acts through short-term interest rates • Policy is implemented through the official cash rate target • from 17 March 1999

42. RBNZ Transmission Path Diagram Fig 27.3, p490

43. Current Monetary PolicyRBNZ Jun-06 Projections • Forecast annual CPI of 3.9% p.a. (falling to 2.4%) • Cash rate unchanged on the day (7¼%) • Assumes growth slowing • GDP Mar 04/05 +3.5% to 06/07 +1.1% “Growth to remain low … headline CPI inflation above 3% well into 2007 … do not expect to tighten … no scope for easing of the OCR this year” Source: www.rbnz.govt.nz

44. No imminent change expected

45. Monetary Theory and PracticeGeneral • Theory links money growth with inflation • Correlation between money and nominal output exists in long-run (Quantity equation again) • in short-run, relationship is not evident • Chronic and acute inflation has been associated with money-financed government budget deficits

46. Monetary Theory and PracticeNZ experience • NZ Government debt-finances • Money growth plays small role • Early 90s fall in inflation coincided with international recession and fiscal tightening • There exist long and uncertain lags between changes to monetary conditions and inflation • Large changes in interest rates are needed to change exchange rates & inflation rates • Low elasticity with respect to interest rates.

47. Interest Rates • Many interest rates • primary & secondary markets • wholesale & retail (say <$1m) • Short-term yields (or rates) • set in money market • where cash, bills and notes are traded • Long-term yields (or rates) • set in bond market • where bonds, gov’t stock & notes are traded

48. 90 Day Bank Bill

49. Retail Floating Rates

50. Retail Floating Ratesand Wholesale Rates