Readers Question: What is the relationship/theory between the OCR (Official Cash Rate) and Inflation?
The Official Cash Rate is the interest rate the New Zealand Reserve Bank use to control inflation. It is very similar to the base rate used by the MPC, Bank of England.
Graph Interest Rates New Zealand
Interest Rates in New Zealand. Source
Because New Zealand commercial banks borrow from the reserve bank, this official cash rate influences all interest rates in the economy.
The Reserve bank will increase interest rates (tightening of monetary policy) to reduce inflationary pressure.
Higher interest rates:
increase cost of borrowing
increase incentive to save
reduce disposable income of people with variable mortgages
This reduces consumer spending, investment and therefore aggregate demand growth; this helps reduce inflation.
At the moment, the New Zealand Reserve bank is cutting interest rates (like Central banks around the world) because of the global slowdown. WIth inflation falling, the Reserve bank are cutting rates to try and prevent recession.
Generally lower inflation enables lower interest rates. Higher inflation leads to higher rates.
However, sometimes, Reserve banks will increase interest rates in anticipation of inflation.
Or at the moment, the Bank of England is cutting rates aggressively in anticipation of lower inflation next year.
Graph inflation NZ
Inflation in New Zealand. Source
Forecasts for NZ Inflation and Interest rates
With end in cost push inflation and the global slowdown spreading, the NZ economy is likely to have lower inflation and lower interest rates in 2009
Readers Question: What is meant by the term inflationary noise ?
Definition of Inflationary noise. When inflation distorts price signals.
If inflation is 0%, and Peugeot cars increase in price then this is a signal Peugeot are more expensive. However, if inflation is 5 or 6%, it is harder to work out whether the increased price of Peugeot cars is due to inflation or an increase in the relative price.
Inflationary noise is more of a problem when inflation is unexpected. e.g. if inflation is always 2% and this is what people expect, it is easier to work out relative prices. However, if inflation is unexpectedly high, it becomes more difficult to work out relative price changes.
Deflation would also make it difficult to work out relative prices.
Readers Question: Could deflation lead to devaluation of the UK Pound?
Deflation in the UK means prices fall. This hasn’t happened since the 1930s, but, if it did happen, it could lead to a further depreciation in Pound Sterling.
Firstly, deflation would mean interest rates would likely fall to 0%. This fall in interest rates would make it less attractive to save in the UK, reducing hot money flows. UK investors would save oversees. The recent fall in the Pound sterling, is due in part to the deterioration of the economy and expectation of lower interest rates. Deflation would imply a serious downturn and interest rates would fall close to 0%. This would have a big impact on reducing demand for sterling.
However, if the UK has falling prices and other countries have inflation, then in theory UK goods will become more competitive and this might increase demand for sterling. If the deflation is caused by increase in competitiveness and better productivity this should increase demand for UK Exports and therefore help sterling rise.
I believe the interest rate factor would outweigh the increased competitiveness though and Pound Sterling would fall.
Benefits of Depreciating Pound
British Exports will become more competitive. However, in the current climate, the fall in the value of the pound has not really helped exports. This suggests that demand is relatively inelastic and also it reflects the slowdown in global growth. In other words despite lower prices of UK exports the demand isn’t really there. However, in theory the depreciating pound should help boost exports and growth
Cost of Depreciating Pound
In theory, the depreciating Pound could cause inflation (rising AD, more expensive imports). However, since the UK is in a recession, inflationary pressures are muted. Readers Questions If so, could there then be a case for the UK joining the Euro (if devaluation meant parity with Euro)?
Generally, university education does offer some external benefits to society. Therefore, there is a justification for the government subsidising higher education. There is also a powerful argument that university education should be free to ensure equality of opportunity. However, just because higher education is beneficial to society doesn’t mean we are obliged to offer unlimited funding. Perhaps society would benefit if the government offered more free training so people could become plumbers, electricians. If we spend billions on free university education there is an opportunity cost of higher taxes or less spending elsewhere. Because so many people go to university, it is unfortunately necessary we need to charge at least some students for higher education. However, I really question whether we need 50% of students to go to university. This is main reason why cost of university education is rising and government are having to use more top up fees.
Today, Mervyn King painted a gloomy picture of the UK economy. He said:
“It’s very difficult to know how long we’ll be in recession. I think we probably are in recession now - 2009 is going to be a difficult year.”
Mervyn King also said inflation was likely to fall below the target of 2% next year, but he admitted the outlook was generally bleak and would not hesitate to cut rates again if necessary. Quotes by Mervyn King from November inflation Report.
The report came out on a day when unemployment rose to an 11 year high of 1.825million. [link] Unemployment is forecast to rise sharply as the economy continues to contract and unemployment often lags 6 months behind changes in economic growth.
The causes of the sharp economic downturn in 2008 are:
Readers Question: discuss the implications of the different definitions of horizontal equity?
I’m afraid I am not familiar with the different definitions of horizontal equity.
Horizontal equity implies that we give the same treatment to people in an identical situation. E.g. if 2 people earn £15,000 they should both pay the same amount of income tax. Therefore, horizontal equity makes sure we don’t have discrimination on the grounds such as race / gender / different types of work.
Vertical Equity: Implies that that people with higher incomes should pay more tax. Vertical equity seeks to tax in a proportional or progressive way - People with more ability to pay should pay more tax.
Horizontal equity is an important starting point for any tax system. Horizontal equity can be consistent with also achieving vertical equity. Horizontal equity is the equal treatment of equals and this is a means for achieving a distribution of tax burdens that is vertically equitable.
Examples, The Poll Tax is an example of a tax that has horizontal equity (everyone pays a lump sum of £500 a year). Mrs Thatcher’s theory was that since everyone had the same access to council services everyone should pay the same tax. However, the poll tax does not meet the criteria for vertical equity. For those on low incomes, the poll tax was a high % of their disposable income. For those on high incomes and more ability to pay it was a low %.
Different Types of Horizontal Equity
I’m afraid I can’t help you out here. You might look at:
Readers Question: What would be opportunity cost of buying a house for £250,000 for a year? Thanks
I’m not sure why you would buy a house for a year. Do you mean buy it for one year and then sell it?
The opportunity cost is next best alternative foregone. So the next best alternative to buying would be renting. If you rent, you will save yourself £250,000 and a likely depreciation in house value, and you will pay rent rather than a mortgage
The opportunity cost of buying a house would be the cost of renting rather than paying a mortgage. If house prices rise, you will lose out on capital appreciation. If house prices fall, you benefit from not losing capital value.
With house prices falling rapidly in the UK, 2009 would not be a good time to buy!
Readers Question: If central bank wants high interest rate to contain inflation, but low interest rates to help exporters then what are the policy instruments available at the same time? If interest rate is the only policy instrument, then would one objective has to be sacrificed for the other?
If the Central bank increased interest rates to reduce inflation, the higher interest rates would cause an appreciation in the pound. This is because the higher rates would attract hot money flows increasing demand for holding sterling. The higher value of the pound would harm exporters because exports would become more expensive.
If the government / Central Bank wished to reduce inflation without causing an appreciation in Sterling, they could use deflationary fiscal policy (higher taxes and lower spending). This would slow economic growth and reduce inflation without causing an appreciation in sterling. It would reduce government borrowing though would be quite unpopular. The government could also implement supply side policies to try improve competitiveness of exports but, at best these would take a long time.
If you just use interest rates, then there is inevitably some conflict between different objectives.
Earlier this year, the main conflict was between inflation and economic growth. The MPC didn’t want to cut interest rates because inflation was above target, but, this high interest rate contributed to a sharp economic slowdown.
Readers Question: What is dependency ratio? How this can be explained in term of ageing population. How is it linked to GDP?
The formula for the dependency ratio is:
Number of Children (0-15) + Number of Pensioners ( > 65 )
—————————————————
Number of Working age 16-65
The dependency ratio measures the economically inactive population compared to the economically active population.
An ageing population means an increase in the number of people over 65 relative to the population. Therefore, the dependency ratio will rise. (In the UK, the dependency ratio is forecast to rise from 0.34 to 0.65 by 2040)
An increase in the dependency ratio, may mean tax as a % of GDP needs to rise to meet the governments spending commitments on health, education and pensions.
Europe’s ageing population is also worsened by the fact that falling birth rates mean a decline in the number of people of working age. However, this impact is slightly offset by - declining number of children and the recent rise in female participation.
