Macroeconomic policy and international trade
This domain examines how governments use monetary and fiscal policy to influence the macro objectives, and how international trade and the exchange rate affect New Zealand.
Core rules
- Monetary policy is run by the Reserve Bank of New Zealand. The Remit targets CPI inflation at 1–3% over the medium term, centred on 2%. The OCR is the main instrument; changes transmit to retail interest rates, the exchange rate, spending and inflation, with lags.
- Fiscal policy is government spending and taxation. Automatic stabilisers (tax revenue and welfare spending) cushion the cycle; discretionary policy changes spending or tax rates. Expansionary fiscal policy shifts AD right but may crowd out private investment and worsen the fiscal balance.
- Supply-side policies raise productive capacity: education, infrastructure, R&D and regulatory reform. They affect the trend, not just the cycle.
- Trade: comparative advantage explains gains from specialisation; the terms of trade = export prices ÷ import prices. A tariff raises domestic price, cuts imports, creates deadweight loss and transfers surplus to producers and government.
- Exchange rate: a depreciation makes exports cheaper and imports dearer, improving the trade balance with a lag but raising imported inflation.
Worked example
The RBNZ cuts the OCR from 5.5% to 5.0%. Retail mortgage and business rates fall, raising consumption and investment; AD shifts right. Output and employment rise, but inflationary pressure increases. Because the effect on inflation appears after several quarters, the Bank acts pre-emptively. If the economy is already at capacity, the main result may be higher prices rather than higher real output.
Traps
- Claiming the OCR directly sets all interest rates.
- Ignoring policy lags and capacity constraints.
- Assuming a tariff is paid by the exporting country.
- Confusing a depreciation with a deterioration in the terms of trade; the terms of trade is the ratio of export to import prices.