Inflation

In our discussion of inflation, we looked at why inflation is bad, why deflation is bad and the difference between deflation and disinflation. We looked at the policy tool available to the NZ government (the Official Cash Rate) and how and why this is used. We discovered that the OCR is the Reserve Bank's way of influencing interest rates, which in turn affect spending decisions. When people spend a lot, this puts upward pressure on prices. When people cut back on spending, this puts downward pressure on prices. Remember that aggregate demand is really just C+I+G+(X-M). The OCR is used to try and keep the rate of inflation between 1% and 3% (the target band) but it is an imprecise science! Why is that? Because it works like this: 

Example of the chain of events when the RB increases the OCR:

• The OCR is the interest rate that the Reserve Bank charges commercial banks (the banks businesses and ordinary people use) on their settlement accounts (the accounts that commercial banks have with the Reserve Bank - yes, they do their own banking!).
• When the Reserve Bank increases the OCR, commercial banks borrow less through their settlement accounts and, therefore, have less money available to lend out to the market (at this stage in the process we are referring to the money supply, i.e. the money supply is the amount of money in circulation, not what is in the Reserve Bank).
• If commercial banks have less available to lend out but are still facing the same demand from consumers and businesses, they will need to increase interest rates until the demand for money decreases to the same level as the newly reduced supply of money.
• When consumers and businesses see that interest rates have increased, they will be less interested in borrowing (reduced demand for money) and, of course, if they don't borrow as much they will have to reduce spending.
• When consumers reduce spending, we see this as a decrease in C (the consumer spending component of aggregate demand); and, when businesses reduce spending, we see this as a decrease in I (the investment component of aggregate demand). So, aggregate demand shifts left, resulting in a decrease in real GDP as well as a decrease in the general price level.