Academic journal article The Reserve Bank of New Zealand Bulletin

Monetary Policy Strategy in New Zealand

Academic journal article The Reserve Bank of New Zealand Bulletin

Monetary Policy Strategy in New Zealand

Article excerpt

1 Introduction

Monetary policy is a crucial part of New Zealand's macroeconomic framework. Sound monetary policy can make a significant contribution to the wellbeing of New Zealanders by maintaining price stability and dampening cycles in output and employment. But achieving these outcomes is not straightforward. Economic conditions are constantly evolving, and monetary policy decision makers must make complex choices in a timely and consistent manner. These decisions involve trade-offs between multiple objectives. Furthermore, such decisions must be made under uncertainty about the state and structure of the economy and the transmission of policy. A clear and effective strategy can help decision makers to connect appropriate policy actions to the state of the economy. In turn, providing a clear strategy promotes effective communication to the public, which increases the likelihood that the goals of monetary policy are achieved.

On 1 April 2019, amendments to the Reserve Bank of New Zealand Act 1989 (the Act) came into effect, establishing a formal Monetary Policy Committee (MPC) in New Zealand. (1) The MPC has ownership over monetary policy strategy, which encompasses how the MPC plans to meet the objectives of monetary policy under different economic circumstances. The amendments also saw the addition of an employment objective to the Reserve Bank's long-standing price stability objective. Given these changes to the monetary policy framework, it is timely to take stock of how the Bank thinks about monetary policy strategy.

The analysis in this Bulletin has fed into the briefing materials prepared for the new MPC, in particular 'Chapter 7: Monetary policy strategy' in the Monetary Policy Handbook (RBNZ, 2019b). Chapter 7 of the handbook provides a framework for considering the components of effective strategy and discusses the Reserve Bank's strategy in terms of that framework. The framework is based on the literature on strategy and monetary policy, the Bank's experience of setting monetary policy, and the approach of other central banks, which are explored in more depth in this Bulletin.

Section 2 of this article sets out the components of an effective strategy. Sections 3 to 5 explore these components in detail in the context of monetary policy. Section 3 explains the objectives of monetary policy. Section 4 discusses how monetary policy strategy in New Zealand is conducted under different economic circumstances to achieve the policy objectives laid out in section 3. Section 5 describes how a monetary policy strategy is implemented in practice, in terms of judging the appropriate stance of monetary policy and deciding on tactical options for achieving that stance. It also illustrates how the Reserve Bank has implemented its strategy in practice using historical examples. Section 6 concludes.

2 Components of an effective strategy

The MPC is tasked with making monetary policy decisions to achieve a set of economic objectives. A critical part of making monetary policy decisions is deciding which strategy to follow.

The term 'strategy' is commonplace in economic theory. Mas-Colell, Whinston and Green (1995, p. 228) define a strategy to be "a complete contingent plan, or decision rule that specifies how a player [a decision maker] will act in every possible distinguishable circumstance". In dynamic macroeconomics, which concerns itself with decision making across time, these contingent plans are commonly called 'policy functions'. (2) In monetary economics, plans such as these are often referred to as 'reaction functions', since the decision maker chooses actions or policies in reaction to the economic environment and outlook that they confront. (3) Reaction functions can be described by 'policy rules', such as the eponymous rule of Taylor (1993), which describes how an interest rate should be set based on a limited set of macroeconomic variables. In practice, monetary policy strategies embody flexibility, since it can be difficult to anticipate all the circumstances that might be faced, and thus difficult to establish all the possible actions that might be taken. …

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