Monetary policy and the OCR

Part (a) — From the OCR to interest rates

The OCR is the rate at which registered banks borrow from and lend to the Reserve Bank of New Zealand overnight. It is therefore the base cost of funds for the whole banking system.

When the RBNZ lowers the OCR, banks can obtain funds more cheaply. Competition between banks passes this on, so retail interest rates fall — on mortgages, personal loans, business lending and savings accounts.

Two consequences follow:

• Borrowing becomes cheaper, so households and firms take on more debt to buy things.
• Saving becomes less rewarding, so households save less and spend more.

Part (b), Step 1 — Trace the policy through AD

Lower interest rates mean:

• Consumption (C) rises — cheaper credit makes cars, appliances and houses more affordable, and lower mortgage payments leave households with more to spend.
• Investment (I) rises — a lower cost of borrowing makes more capital projects profitable, so firms build and buy equipment.

Because AD = C + I + G + (X − M) and both C and I have risen, AD shifts right to AD₁.

There is a second route: lower New Zealand interest rates make New Zealand assets less attractive to overseas investors, so demand for the $NZ falls and the currency depreciates. That makes exports cheaper overseas, raising export receipts (X), and imports dearer, reducing import payments (M). Net exports rise, shifting AD further right.

Part (b), Step 2 — The large recessionary gap

With a large recessionary gap, equilibrium real GDP Y is a long way left of Yf. There is a great deal of spare capacity: idle factories, unused equipment, and many unemployed workers looking for jobs.

The economy is therefore on the flat section of the AS curve. Firms can meet the extra demand by putting spare resources back to work without having to bid up wages or input prices.

So the rightward shift from AD to AD₁ produces:

• a large increase in real GDP, from Y to a much higher Y₁
• only a small rise in the price level

Because firms need many more workers to produce that much more output, employment rises substantially and unemployment falls a long way. The recessionary gap narrows sharply.

Expansionary monetary policy is highly effective at lowering unemployment here, and it does so with little cost to price stability.

Part (b), Step 3 — The small recessionary gap

With a small recessionary gap, equilibrium real GDP Y is already close to Yf. There is little spare capacity — most machinery is running and most workers who want jobs have them.

The economy is on the steep section of the AS curve. Firms wanting to expand must compete for the same scarce workers and materials, bidding wages and input prices up.

So the same rightward shift from AD to AD₁ produces:

• only a small increase in real GDP
• a large rise in the price level

Because real GDP barely rises, firms hire only a few extra workers, so unemployment falls only slightly.

Expansionary monetary policy is far less effective at lowering unemployment here, and it now threatens the goal of price stability, potentially pushing inflation above the RBNZ's 1–3% band.

Part (b), Step 4 — The comparison and the conclusion

	Large gap	Small gap
Position on AS	Flat section	Steep section
Spare capacity	Plentiful	Little
Effect on real GDP	Large increase	Small increase
Effect on unemployment	Large fall	Small fall
Effect on price level	Small rise	Large rise
Effectiveness on unemployment	High	Low

The same policy, applied with the same force, produces very different results — and the variable that decides it is the amount of spare capacity, shown on the model by how far Y sits from Yf and therefore which section of the AS curve the economy is on.

This is why the RBNZ's judgement about where the economy sits relative to Yf matters more than the size of the OCR change itself.