We have family from New Zealand visiting us in Denmark these days so I have been paying a bit more attention to the Kiwi economy than I normally would – and particularly to Kiwi monetary policy.
As I was going through the Reserve Bank of New Zealand’s (RBNZ) website I came across an interesting note on “Fiscal and Monetary Coordination” – a topic, which I have been giving a bit of attention to recently (See an overview of related posts below).
In the note it says:
“the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”
And further it says:
“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”
“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”
What does that mean? Well, first of all the RBNZ is playing a game (in a game theoretical sense) against the fiscal authorities (the NZ government). This is an non-cooperative game and the government is the Stackelberg leader – first the government decides on the level of public spending (and thereby its “contribution” to aggregate demand in the economy). The RBNZ then sets monetary policy “taking fiscal policy into account” to hits the level of aggregate demand that will ensure the RBNZ fulfilling its inflation target. In the note this is called coordination of economic policy. However, that is not entirely correct. The RBNZ (alone!) determines the level of aggregate demand in the NZ economy, while the government determines the budget surplus/deficit and the level of public spending given what the RBNZ already have decided will be the level of aggregate demand.
This is exactly one of the games that Nick Rowe and Simon Power discuss in their 1998 paper on “Independent Central Banks: Coordination Problems and Budget Deficits”. Nick and Simon conclude about the game described above:
“(The) (c)entral Bank achieves its target level of aggregate demand exactly – there has been no compromise between the two aggregate demand targets (the government’s and the central bank’s), while with respect to fiscal policy, upon which (the government) and (the) (c)entral Bank agree, the end result is more expansionary than desired (and has been exactly offset by a contractionary monetary policy in order to attain the (c)entral bank’s target for aggegate demand).”
Hence, it is the central bank alone that determines the level of aggregate demand in the economy – or nominal GDP. The RBNZ reaches the same conclusion as the quote above demonstrates (“ if the government increases its net spending…monetary policy needs to be tighter …so as to slow growth of private demand and “make room” for the additional government spending.”). Here the RBNZ basically acknowledges that it has the following reaction function:
Where M is the “monetary instrument” and A* is the central bank’s target for aggregate demand (NGDP) and F is the “fiscal instrument” (in Nick’s and Simon’s paper this is equation 4). It is very clear from (1) that if government spending is increased to increase aggregate demand then the RBNZ will counteract that one-to-one. This is of course the Sumner Critique – the government cannot increase aggregate demand (NGDP) if the central bank will not play along (assuming quite realistically that the government is the Stackelberg leader).
Said in another way the RBNZ’s note demonstrates that the Sumner Critique so to speak is official policy for the RBNZ. There is absolutely nothing controversial about this as it follows directly from the RBNZ being an inflation targeting central bank. However, it do lend support to Scott Sumner’s view that the fiscal multiplier is zero under for example inflation targeting (or NGDP level targeting for that matter) – and this will be the case even in an economy, which is keynesian in nature.