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.”
And finally:
“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:
(1) M=A*-F
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.
PS The Christensen family will be cheering for Anton Cooper at the Mountain bike World XCO Championships in Austria in the coming week!
Related posts:
Policy coordination, game theory and the Sumner Critique
The fiscal cliff and why fiscal conservatives should endorse NGDP targeting
The Bundesbank demonstrated the Sumner critique in 1991-92
The Market Monetarist 
Robert
/ August 30, 2012It is intriguing to know that New Zealand is actually implementing the Sumner Critique – which is by far not true for every inflation-targeting country, the Hungarian Central Bank f.e. claims that “controlling inflation can’t be the responsibility of only the central bank” and “un-coordinated fiscal and monetary policies will cause such distortions that deflation would become socially unaccomplishable.”
Of course, NZ was always a pioneer of monetary policy – they were the ones who invented inflation targeting in the first place, which has by now became the dominant monetary regime. (I did a map of monetary regimes on my blog, it’s probably worth checking out for the sake of visualization). It’s good to know that this tradition of innovation is still there, and of course, go Cooper 🙂
Lars Christensen
/ August 31, 2012Robert…thanks for the comments. Excellent map on your blog.
Where did you find that quote from the Hungarian central bank? If you look at the policy mix in Hungary over the past decade it is actually as if the opposite is the case. Real interest rates much higher than in other Central and Eastern European countries and the Hungarian government have been running large public deficits for years. Furthermore, I don’t remember at anytime over the past decade that the Hungarian government and the central bank in anyway have coordinated economic policy. In fact it seems like there is a more or less permanent war of words between the two institutions. But nonetheless it is a very interesting quote you have find and I am surely interested in digging more into that. After all I do follow Hungarian monetary policy very closely in my day job…
Robert
/ August 31, 2012My source was not relevant enough, I found it in an educational paper published on the webpage of the MNB so it it merely theoretical, nonetheless it was written under Andras Simor who never exactly had a peaceful relationship with the current government. (It may be an indication of wish for cooperation, though.)
About the war of words between the institutions, in my opinion it can be attributied to the difference between central bank term lengths and government term lengths – the former is 6, the latter is 4, so the overlapping two years usually mean conflicts between a right-wing central banker and a left-wing government (Zsigmond Jarai), or vice versa (Andras Simor). Unfortunately, independent governmental institutions don’t have a long enough tradition to either choose bipartisan candidates or choose candidates without a history of political alignation. (Mr Jarai was a finance minister; Mr Simor was a head consultant to the Mr Gyurcsany)
However, the war probably subsided for now, given the fact that Mr Orban at least temporarily backed off with his threats regarding central bank independence. (Word is, he wished to use it’s foreign currency stocks to finance deficit.) The current base rate decrease of 0.25% to revive the recession-striked economy is probably a sign of this, given the fact that the markets didn’t expect the move – nonetheless, it actually serves as a living presentation of the Sumner Critique (fiscal policy was tight this year), so it seems after all that I was mistaken, and Hungary does implements it, even though not explicitly stated so.
Alex Salter
/ August 30, 2012It sounds like they’re out for price stability, so they’re still vulnerable to supply shocks. Still, and explicit nominal anchor is better than no anchor at all. Hurray for taking expectations seriously!
Lars Christensen
/ August 31, 2012Robert,
I agree with your assessment of modern Hungary monetary policy and the lack of coordination between monetary and fiscal policy.
Anyway I have to brag a bit. Somebody did see this week’s rate cut coming. See here: http://danskeresearch.danskebank.com/link/FlashCommentHungaryRateDecision280812/$file/FlashComment_HungaryRateDecision_280812.pdf
And here: http://danskeresearch.danskebank.com/link/EMEAWeeklyweek35230812/$file/EMEAWeekly_week35_230812.pdf
Actually I come to think that the way the Sumner Critique works in Hungary is probably not through a focus on the budget deficit, but rather on the current account deficit. If the current account deficit worsens the MNB will tend to be more or hawkish. If the government ease fiscal policy the current account deficit will tend to increase and that will push the MNB in a more hawkish direction. I think this is particularly was the case 6-7 years ago when Hungary had a near 10% of GDP C/A deficit.
schoolonomic
/ August 31, 2012Now that I think of it, certain members of the monetary council have been proposing a rate decrease for a while (the council reports can be found at http://bit.ly/PUhHui , they are written in Hungarian but the vote counts at the end are understandable). In my opinion, the focus of the MNB on current account as opposed to budget is a consequence of the lack of a long-term concept of fiscal policy (They simply can’t adjust for budget, given the fact that there is no such a thing as a stable budget) – which as you argued in your post on Monetary disorder in Central Europe, is a symptom of “regime uncertainty” itself.
PoorRicardo
/ September 1, 2012Hi Lars,
Interesting post, and good to see at least one world central bank has it’s head screwed on right.
I still think the Sumner critique breaks down when interest rates hit zero and central banks become overly cautious about using unconventional monetary policy to offset fiscal tightening – as you surely must agree has happened in the UK, for example (plus the US and Europe).
The first-best answer must be for central banks to do their jobs properly. Given the absence of sufficient monetary easing however, is the second-best answer not to relax fiscal policy?