The visible hand in economics

Outgrowing the inflation problem

Posted on: August 23, 2007

In this article, Rod Oram discusses the two options he sees for battling inflation:

  1. Raise interest rates to slow growth, thereby reducing the pressure on our limited resources.
  2. Increase the resource base

Both of these ‘strategies’ would reduce inflationary pressure. One would reduce aggregate demand; the other would increase aggregate supply.

The first strategy is what NZ is doing (and most countries try to do when inflation comes out of the bag). The second ‘strategy’ would be preferable, as it would increase the number of goods we can buy as a nation. However, Rod didn’t tell us how we are supposed to increase our resource base. According to him we can ‘grow it’, so as the economy is growing the resource base will magically grow as well.

I don’t agree with this idea, but I’m going to try and rationalize what he is saying, and then say why I think it won’t work. Many people have been saying that if we had lower interest rates, investment would be greater, which is an increase in our resource base. As a result, this may be his solution, lower interest rates increase investment, which increases aggregate supply. The problem is, if we kept interest rates at a lower level, we are implicitly allowing a greater level of money supply growth into the economy, which will in turn cause upward pressure on inflation. Which effect dominates depends on the productivity of new capital investment, as if new capital is very productive then the increase in resources requires an increase in the money supply for prices to remain constant.

New Zealand currently has relatively low capital productivity (capital productivity has only risen 1.2% in the last 10 years), and at the margin, this level of productivity will be even lower. This implies that any increase in the supply of resources from a lower interest rate will be very small, and as a result inflationary pressures will be strong.

Furthermore, when a firm makes a long-run investment decision what matters is the long run (risk adjusted) cost and benefit of that investment. In this case the short-term interest rate is not of importance, it is the long-run rate of interest that matters (as interest rate changes can be insured against). Uncertainty for the firms investment decision comes from issues of price, if the level of inflation is high there will be significant volatility between the price of goods (as prices would change at different discrete time periods) making the return on the investment more volatile than in a low inflation environment. As firms are risk averse, higher inflation will lead to lower long run investment – implying that trying to grow our way out of inflation will not work.

8 Responses to "Outgrowing the inflation problem"

I agree that if we could just biff some fertiliser at the economy to grow it then that would be the best way to overcome inflation. It would also make us a world leader in economic growth. Unfortunately, economics is full of trade-offs, and this is one of them: in the short-run we can trade off inflation against growth, but in the long-run the higher inflation comes back to bite us.

Rod Oram is a dipshit of the highest order. Another of the brainless socialists who think that you need to kill the economy to improve our standard of living. Has he not noticed how far we have slipped behind the reat of the real world under a regime of ‘high interest rates’?

Rodney Hide actually has the right idea. (No I’m not an Actoid. A Gnat actually) The best way to kill off inflation is to increase our growth rate by producing more real goods and services and less public servants.

In a sense what you are saying is the same as what Rod Oram is saying, if we could produce more, there would be less of an inflation problem. And I agree, if there were more goods and services, prices wouldn’t be driven up as quickly.

However, I don’t think that firing a few civil servants or keeping interest rates so low that inflation goes through the roof are solutions to increasing NZs productive capacity. A low inflation environment is what we need to promote investment, and at the moment that requires having high interest rates. Trust me, other countries will be stuck under the pressure of high interest rates in a few years, and they’ll be complaining just like we have been.


How accurate are our CPI and inflation statistics anyway? Are they manipulated to the extent that such statistics are in the United States as revealed by the shadowstats website? I honestly wouldn’t put it past the Labour government. Thats coming from someone who voted for them.

Besides I think its an exercise in futility for the government to try and mitigate the effects of inflation, because the causes for it are beyond their control. The causes are the strong growth in commodity consumption due to the rapid economic development of China and India.

The unintended consequence of the manipulation of by the Reserve Bank as it absolves private enterprise of the need to increase their resource productivity (which would be more beneficial longterm) as they can rely on the Reserve Bank to do that job for them e.g. controlling prices.

Weren’t imports meant to be a supplement to domestic production, rather than a substitution, so as to mitigate the chances of inflation?

As for solution to improve the productive capacity of this country, how about radical reform of our education system (English Tripartite School System), targetted funding of tertiary education to alleviate our current skill shortage. A precedent of the success of this is Ireland in the 90s, the issuing of municipal bonds to make up for two decades of chronic underinvestment in our infrastructure (telecommunications, power, water, sewage, transport etc), reform of our tax policy (accelerated depreciation, taxshifting etc), and a radical rethink regarding local and central government resource use regulations (MUL).

What do you think of this proposal Matt?

“One possible solution is to turn each state road system into a non-profit corporation funded entirely from tolls not taxes. The stockholders in the corporation would be the road users. They elect a board to run the roads and determine road spending and tolls. Funds can not be diverted to other vanity projects since all funding belongs only to the road corporation. And the only source for funding would be the tolls not taxes subject to political control.”

I though of a similar concept awhile ago that I thought would be perfectly suited to our healthsystem, which you must admit is in drastic need of reform.

“The causes are the strong growth in commodity consumption due to the rapid economic development of China and India.”

I think the local labour market has a significant impact as well. Housing as well.

The Reserve Bank doesnt control prices. I dont see how they increase the resource productivity of private enterprises.

“Weren’t imports meant to be a supplement to domestic production, rather than a substitution, so as to mitigate the chances of inflation?”

Tradeable inflation is running about 1.2% (???), non-tradeable inflation is running at over 4% for the year. So I reckon imports are dampening the overall inflation.

In the US thy have municipal bonds which are sold for a specific use and sometimes will have their payments coming from that use. For example, a bond will be issued for a new highway, that highway is tolled, the tolls are used to pay the bonds. This is all set in stone before the bonds are issued.

JamesE, I’m pretty confident that Statistics NZ is objective, I’m willing to trust there stats above anything other stats that appear.

Blaming China and India for our inflation doesn’t really work. I agree that soft commodity prices are rising as a result of them, however the world price of manufactured goods is falling. The main factor driving the rise in the general price level is short run demand, which is a factor of the tight labour market and strong house prices.

Furthermore, Kimble is right about the tradeable business, the price of imports is helping us out. Furthermore, since we don’t make everything in this country, some imports have to substitute domestic production (eg Cars).

If our labour force was more skilled, they would all go overseas 😉 . I don’t think our education system is a dead duck. If people want to train, they have the opportunity, they just have to do it. Tax is a complicated issue, I think we should have toll roads, but I don’t think they should be our only tax. If we could fund everything through correction taxes that would be awesome, but we can’t. So we need either some GST or income tax.

[…] where we could grow, rather than attacking monetary policy as he did in the first article, which we wrote about.  However, I don’t believe that he has shown that all things constant higher growth leads to […]

[…] random economist had a more sensible argument, one that Rod Oram is a fan of. According to Kiwiblog it took the […]

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