ELASTICITY OF SPARE CAPACITY

As capacity is exhausted, Reserve Bank
governor Don Brash gets twitchy about inflationary implications and raises interest rates.
The first rise in the official cash rate this year was announced on January 19, then Brash explained that both the domestic and world economies were growing strongly. “Strong growth is gradually using up spare capacity in the economy,” he said. As this happened, he had to ease back on the degree to which monetary policy was stimulating the economy to avoid inflation pressures building.
The monetary policy statement on March 17 raised the OCR another notch. The economy had been growing since mid-1998, helped by very stimulatory monetary conditions, Brash pointed out then. For all of that period there had been surplus capacity in the economy; it had contributed to the generally low inflation of the past year or so. “But we estimate that the surplus capacity has now been largely exhausted,” Brash said.
A week later, he addressed the Auckland Chamber of Commerce on “Will the Reserve Bank choke the recovery?”
The short answer was “no”, but Brash elaborated on the bank’s thinking about spare capacity and the relationship between inflation and growth. This, he said, went “to the heart of monetary policy decision-making”.
Actually, it was variant of text-book argument, taught in stage one economics at Victoria University. Basically, NZ has good climate, we can grow grass, we have capable work force, we have machines, we have factories and we have some managerial ability.
This capacity mix can generate certain sustainable rate of GDP growth, without blowing the inflationary fuses. But it’s the best we can do, no matter what side of the bed the minister of finance climbs out of tomorrow. It’s Brash’s job to make sure we don’t stray too far from that sustainable pace of growth.
Copies of Brash’s speech included an illustration of the argument in the form of simple graph. It featured straight line from to B, representing the economy’s capacity to deliver goods and services at steady pace of growth without inflation. This is the trend line. In practice it varies, depending on raft of factors such as changes in net migration.
A second line represented demand. Sometimes it falls short of the economy’s capacity, the economy can then grow rapidly while inflation is low or falling. When demand exceeds capacity, the economy can grow very slowly or shrink while inflation rises.
The Reserve Bank estimates sustainable growth rate for our economy is around three percent. When growth slips below three percent Brash can ease monetary conditions to fuel an acceleration. When it rises he must ease up on the accelerator and/or slam on the brakes.
Not all economists share this view of how the economy works.
“The economy is an interdependent animal, not set of mutually exclusive phenomena,” BERL economist Ganesh Nana contends.
He explains: business leaders are being conditioned by Brash’s management to expect the good growth they enjoy for few years to be slowed before it gets too strong. They believe recovery in their profitability will be eroded by rising interest rates, or an export-hostile exchange rate, so they’ll defer investing each time monetary policy is tightened because capacity is exhausted.
But if they don’t invest, how can the economy get more capacity and without new capacity how can it increase growth?
Brash holds the line by ensuring inflation doesn’t move too far from l.5 percent annually, around the mid-point of his 0-3 percent policy target. Nana advocates keeping conditions easy by letting inflation go higher than l.5 percent. When the economy grows more than three percent, people will invest in new machines, train to use them, and our economic growth could rise to 3.5 percent or more.
This model, too, is taught in first-year economics.
Whether higher borrowing costs and the resultant slowing of economic activity leads to more or less capital investment, and therefore to greater or lesser inclination by business people to build more economic capacity, is very much moot point.

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