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Special Topic: Macroeconomic equilibrium in the long run

This month’s special topic uses the Swan framework, first developed by the Australian economist, Trevor Swan, in the 1950s, to revisit the concepts of long-run internal and external equilibrium for the New Zealand economy. [1]


The concept of internal equilibrium relates to an economy that is fully-employed and operating in line with its potential level of activity. This analysis defines internal equilibrium in terms of the level of GDP at any point in time relative to its potential level – the so-called output gap – as opposed to its potential rate of growth. However, this is not a precise concept, particularly given the usual lagging relationship between GDP and employment growth.

The concept of external equilibrium relates to when the current account is equal to its desired long-run position. Where this lies depends on your view of a country’s ‘sustainable’ long-run net international investment position (NIIP) and its long-run rate of nominal GDP growth. Table 1 shows indicative long-run levels of the NIIP under different assumptions of nominal GDP growth and the current account.[2] For example, a current account deficit in the region of 4% of GDP is consistent with ultimately stabilising New Zealand’s NIIP in the region of -90% of GDP in the long run. By contrast, a current account deficit of around 3% of GDP is consistent with eventually stabilising the NIIP broadly in line with its present level of around -70% of GDP. The latter is the measure used in the rest of this special topic.

Table 1 – Indicative long-run NIIP positions under different long-run economic assumptions
(% of GDP, abstracting from valuation changes)[3]
  Nominal GDP growth (annual % change)
  4.0% 4.5% 5.0%

Current account balance
(% of GDP)

0 0 0 0
-1 -26 -23 -21
-2 -52 -46 -42
-3 -78 -70 -63
-4 -104 -93 -84
-5 -130 -116 -105

Source: The Treasury

The Swan framework

Figure 9 illustrates the standard Swan framework, dictated by the external and internal equilibrium lines. The intuition behind the former is that the lower a country’s real exchange rate, the more attractive its exports to overseas buyers and the stronger its external position. Accordingly, to help maintain external equilibrium, more domestic demand is needed to boost imports and to bring the external side back into shape. Hence the downward slope of the external equilibrium line.

The intuition is the opposite for the internal equilibrium line: the stronger the level of domestic demand, the higher the exchange rate needed to restrain net exports to prevent the economy overheating (i.e., operating ahead of its potential level).[4] The interaction of domestic demand and the real exchange rate determines which one of the four regions in Figure 9 an economy is operating in at any point in time.

Figure 9 – Swan framework for New Zealand (note that each position of the economy in the diagram is stylised)
Figure 9 – Swan framework for New Zealand (note that each position of the economy in the diagram is stylised).
Source: The Treasury

Recent developments in the New Zealand economy

While highly stylised, the Swan framework can be used to illustrate recent trends in the New Zealand economy and how the Treasury’s forecasts relate to internal and external equilibrium.

In the four-year period prior to the global financial crisis, the New Zealand economy was operating in region A of Figure 9, represented by marker 1. During this period, the current account deficit averaged in the region of 7% of GDP – wider than that consistent with external equilibrium for New Zealand in the long run. Meanwhile, the positive output gap and tight labour market were consistent with the economy operating above its potential level.

Following the recession in the aftermath of the global financial crisis, the economy shifted into region C (represented by marker 2). The real exchange rate fell and the current account balance improved markedly. The current account deficit is now estimated to have averaged 2.1% of GDP between mid-2009 and the end of 2010 – narrower than the notion of external equilibrium mentioned earlier, hence the position to the left of the external equilibrium line. As a negative output gap opened up and conditions in the labour market weakened, the economy shifted to the left of the internal equilibrium line too.

The recovery in domestic demand and the rise in the real exchange rate over recent years have seen the economy move up and to the right somewhere in region B (marker 3 – very much stylised). Following recent revisions, the current account deficit is expected to remain in the region of 3-4% of GDP in the near term, consistent with stabilising net external liabilities in the region of 70-80% of GDP in the long run. While the output gap is estimated to be largely closed, the usual lagging relationship with job creation means that the unemployment rate remains higher than that consistent with internal equilibrium.

Outlook for the forecast period

The economy is expected to shift further to the right of the diagram over the course of the forecast period as domestic demand increases. In terms of dynamics, it will move back into region A for a few years as a positive output gap opens up, before settling to a point on the internal equilibrium line by the end of the forecast period (marker 4). Note that it is standard practice for the Treasury’s forecasts to achieve internal equilibrium by the end of the forecast period, because it is assumed that monetary policy is effective in ensuring that the economy operates at full capacity by the end of the five-year forecast horizon.

Following the revisions to the current account in the 2013 National Accounts, all else being equal we expect the current account deficit to widen to around 6% of GDP at the end of the forecast period, compared to around 6.5% of GDP in the Half Year Update (HYEFU)forecasts. Crucially, however, this would still be wider than the concept of long-run external equilibrium for New Zealand, hence the position of the grey marker 4 to the right of the external equilibrium line. Excluding the Canterbury rebuild-related investment that is expected to take place over the forecast period points to a narrower ‘underlying’ current account deficit of around 4-4.5% of GDP at the end of the forecast period (represented by the blue marker 4).[5] This is closer to being in external equilibrium than the headline forecast, but would still be wider than that consistent with stabilising the NIIP in line with its present level in the long run.

Further macroeconomic adjustment beyond the forecast horizon

The assumed depreciation in the (real) exchange rate towards the end of the Treasury’s forecast period is expected to begin to stimulate activity in the exchange rate-sensitive parts of the economy, such as the services and non-commodity export sectors. Given the lags between changes in relative prices (i.e., the exchange rate) and changes in economic agents’ behaviour, this process is expected to continue beyond the end of the forecast period as well.

However, based on the Treasury’s HYEFU forecasts, further macroeconomic adjustment outside the forecast period is likely in order to achieve external equilibrium in the long run. Based on the Swan framework, this involves a combination of a lower real exchange rate to further bolster activity in the exchange rate-sensitive sectors, as well as weaker domestic demand (i.e., higher national saving) to shift closer to the centre of the diagram.

Conclusions supported by international research

Of course, this conclusion stems directly from the Treasury’s forecast for the current account deficit to widen from its current level over the coming five years or so. However, the prognosis is supported by international forecasters, most notably the International Monetary Fund (IMF), who expect the current account deficit to widen by a similar extent over the same period.[6]

The IMF’s forecasts are used as a direct input into the Peterson Institute’s bi-annual update of global equilibrium exchange rates, which employs a similar, macroeconomic balance-style framework to that of the Swan framework explained above.[7] Given that the Peterson Institute specify a long-run ‘target’ current account deficit for New Zealand of 3% of GDP, the latest update from November 2013 concludes that the New Zealand dollar remains significantly overvalued.


  • [1]The concept of macroeconomic equilibrium has been discussed in a number of Treasury working papers in recent years, including: Cassino and Oxley, How Does the Exchange Rate Affect the Real Economy? A Literature Survey, WP13/26, December 2013; and Labuschagne and Vowles, Why are Real Interest Rates in New Zealand so High? Evidence and Drivers, WP10/09, December 2010.
  • [2]For further discussion of this relationship in the long run, see Sebastian Edwards’ paper, External imbalances in New Zealand, presented at a joint Treasury/Reserve Bank workshop in 2006:
  • [3]The long-run relationship is given by the equation:
    NIIP = CA(1+n)/n
    where NIIP and CA are the long-run NIIP and current account positions expressed as a % of GDP, and n is nominal GDP growth.
  • [4]For further discussion of the workings of the Swan diagram, see: Temin, Peter, Currency Crises from Andrew Jackson to Angela Merkel, MIT Department of Economics Working Paper No. 13-07, February 2013.
  • [5] Note, however, that this should not be considered a forecast or a counterfactual of what would have happened to the current account in the absence of the earthquakes.
  • [6] See the IMF’s World Economic Outlook Database, October 2013:
  • [7] For the latest release from November 2013, see:
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