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A Dynamic Computable General Equilibrium (CGE) Model of the New Zealand Economy - WP 02/07

4  Steady-state model simulation

In this section, we examine some of the properties of the model by simulation analysis. The illustrative simulations presented here identify the new steady-state solution of the model following a shock. These shock experiments are designed to illustrate the properties of the model and the impact of particular calibration decisions on the steady state assumption of the model. The results of the simulation are presented in Table 1.

4.1  A permanent increase in the world price of NZ exports by 1%

In this experiment, we consider a permanent improvement in the terms of trade by raising the world price of New Zealand exports. This permanent shock raises the purchasing power of New Zealand exports and consequently a higher level of imports can be achieved while still maintaining external equilibrium. Consumers benefit from the increase in purchasing power and a larger share of domestic production becomes available for consumers. Higher domestic demand leads to an appreciation of the real exchange rate. Overall, the long-run impact on production of the improvement terms of trade is to raise the desired capital to output ratio as firms benefits from higher export prices. As a result, the domestic productive capacity is increased slightly, by 0.09% at the first quarter and 0.05% by the end of 10 years after the shock.

4.2  A permanent 1% increase in the level of productivity

This shock has no impact on the relative prices of the model and the only long-term consequence is an upward shift in the productive capacity by 1%. As there are no relative price changes, all components of demand for domestic output and the demand for imports rise by 1 %.

Third, there is a negligible change in the income tax rate because government expenditure is set exogenously and grows at the same rate as the private productive sector.

4.3  Lowering the real household financial assets to GDP ratio

In this experiment, the long-run real household financial asset to GDP ratio is decreased from –0.9 to –1.2 (a decline of 0.3). As a result, the foreign debt to GDP ratio is increased by 0.3 from 2.94 to 3.24, reflecting the switch from domestic to foreign savings to finance domestic investment and imports. The increase in foreign liabilities means a higher debt-servicing burden. Hence, the real exchange rate is required to depreciate, leading to an increase in exports and a fall in imports. In the long run, the shock has a negligible impact on the private sector output but the consumption’s share of output is lower in the new equilibrium.

4.4  Reducing the public liability to GDP ratio

In this experiment, the government reduces the public liability to GDP ratio from 30% to 28%. As government spending remains unchanged, a lower debt to GDP ratio implies a lower level of government debt and a lower debt-servicing burden, which in turn leads to a lower income tax rate in the new equilibrium.

Since consumers must hold a lower level of government bonds, households raise their desired level of real assets to compensate for the decrease in their level of holdings of government bonds and therefore financial wealth. The impact of a lower income tax rate raises higher household disposable income which leads to higher consumption. The other adjustment comes through the consumption deflator. In the new equilibrium, the consumption deflator is lower.

4.5  An increase in government consumption and investment by 10%

This simulation illustrates the effects in NZTM of a 10% increase in government consumption and investment. In this simulation the government debt to GDP ratio is held constant. Hence, the increase in government spending is financed by an increase in income tax. As the output of the domestic good remains almost unchanged, fiscal expansion crowds out private consumption of the domestic good and housing services.

The reduction in private demand for consumption goods is induced through two channels. The first channel is through higher taxes lowering disposable income, and hence consumption. The second adjustment comes through lower real assets. With lower consumption of housing services, the housing stock must be lower in the new equilibrium. Therefore, household wealth is also reduced.

Although private sector output remains unchanged, the shock affects total GDP through its impact on the consumption of housing services. As a result, there is a small appreciation of the real exchange rate in response to a lower equilibrium level of foreign debt.

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