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5.5  Exports

In a small country like New Zealand, it is reasonable to assume that New Zealand is a price-taker in the markets for our exports. Export volumes respond to a change the relative price of exports. Therefore, a change in world growth affect exports through its impact on the foreign price for exports. The other prices that affect the supply of exports are the prices of production inputs, wages and import prices. Export supply increases in response to lower wages and import prices.

From the production block the model generates a path of medium-run equilibrium solution for export supply (EXRSR). These medium-run solutions represent the optimising or neoclassical solution from the production block. Total export supply (TEXRS) adjusts to equilibrium supply (EXRSR) in a partial adjustment model.

(28)    LOG(TEXPS)=C1101*LOG(GR*EXP(-1*π2 /4)*EXRSR(-1))+(1-C1101)*LOG(GR*EXP(-1*π2 /4)*TEXPS(-1))+Z_TEXPS,

where GR-1 is the natural rate of growth of the economy. π2 is a trend growth rate that captures changes in import penetration and a more open economy. The production of total exports is then disaggregated into commodities (CEXPS) and other exports (NCEXPS) where commodities are at constant share of total export supplies

5.6  Imports

The dynamic structure of the import equation is also formulated as a partial adjustment model. The production block also determines equilibrium imports in the dynamic model. Since imports are considered to be an intermediate input, higher wages leads to an increase in imports as firms substitute imports for labour.

Actual imports (IM) adjust to equilibrium imports (IMSR) according to the following partial adjustment model.

(29)    LOG(IM)= C0902*LOG(GR*EXP(-1*π1 /4)*IMSR(-1)) +(1-C0902)*LOG(GR*EXP(-1*π1 /4)*IM(-1))+Z_IM,

5.7  Labour market

5.7.1  Employment

Actual business sector employment (NT-NGG) is the difference between total employment (NT) and government sector employment (NGG), and adjusts to equilibrium employment (NSR), which is derived from the production block in a partial adjustment model. The coefficient of C1001, which can be interpreted as the speed of adjustment to equilibrium, is imposed at 0.15. This is marginally slower than recent empirical estimates; see for example Gardiner (2001).

(30)    LOG (NT-NGG) = (C1001*LOG) (NSR(-1))*EXP(POPGR_EQ)) + (1-C1001)*LOG((NT(-1) - NGG(-1))*EXP(POPGR_EQ))) + Z_NT,

Having modelled business employment (NT-NGG), total employment is obtained by adding general government employment (NGG), which is treated as an exogenous policy variable.

5.7.2  Labour Force

The labour force participation rate is the ratio of the labour force to the population aged 15 years and over.

(31)    PARTT= C2001*PARTT(-1)+C2002*(PARTT_EQ)+C2003*(NAIRU(-1)-URT(-1)),

For the purposes of the participation rate equation, the population aged 15 years and over is measured using demographic data sources. This is to ensure consistency with the age-specific population effects appearing in the rest of the model. However, official data for the participation rate (PARTT) uses a different measure of the population aged 15 years and over. To match this official definition, an equation for PARTT is included in which the appropriate scaling factor (RPOP3) is applied to correct the demographic sources estimate of the population aged 15 years and over.

(32)    PARTT = 100.NTS/(RPOP3.(POP3 + POP4))

A further equation appears for the trend growth rate of the working age population, POPGR_EQ. In the long run, the participation rate is assumed to stabilise, and growth in the working age population determines growth in the labour force which in turn is part of the sustainable growth rate of real output, GR-1.

(33)    POPGR_EQ = ΔLOG(POP3_EQ + POP4_EQ)

Using total employment (NT), and the labour force (NTS), which is derived form the above specification of the participation rate (PARTT), unemployment (NUN) and the unemployment rate (URT) and can be calculated.

(34)    NUN = NTS – NT

(35)    URT = 100.(1 - NT/NTS)

5.7.3  Wages

The wage equation is an inflation expectations augmented Phillips Curve.

(36)    (1+INF_WA)=EXP(INFE(-1))*(C0301*A1(-3)/A1(-4)+C0302*A1(-4)/A1(-5) +C0303*A1(-5)/A1(-6)+C0304*A1(-6)/A1(-7))-C0305*(URT(-2)-NAIRU)+C0306*LOG(ERWA(-2)/RWA(-2))+C0307*LOG(RPYDMR(-1))+Z_W,

Wage inflation is determined by backward-looking expectations of inflation, lagged productivity growth and excess demand pressures in the labour market as measured through deviations of the actual unemployment rate from its equilibrium value. The equation also includes the medium-run variable, RPYDMR, which proxies the profitability of firms. Finally, the equilibrium real wage (ERWA) derived from the production block provides a long-run anchor for the equation.

5.8  Inflation

Inflation can diverge from the target rate of 1.5% per annum as a result of three influences. The first concerns the degree of excess demand. This is measured by the output gap, which has become a popular way to model inflationary pressures. In this framework, inflation will deviate from the monetary authority’s target rate when demand pressures deviate from the economy’s potential to supply. Potential output is unobservable and therefore needs to be calculated. As mentioned before in the steady state model, the estimate of potential is based on the estimated production function.

Inflation can also deviate from its target rate through inflation expectations. Inflation expectations are formed as a mixture of both forward and contemporaneous inflation.

Changes in mark-ups will also influence inflation. The coefficient of RPYDMR is relatively small so that less weight is placed on this channel in the model.

The following autoregressive specification recognises the persistence of inflation.

(37)    (INF_PYD-INF_TAR)=C1204*(C1205*(INFE(-1)-INF_TAR)+(1-C1205)*(INF_PYD(-1)-INF_TAR))+(1-C1204)*(C1206*LGAP(-1)+C1207*LGAP(-2)+C1208*LGAP(-3)+C1209*LOG(RPYDMR(-1))),

The measure of inflation targeted by the monetary authority is the growth rate of the Consumer Price Index (CPI), which is represented by the following equation:

(38)    INF=((1-(SHARE/(1+SHARE)))*(INF_PYD)+ (SHARE/(1+SHARE))*(INF_PCONH))

where INF_PCONH is the inflation of housing services and share is the ratio of housing services expenditure to other consumption. Therefore, both the price deflator for YD and the price deflator for housing services are the main ingredient determining the CPI index.

5.9  Monetary policy

In the model, the central bank adjusts short-term interest rates to achieve an inflation target of 1.5% per annum. The reaction function is forward looking with the monetary authority targeting deviations of annual inflation from the target rate over a 5 to 7 quarter horizon. Equal weight is placed on these target quarters.

(39)    RCS=(C5001*(INF_CPIX(5)-CPI_TAR)+C5002*(INF_CPIX(6)-CPI_TAR)+C5003*(INF_CPIX(7)-CPI_TAR)-C5004*(RCS-RCS(-1))+RL),

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