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5.10  Fiscal policy

The fiscal authority rule is set so that the authority targets both the level of public debt to GDP and the rate of change. The fiscal authority has a target for public debt relative to GDP, which is pursued through adjustments in the rate of labour income tax. The fiscal policy rule like the monetary policy rule is forward looking.

(40)    POL1=POL1(-1)+C8001*(PUBDER(8)/ERGDP(8)-PUBDE_EQ(8))+C8002*((PUBDER(9)/ERGDP(9)-RPUBDE_EQ(9))-(PUBDER(8)/ERGDP(8)-RPUBDE_EQ(8))) +C8003*(RPUBDE_EQ-RPUBDE_EQ(-1)),

5.11  Financial Markets

5.11.1Exchange Rate

The determination of the equilibrium real exchange rate has been discussed in section 2.3 on the steady state structure. A common specification of the exchange rate dynamics focuses on using some form of uncovered interest rate parity (UIP) to explain exchange rate deviations from the equilibrium value. However, recent experience with applying such a model to the exchange rate have proved unsuccessful in explaining recent developments in the value of the New Zealand Dollar (King 1998).

The steady state model generates an equilibrium path for the real exchange rate index (ERE) for a given set of real variables such as world prices and technology. The medium-run equilibrium real exchange rate index (RE) is driven by the future deviation between the target and actual foreign debt to GDP ratio and can deviate from its steady value in the medium term.

(41)    RE = (((0.25*ERE+0.25*ERE(-1)*EXP(INF_TAR) +0.25*ERE(-2)*EXP(INF_TAR*2)+0.25*ERE(-3)*EXP(INF_TAR*3)) - 1.2* LDGDPR(4)-1.2*LDGDPR(5)) ),

The following equation shows the adjustment process of the actual real exchange rate index (RER) towards its equilibrium. The assumption of uncovered interest parity continues to hold if the partial adjustment coefficient (C1600) is set to 1.

(42)    RER=(1-C1600)*RER(-1)*EXP(INF_TAR)+C1600*RE*(1+RCS/400-INF) /(1+(RCSFB+RPRCS)/400-INFW)

RCS is the 90-day bill rate and RCSFB is the foreign bill rate. Equation (42) implies that after adjusting for both domestic (INF) and foreign inflation (INFW) and risk premium (RP), the expected return from domestic and foreign 90-day bills are equal. However, the assumption of uncovered interest parity is not imposed in the model.

5.11.2Bond Market

The bond market is modelled using the expectations theory of the term structure of interest rates. This sets the yield on a 10-year bond equal to the expected yield from holding a continuous sequence of 3-month bank bills over the same 10-year period. This would involve a sequence of 40 bank bills, which would add 39 expected future bank bill rates to the model. To avoid this complexity, it is assumed that the 10-year bond rate equals a geometrically declining weighted average of expected future bank bill rates, rather than a simple five-year average. This approximation allows a transformation to be applied which results in the 10-year bond rate, RL, equalling a weighted average of the one quarter-ahead forecast for the 10-year bond rate, RL(1), and the current 3-month bill rate.

(43)    RL = (1 - 0.95).RCS + 0.95.RL(1)

Rational expectations are assumed. Thus new information changes the model forecast for RL(1), causing RL to jump to a new level. The objections and counter-arguments to this approach are the same as for uncovered interest parity. In the forecasting environment, rational expectations are not assumed. Thus a 10-year expected inflation rate, INFE, is needed to convert RL to a real rate. For consistency, the relationship of INFE to the annualised quarterly inflation rate, INF, is the same as the relationship of RL to RCS.

(44)    INFE = (1 - 0.95).INF + 0.95.INFE(1)

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