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

6  The dynamic properties of the model

In this section, we describe the dynamic properties of the model by presenting the results of seven shocks. The first three shocks describe the mechanism through which changes in world prices affect the economy. These experiments demonstrate that the dynamic path of the external export price shock is quite different from that of the import price shock, a result first demonstrated empirically for New Zealand by Wells and Evans (1985). This illustrates that in a three-sector economy, it is important to determine how the terms of trade shocks are formed. The fourth shock is intended to illustrate how the economy responds to higher nominal wage inflation. We consider a temporary reduction in aggregate demand in the fifth experiment. The final two shocks, which lead to a permanent change in the economy, involve raising the level of productivity and lowering the government liability to GDP ratio.

The results of the simulation experiments are presented in Figures 16 to 22. The responses are expressed either as per cent or percentage point deviations from the steady-state levels. The units on the horizontal axis are years.

6.1  A Temporary World Export Price Shock

The decrease in the world price of New Zealand exports shock is introduced as a 3 percentage point decrease in the world export price. The shock lasts for 3 quarters. The responses to this shock are shown in Figure 16.

This shock results in an immediate deterioration in the current account, which leads to an increase in foreign debt. The real exchange rate depreciates instantly, responding to the future deviation between the target and actual foreign debt to GDP ratio.

Exports are lower initially in response to lower export prices but increase gradually as the real exchange rate depreciates. Demand for imports remains below control until the real exchange rate returns to equilibrium.

The depreciation in the real exchange rate first leads to a moderate increase in inflation. The initial excess supply then reduces inflation to control. Finally the excess demand owing to higher net exports results in stronger inflationary pressure. Notice how the forward-looking monetary authority looks through the initial inflation volatility and begins to tighten the monetary conditions five quarters after the shock.

Note that demand for the domestic good declines initially due to the initial monetary tightening and lower household real disposable income arising from higher unemployment. The demand for domestic goods then begins to increase in response to the subsequent easing in monetary conditions.

6.2  A temporary world import price shock

This experiment involves a 3 percentage point increase in the world price of New Zealand imports. The size and the duration of the terms of trade shock are similar to the previous experiment and the responses to this shock are shown in Figure 17.

As in the previous shock, worsening the terms of trade induces a real exchange rate depreciation. However, unlike the previous shock, the initial fall in exports is much smaller and the initial decrease in the demand for imports is much larger. Consequently, it results in excess domestic demand, which kicks off an inflation and the monetary policy response. The monetary authority raises interest rates sharply after the shock, illustrated by the yield curve.

There is an initial increase in employment which reduces the unemployment rate. As the cost of imports increases, firms substitute labour for imports in production. Firms continue to take on workers while the real exchange rate remains above control.

6.3  A permanent increase in world export prices

In this experiment shown in Figure 18, we investigate the dynamic path of a permanent improvement in the terms of trade arising from a permanent 1% rise in export prices. The world price of imports remained unchanged. The impact of the permanent shock leads to a new long-run equilibrium path. The long-run properties of the steady state model with a permanent shock to the world export prices have been discussed in detail in the previous section.

Given that the desired foreign debt ratio has not changed, the real exchange rate must appreciate to achieve the desired target in the long-run equilibrium, which reduces the cost of imports and make more resources available for the domestic goods sector. The welfare gain from the permanent increase in world export prices can be estimated roughly by the amount of increased demand for domestic goods.

Initially, the dynamic adjustment path is similar to that of the temporary world price shock. The shock affects the current account balance first through rising world prices and hence the foreign debt position is lower than the desired level. Consequently, the real exchange rate appreciates and overshoots the new equilibrium level.

The impact of higher world export prices on export volumes is fully offset by the real exchange rate appreciation by the end of the first year. Combined with the increase in imports, lower foreign demand for exports generates a decline in aggregate demand.

As a result, there is downward pressure on inflation and the level of unemployment is above its equilibrium. The forwarding-looking monetary authority projects that inflation will fall below the target and therefore loosens monetary policy, which helps to stimulate domestic demand, and the demand for domestic goods gradually converges to its new equilibrium.

After seven years, the real exchange rate returns to its new equilibrium as the desired foreign debt to GDP ratio is achieved.

6.4  A temporary increase in nominal wages

This shock, shown in Figure 19, involves a temporary increase in nominal wages, which raises the real wage by close to a percentage point. The increase in real wages stimulates consumption demand, which in turn causes inflation to rise. Monetary policy tightens to prevent inflation from rising. On the supply side, firms take on fewer workers and more imports in response to higher real wages. Higher input costs also make the export sector less competitive internationally. As a result, the level of the current account deficit is above its equilibrium and hence leads to higher foreign debt.

In order to attain the external balance, real exchange rate must depreciate. The real wage is gradually reduced to its equilibrium as price inflation picks up and rising unemployment begins to dampen nominal wages growth.

6.5  A temporary demand shock

This shock is intended to illustrate how a temporary increase in aggregate demand is transmitted through the economy and is shown in Figure 20. Consumption increases by 0.5 per cent and both business and residential investment increase by 1 per cent. The shock lasts for one quarter.

The increase in demand leads to an increase in inflation and the monetary authority tightens monetary policy instantly to prevent inflation expectations from rising. Strengthening domestic demand fuels import growth. Exports increase as a result of stronger investment growth. However, net exports are below equilibrium and cause the current account deficit to rise. This causes the real exchange rate to depreciate. It takes about two years for inflation expectations to return to control.

6.6  A permanent increase in the level of productivity

In this shock, the level of productivity increases permanently by 1 per cent. The results are shown in Figure 21. The dynamic path of the shock is very similar to that of a permanent increase in world export prices. Both shocks permanently raise the level of the living standard by increasing private consumption and investment in the long run. The initial negative output gap reflects the higher productivity of the firm and hence the deflationary impact of the shock.

Consequently, the monetary authority needs to loosen monetary policy to stimulate aggregate demand. In response to the monetary easing, firms increase the capital stock to its new long-run level as higher productivity raises the marginal return of capital. The benefit arising from higher productivity gradually passes to households by raising real wages. The increase in disposable income raises consumption slowly to its new equilibrium.

Initially, the adjustment to the new steady state also requires the real exchange rate to appreciate, as the desired level of foreign debt is higher than its initial equilibrium. However, it is important to note that the desired ratio of foreign debt to GDP remains unchanged and the real exchange rate rises smoothly back to its original long-run level. In response to the initial real exchange rate appreciation, firms reduce their export supply. On the back of the real exchange rate depreciation, exports begin to rise. Both imports and exports are higher in the new equilibrium by 1 per cent. In this respect, it is interesting to contrast this shock with the permanent increase in world export prices. In the export price shock, there is a permanent appreciation of the real exchange rate and exports stabilise just above their initial level.

6.7  Reducing the public liability to GDP ratio

This shock involves the government lowering the target debt to GDP from 30 per cent to 28 per cent. The results are shown in Figure 22. In order to pay off debt faster, the government has to raise the personal income tax rate sharply. Consequently, consumption falls relative to control, which in turn leads to a reduction in aggregate demand. As a negative output gap emerges, the monetary authority must loosen monetary policy in order to offset the impact of the shock.

The decline in government debt implies that there are fewer financial assets available for households' wealth. To maintain the same level of financial wealth as before, households substitute foreign assets for domestic assets. Consequently, the new desired foreign debt to GDP ratio must fall, which sets off a real exchange rate depreciation. Combined with the easing in monetary conditions, the real exchange rate depreciation raises aggregate demand above supply just one year after the shock.

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