3  An open economy structural VAR model of the New Zealand economy

The structural VAR model of the New Zealand economy contains 13 variables and structural equations. There are two stages in the process that has been followed to decide on the functional form of each structural equation. The first stage is to arrange the variables into four blocks. The second stage involves specification of the functional form of each equation in each block. The functional form for each equation must be consistent with the block exogeneity restrictions and will reflect information from prior theoretical research or empirical single equation and VAR research that has been accepted as a useful characterisation of the variable being modelled.

3.1  Block structure

The equations in this model are arranged into four blocks. There is an international economy block, an international trading prices block, a domestic block, and the fourth block emerges by breaking the domestic block into two parts: a domestic economy block and a domestic climate block. The four blocks are a consequence of the reasonable assumptions that New Zealand is a small open economy and that climate is exogenous. Dependent variables in the two domestic blocks are completely absent from the international economy block and the trading prices block. Furthermore, variables appearing in the trading prices block are also completely absent from the international economy block. Variables appearing in the international economy and trading prices blocks may appear in the domestic economic block, but they cannot appear in the system exogenous domestic climate block. Variables in the domestic climate block can appear in the domestic economic block (but not in the international economy block or the trading prices block).

These block exogeneity restrictions are summarised in Table 1. The rows indicate whether the dependent variables that appear in the specified block are influenced by dependent variables located in another block. The columns show whether dependent variables located in a particular block appear as explanatory variables in any equation for a dependent variable that is located in another block. These relationships are indicated by the symbol “*”.

3.2  Data and variables

Our choices of quarterly data series to represent the 13 variables contained within the four blocks are as follow. Foreign real output is represented by the log of trade weighted world industrial production ().[1] Foreign nominal interest rates () are represented by a weighted average of Australian, United States, United Kingdom, Japan and German 90 day interest rates, where the weights are determined by the ratio of country GDP to the sum of GDP for all these economies. Foreign real asset returns are represented by the log of the Morgan Stanley World Capital Index of gross equity returns () deflated by an index of United States consumer prices.

The foreign currency price of New Zealand exports is calculated by multiplying Statistics New Zealand’s domestic currency export price index by the trade weighted exchange rate and expressed in logs (). The foreign currency price of New Zealand imports is calculated by multiplying Statistics New Zealand’s domestic currency import price index by the trade weighted exchange rate, and expressed in logs (). The domestic exchange rate is represented by the nominal trade weighted exchange rate for New Zealand, expressed in logs ().

Domestic real aggregate output is represented by Statistics New Zealand’s chain-linked measure of production based quarterly real GDP that has been calibrated back to 1978 by Haugh (2001) and expressed in logs (). Domestic real aggregate demand is represented by Statistics New Zealand’s chain-linked measure of quarterly real gross national expenditure back-dated[2] to 1982:2, expressed in logs (). Domestic real exports are represented by Statistics New Zealand’s System of National Accounts measure of real exports of goods and services, expressed in logs () and also backdated to 1982:2.

Domestic prices are represented by Statistics New Zealand’s Consumers’ Price Index for New Zealand, expressed in logs (). Domestic interest rates are represented by New Zealand 90-day interest rates (). Real returns on domestic equities is represented by the NZSE40 gross return index available from Datastream, deflated by the New Zealand Consumers’ Price Index and expressed in logs (). Domestic climate is represented by the number of days of soil moisture deficit in each quarter estimated by the National Institute of Water and Atmospheric Research Limited (NIWA) (2001), and is denoted as ().

Each data series enters the structural VAR as a deviation from long run trend, where the trend is estimated using the Hodrick-Prescott filter, with the smoothing parameter, λ, set equal to 1600. The value for λ is based on Kim, Buckle and Hall (1994) who used λ=1600 to analyse key features of New Zealand business cycles. The climate variable is detrended by removing from each quarterly value the long run average value for that quarter. This is done to measure climatic conditions that differ from the normal seasonal pattern to model the impact of climatic conditions above and below the norm on the New Zealand economy. The climate variable therefore represents the soil moisture deficit level above or below the normal seasonal level. The quarterly values and trend lines for all variables are displayed in Figure 1. The model is estimated using the deviations from trend quarterly data from 1983:1 to 2002:1.