3.6  The Domestic Climate Block

The significance of the agricultural sector as a source of final output and intermediate inputs to several manufacturing industries and the significance of hydro electricity as a source energy renders New Zealand aggregate real output potentially sensitive to changes in climatic conditions. One of the reasons for constructing this structural VAR model is to try to identify the impact of climatic conditions on New Zealand business cycle fluctuations.

New Zealand research examining the impact of climate on New Zealand agriculture dates back to Maunder’s impressive programme of research initiated during the 1960s. This research involved the creation and development of indicators of climatic conditions generated from data collected by the New Zealand Meteorological Service. Maunder’s research included the development of agroclimatological models using rainfall, temperature and sunshine to predict the effect on butterfat production (see for example Maunder 1966; 1968 and Maunder and Ausubel, 1985). Building on these developments, subsequent research estimating single equation behavioural models have evaluated the impact of climatic conditions on livestock investment and slaughter rates (Tweedie and Spencer, 1981) and on farm profits (Wallace and Evans, 1985).

The National Institute of Water and Atmospheric Research Limited (2001) identifies several potentially suitable indicators of climatic conditions including the southern oscillation index which has been shown to have a significant impact on Australian agricultural production, various indices of wind strength, temperature variations across regions, sea surface temperatures and a measure of soil moisture conditions. We have chosen to use the soil moisture conditions variable derived by Porteous, Basher and Salinger (1994) to capture the impact of climatic conditions on New Zealand real GDP and exports. This soil moisture variable is calculated from the daily water balance. It measures the net impact of rainfall entering the pasture root zone in the soil and that which is lost from this zone as a result of evapotranspiration or use of water by the plants.

The soil moisture variable is block exogenous. To capture the impact of climatic conditions we postulate that changes in soil moisture conditions have significant contemporaneous and lagged effects on total New Zealand real GDP () and on New Zealand export supply ().

3.7  The Domestic Economy Block

The previous three blocks identify international trade, international financial, and domestic climate shocks to the New Zealand economy. The domestic economy block contains the domestic reactions to these shocks. It is also the source of domestic policy and non-policy shocks such as exogenous changes to interest rates, the exchange rate and equity returns, and exogenous changes to private demand.

There are two main components to the domestic economy block. Three variables represent aggregate real domestic output and aggregate real demand for domestic output (). Four variables represent prices and real returns to wealth (). Since real GNE includes spending on imports, the inclusion of real GDP and real GNE in the same model imply the model captures shocks to the balance of trade. This feature is also present in Dungey and Pagan’s (2000) model for Australia. They point out that because log GNE minus log GDP is approximately equal to the trade balance to GDP ratio, whenever log GNE and log GDP are included in the same equation the two variables are equivalent to log GDP and the trade balance ratio.

Shocks to GNE are interpreted as aggregate demand shocks. Contemporaneous influences on domestic demand include shocks to foreign prices for exports and imports (and ), reflecting the terms of trade effect on the purchasing power of New Zealand output, and domestic equities. Income and relative price effects arising from changes to domestic real GDP (), interest rates (), the exchange rate and domestic prices (), impact after a one-quarter lag. Apart from the terms of trade effect, other international variables are considered to impact on domestic demand indirectly via their impact on real output and relative prices. This may appear unduly restrictive, particularly if international conditions affect expectations and spending decisions other than through their impact on export and import prices. However, sensitivity analysis suggests that allowing all the foreign variables to affect domestic demand directly does not materially change the impulse response function of domestic demand to foreign shocks.

During the late 1980s, the evolution of GNE was affected by demand shocks associated with unusually high demand in anticipation of the foreshadowed introduction of a goods and services tax (GST). The GST changes were introduced in 1986:4 and 1989:3. Domestic spending was unusually high during the quarter immediately prior to each tax increase. We have absorbed these shocks into two GST dummy variables. The first takes the value 1 in 1986:3 and zero in all other quarters; the second takes the value 1 in 1989:2 and zero in all other quarters.

Contemporaneous shocks to aggregate real GDP arise from two sources of demand shocks, domestic GNE (), and export demand (), and two supply shocks, climate () and other unexplained supply shocks that are captured by the error term in the equation for real GDP. To allow for the possibility of spillover effects from world productivity shocks, lagged foreign output is included in the equation for domestic real GDP. Other influences include lagged expenditure switching effects arising from shocks to the exchange rate, export prices and import prices.

New Zealand producers are assumed to face infinitely elastic demand on world markets. Contemporaneous influences on export supply include climatic and other export supply shocks. Real exchange rate effects arising from changes to world prices for exports, the exchange rate and domestic prices (, , ) impact after a one-quarter lag.

The domestic price variable () is the difference between the log of the domestic Consumers’ Prices Index and its trend value. It is therefore a measure of the extent to which prices are growing faster or slower than trend growth and can therefore be interpreted as trend adjusted domestic inflation. The equation for domestic prices can be interpreted as a reduced form equation capturing mark-up on cost pricing by domestic firms and the direct price effects of final tradeable goods that are consumed domestically, similar to that estimated by Hampton (2001).

The production costs of domestic firms include prices of imported intermediate production inputs, labour costs and productivity. Labour costs are assumed to be determined by a Phillips curve that relates wage inflation to demand pressure and expected inflation. Demand pressure is proxied by the deviation of real GNE from trend (). Expected inflation is assumed to be determined by a combination of current and lagged price inflation (). Domestic currency prices of imported intermediate goods are captured by the world price of imports (pz^w) and the exchange rate (), while the domestic currency prices of final tradeable goods consumed locally are captured by foreign prices for exports, imports and the exchange rate (,, ).

Shocks to the domestic price equation are therefore a combination of shocks to mark-up pricing, wages and foreign prices of final tradeable goods. Shocks to domestic prices cannot therefore be simply interpreted as “supply” or “productivity” shocks as they are typically labelled in the international literature. The world price indices for imports and exports are only an approximation of the prices of intermediate and final tradeable goods. More detailed modelling of international linkages might warrant separation of price indices for tradeable goods by function (see for example Kose, 2002).

Domestic prices were affected by the two goods and services taxation (GST) shocks during our sample period. A 10 percent tax was introduced in 1986:4 and a further 2.5 percent was added in 1989:3. These GST shocks have been absorbed by two dummy variables. The first takes the value 1 in 1986:4 and zero in all other quarters; the second takes the value 1 in 1989:3 and zero in all other quarters.

The equation for domestic interest rates () is intended to capture the monetary authority’s reaction function. Recent research suggests that for most of our sample period, the conduct of monetary policy in New Zealand approximates a Taylor-type (Taylor, 1993) reaction function (see Plantier and Scrimgeour, 2002; Huang, Margaritis and Mayes, 2001). The basic specification of the interest rate equation reflects this idea, but with several modifications.

The New Zealand monetary authority’s behaviour is probably appropriately described by forward-looking behaviour. This model therefore embodies a variant of the Taylor Rule in which the monetary authority reacts to forecasts of inflation and demand three quarters in the future. The Taylor Rule takes the form expressed in Tables 2 and 3, but with the independent variables replaced with three-quarter-ahead forecasts generated from the reduced form VAR. Stock and Watson (2001) compare the implications of backward and forward-looking Taylor Rules in a three variable model of U.S. inflation. They found the choice of specification affected interest rate impulse response functions. We found that the choice of a forward-looking specification produced different and more sensible reactions to interest rate shocks.[3]

Although the cash rate is the current monetary policy instrument in New Zealand, this variable is unavailable for the full sample period. We have therefore used the 90-day rate as a proxy variable. The 90-day rate is not strictly controlled by the monetary authority and can be influenced by private expectations and shifts in portfolio decisions. We therefore include the world interest rate as a direct contemporaneous and lagged influence on the domestic interest rate.

Real returns on domestic equities (), represented by the NZSE40 gross return index and deflated by the New Zealand Consumers’ Price Index, are specified as a function of contemporaneous foreign real output (), foreign real asset returns () and the exchange rate () to reflect the globalisation of international asset markets. Real domestic equity returns are also specified as being influenced by variables considered likely to affect expectations of domestic real output growth (,,) and returns from alternative financial assets ().