4.3  Terms of trade shocks

4.3.1  Export price shock

Responses to a rise in export prices () are shown in Figure 5. The exchange rate () appreciates resulting in a decline in export volumes. There is a sharp rise in domestic interest rates. The rising terms-of-trade-adjusted income, probably explains the strong increase in domestic demand () for several quarters after the shock. Although domestic output () also increases to satisfy higher domestic demand, its response is not as strong, implying deterioration in the trade balance.

Figure 5: Responses to export price shock

4.3.2  Import price shock

The responses to an increase in foreign import prices are shown in Figure 6. Although domestic output (y) falls one quarter after the shock, the maximum response does not occur until the third quarter. This decline in domestic output (y) may reflect the higher cost of imported intermediate inputs to production. It will also reflect the sharp fall in domestic demand (d) in response to higher import prices.

Reflecting the combined impact of an appreciation in the exchange rate (e) and a decline in both domestic demand (d) and domestic output (y), domestic prices (pc) fall. Although domestic prices (pc) decline almost immediately, the trough does not occur until eight quarters after the shock. This trough in domestic prices (pc) is sometime after the maximum response of the exchange rate (e), domestic demand (d) and domestic output (y) to the import price shock. Owing to the falls in domestic demand (d) and domestic prices (pc), the domestic interest rates (i) (not shown) also falls.

Figure 6: Responses to import price shock

4.4  Domestic financial shocks

4.4.1  Domestic interest rate shock

The responses to an increase in domestic interest rates () are shown in Figure 7. As expected, there is an immediate decline in domestic equity returns as equities are substituted for bonds. The exchange rate () appreciates, although the strongest reaction is after four quarters. This response is likely to reflect the impact of an increase in the interest rate differential between the domestic and foreign interest () rates.

As a consequence of the exchange rate appreciation, domestic consumer price inflation () falls. While domestic inflation starts to fall almost immediately after the increase in the domestic interest rate, the trough occurs over eighteen months after the shock. This is consistent with the presence of nominal price rigidities and slow exchange rate pass through (IMF, 2001). Domestic output’s response to the interest rate innovation follows a similar profile to that generated for the CPI.

A number of VAR studies have encountered difficulties in detecting the impact of monetary policy actions on other macroeconomic variables. Kim and Roubini (2000) outlined several empirical “puzzles“ that have been associated with attempts to identify monetary policy in both open and closed economies. One attractive feature of this structural VAR model developed is that it does not encounter two of the puzzles discussed by Kim and Roubini (2000), namely the price puzzle (where the price level rises in response to a positive interest rate shock) and the exchange rate puzzle (where the exchange rate falls following a positive interest rate shock). Monetary policy appears to have been successfully identified using a forward looking Taylor rule (explained in Section 3.7), without the need to include non-monetary policy variables that several other VAR studies have had to resort to in order to identify monetary policy (see for example Brischetto and Voss, 1999 and Kim and Roubini, 2000).

Figure 7: Responses to domestic interest rate shock

4.4.2  Domestic equity shock

Figure 8 shows the responses to a positive innovation to domestic equity returns (). There is an immediate increase in domestic demand (). This demand reaction is likely to represent increased investment by firms (a Tobin q effect) and higher consumption by households (a wealth effect). Given that monetary policy is forward looking in this model, the current and expected future rise in domestic demand results in a rise in domestic interest rates () (not shown) to dampen the demand pressure on inflation. The rise in domestic interest rates is also consistent with results for the domestic interest rate shock and perhaps also reflects the substitution out of bonds. Domestic output () initially rises but falls soon thereafter, despite domestic demand rising over the first year. This may be in part a response to a decline in exports, which fluctuate with the exchange rate.

Figure 8: Responses to domestic equity shock

4.5  Climate shock

We expect New Zealand’s geographical characteristics and industrial structure will combine to render domestic output sensitive to climate changes. If so, we would expect to find a significant business cycle response to changes in climatic conditions. The responses to an increase in the soil moisture deficit shown in Figure 9 are consistent with this hypothesis.

A positive innovation to the soil moisture deficit () results in an immediate and significant fall in domestic output (). The trough in real GDP occurs after two quarters. Interestingly, export volumes () increase contemporaneously with the climate shock. This may reflect an increase in the slaughter rate by farmers in response to unexpected drier climatic conditions. Eventually exports also decline and the peak decline occurs after three quarters. This may be the consequence of reduced livestock as a result of the initial increase in the slaughter rate. Domestic demand () falls, however the trough comes four quarters after the peak decline in GDP.

Domestic prices () increase relative to trend during the first three quarters following the climate shock. This may reflect price responses to shortages in agricultural produce that are sensitive to climate change, such as fruit and vegetables. Although domestic demand initially falls in response to the climate shock, the interest rate () rises (not shown). This reflects the reaction to the outlook for inflation. This increase in domestic interest rates, in conjunction with an appreciation in the exchange rate () (not shown), leads to a fall in inflation () after the first three quarters.

Figure 9: Responses to climate shock

In general, the impulse response functions generated from the SVAR model produce sensible reactions by variables in the domestic economy block. These impulse response functions are helpful in informing how the economy responds if a particular shock occurs. In Section 5 the model is applied differently by using it to identify what shocks actually occurred over the past two decades and examine what the effects of those shocks were on New Zealand’s business cycle.