1  Introduction

New Zealand introduced formal inflation targeting to the world with the introduction of the Reserve Bank of New Zealand Act (1989).[1] At least 18 other central banks have since adopted inflation targeting and evidently more are considering adoption of this monetary framework (Mishkin and Schmidt-Hebbel, 2001). According to Walsh (2002) the New Zealand model nevertheless remains a good example of monetary reform designed to ensure the economy has a nominal anchor, to ensure policy transparency, and to promote accountability.

The outcome of the New Zealand inflation targeting experience has therefore attracted considerable international interest and debate. The purpose of this paper is to evaluate the impact of New Zealand monetary policy on real output and inflation variability since the introduction of formal inflation targeting. Its purpose is to try to answer three questions. First, has monetary policy during the period of inflation targeting accentuated or mitigated booms and recessions in New Zealand business cycles? That is, in the pursuit of low inflation has monetary policy been pro-cyclical or counter-cyclical in its impact on GDP? Second, has monetary policy accentuated or mitigated inflation variability around trend inflation. Third, what effect has monetary policy had on the output/inflation variability trade-off?

The approach in this paper is to answer these three questions using an open economy structural vector auto-regression (SVAR) model of the New Zealand business cycle. VAR models are designed to capture empirically the impulse propagation framework that has come to dominate the analysis of expansions and recessions that characterise the evolution of business cycles. This approach, well illustrated by Blanchard and Watson’s (1986) analysis of US business cycles, conceives of fluctuations in economic activity as arising from impulses (shocks) that affect the economy through a complex dynamic propagation process. Therefore identification of shocks that precipitate expansions and recessions in economic growth, or business cycles, represents a major conceptual and statistical challenge. This complexity means that debates concerning the impact of monetary policy are difficult to resolve without the aid of techniques that control for the impact of other shocks. This is precisely the type of issue for which vector autoregression (VAR) models have been developed since they were first introduced by Sims (1980).

International and domestic debate concerning New Zealand’s inflation targeting experience have tended to range over four major themes. These themes include policy coordination issues, whether the contract implicit in the New Zealand legislation is in some sense optimal, whether the policy implementation procedures applied by the Bank have been appropriate and, in light of these issues, whether in the pursuit of inflation targeting monetary policy has generated adverse outcomes for other macroeconomic variables such as interest rates, the exchange rate and the volatility of real output growth.

An impressive flow of research has emerged from debates on the first three issues.[2] Although there have been several papers comparing the behaviour of macroeconomic variables pre and post-inflation targeting (For example Orr and Rae, 1996; Mishkin and Posen, 1997; Reserve Bank of New Zealand, 2000a; Buckle, Haugh and Thomson, 2001), despite ongoing debate (see for example Harris, 1996 and Reserve Bank of New Zealand, 1998 and 1999) there has been little empirical research that has endeavoured to systematically isolate the impact of monetary policy on other macroeconomic variables. Exceptions are the papers by Fischer and Orr (1994) and Hutchison and Walsh (1998) identifying the impact of central bank reform on price uncertainty and monetary policy credibility. This paper is intended to fill that gap by providing an empirical contribution to the debate surrounding the impact of monetary policy on New Zealand’s business cycles and inflation.

The paper is structured as follows. Section 2 explains the main features of the SVAR model used to incorporate and evaluate the impact of monetary policy on business cycles and the variability of output and inflation. The method used to identify monetary policy is discussed in Section 3. Section 4 briefly discusses the historical contribution of alternative shocks to New Zealand business cycles. Section 5 evaluates the impact of monetary policy on business cycles and inflation, while Section 6 evaluates the impact of monetary policy on the output/inflation variability trade-off. Section 7 provides concluding comments.