2.3 Block structure and structural equations
This New Zealand economy structural VAR model is composed of an international economy block, an international trading prices block, a domestic economic block and a domestic climate block. The choice of four blocks is based on the reasonable assumptions that New Zealand is a small open economy and that climate is exogenous. Variables appearing in the two domestic blocks are absent from the international economy block and the trading prices block. Furthermore, variables appearing in the trading prices block are also absent from the international economy block. Variables appearing in the international economy and trading prices blocks may appear in the domestic economic block, but do not appear in the 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.
Table 1 summarises the 13 structural equations. The rows show the dependent variable in each equation. The columns show which explanatory variables appear in each equation, as indicated by the shaded cells and asterisks. Shaded cells indicate the contemporaneous relationships. Asterisks indicate the lagged variables that appear in the equations for each dependent variable.
This model is intended to capture the key macroeconomic characteristics of the New Zealand economy since the early 1980s. Some of these characteristics are captured in the first structural VAR model of the New Zealand economy developed by Wells and Evans (1985). However, their model was estimated for the period 1961 to 1981. Subsequent wide-ranging economic reforms have changed some of those characteristics and the institutional settings for monetary policy.
International linkages are likely to have become more complex and more pervasive as a result of deregulation of New Zealand trade and financial markets since 1984 (as demonstrated for example by Conway, 1998). The international block therefore includes foreign real output, foreign interest rates and foreign real asset returns. The international block is a Wold recursive system in the contemporaneous variables. The contemporaneous causal ordering runs from foreign real output to foreign interest rates and real asset returns. Foreign real output (yw) depends upon lags of foreign nominal interest rates (iw) and foreign real asset returns (qw).
Foreign nominal interest rates respond to contemporaneous and lagged movements in foreign real output and to lags in foreign interest rates. Foreign real asset returns (qw) respond contemporaneously to foreign real output and foreign interest rates, and to lags in these variables and its own lags. The inclusion of (qw) reflects growing integration of New Zealand financial markets with international markets since financial deregulation during the mid 1980s.
The international trading prices block reflects the Australian three-goods model of the dependent economy (developed by Salter, 1959 and Swan, 1963). This approach emphasises the distinction between imports, exports and non-traded goods, and has exogenous terms of trade. The reason for adopting this three-good approach is New Zealand’s industrial structure. A substantial proportion of New Zealand’s imports are inputs to the production process and a significant proportion of its exported products are primary based with a low proportion of exportable production absorbed by home consumption.
Within the context of this type of commodity structure the effects of import and export price shocks on domestic real output and inflation therefore need not necessarily be mirror images of each other. This argument is supported by Wells and Evans (1985) who found that an increase in export prices raised private sector output and employment and had virtually no effect on output prices. An increase in import prices reduced private sector output and employment but also raised output prices, the classical stagflation effect.
Note :yw = foreign real output; iw = foreign nominal interest rates; qw = and foreign real asset returns; pxw = foreign
currency price of New Zealand exports; pzw = foreign currency price of New Zealand imports; d = aggregate real
domestic demand; y = aggregate real domestic output; x = New Zealand supply of exports; e = the nominal exchange rate; i = domestic interest rates; q = real domestic equity returns; pc = domestic prices; c = domestic climatic conditions.
Consistent with the small open economy assumption, we model the foreign currency price of New Zealand exports (pxw ) and the foreign currency price of New Zealand imports (pzw ) as responding to contemporaneous and lagged foreign real output and to their respective lagged values.
A domestic climate block is included to capture the importance of the agricultural sector as a source of final output and intermediate inputs to several manufacturing industries and the importance of hydro electricity as a source of energy in New Zealand. Earlier industry level studies suggest that variations in climatic conditions have the potential to influence the aggregate level of economic activity. We use the soil moisture conditions variable derived by Porteous, Basher and Salinger (1994) and analysed by NIWA (2001) to capture the impact of climatic conditions on New Zealand real GDP and exports. The soil moisture variable is block exogenous. To capture the impact of climatic conditions we postulate that changes in soil moisture conditions have important contemporaneous and lagged effects on total New Zealand real GDP (y) and on New Zealand export supply (x).
There are two main components to the domestic economy block. Three variables represent aggregate real domestic output and aggregate real demand for domestic output (y,d,x). Four variables represent prices and real returns to wealth (e,i,q,pc). Since real gross national expenditure (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.
Shocks to GNE are interpreted as aggregate demand shocks. Contemporaneous influences on domestic demand include shocks to aggregate demand and foreign prices for exports and imports (pxwand pzw ), the latter reflecting the terms of trade effect on the purchasing power of New Zealand output. Income and relative price effects arising from changes to domestic real GDP (y), the interest rate (i), the exchange rate (e), and domestic prices (pc), impact after a one-quarter lag. The introduction of a goods and services tax (GST) in 1986:4 and a further increase in 1989:3 was foreshadowed by increases in domestic demand in the quarters prior to each tax increase. These shocks have been absorbed 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 (d), and export demand (x), and two supply shocks, climate (c) 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 (pxw, e, pc) impact after a one-quarter lag.
- These studies include the pioneering research by Maunder (1966, 1968) and Maunder and Ausubel (1985) using agroclimatological models to predict the effect of rainfall, temperature and sunshine on butterfat production, and subsequent investigations of the impact of climate on livestock investment and slaughter rates (Tweedie and Spencer, 1981) and on farm profits (Wallace and Evans, 1985).