4  Contributions to New Zealand growth cycles

The purpose of this section is to use the structural VAR model to identify the relative importance of domestic financial (domestic interest rate, exchange rate and equity) shocks compared to international, domestic economic, and domestic climate shocks in contributing to business cycle fluctuations. The sample period includes the 1991 to 1993 recession, the boom during the mid 1990s, the 1998 recession and subsequent growth recovery.

The business cycle represented here is the percentage deviation of real GDP from its trend level, which is also known as the growth cycle. Therefore, this part of the paper concentrates on contributions to detrended domestic GDP (). Following equation (8), the structural VAR can be written in moving average representation to explain the impact of shocks to detrended GDP as follows:

(9)    y_t = initial conditions

where θ_ij is the ith impulse response associated with the jth shock, with 13 shocks in our system.

At the beginning of the sample period, initial conditions will contribute a substantial proportion to deviations of real GDP from trend. But over time the contributions from initial conditions converge toward zero. The relative contribution of domestic financial shocks compared to international, domestic economic (which includes the effect of initial conditions) and domestic climate shocks can be seen in Figure 2.

In general, the main reasons for New Zealand business cycle fluctuations are international shocks, domestic climate shocks and domestic economic (non-financial) shocks that have tended to be pro-cyclical. The contributions from domestic climate shocks were particularly marked during the mid to late 1990s. The contribution of domestic financial shocks, which includes the summation of the effects of domestic interest rate, exchange rate and equity shocks, have been relatively moderate and generally counter-cyclical, thereby dampening the impact of other shocks to the business cycle.

A comparison of the two recessions illustrates how the contributions of these shocks can vary across time. International and domestic economic shocks were the main explanations for the recession that commenced in 1991. Climate contributed moderately to that recession. Contributions from domestic financial conditions tended to offset these forces and moderated the depth of the recession.

In contrast, deteriorating climatic conditions were the main reason for the recession in 1998. International and domestic economic factors were relatively neutral. In contrast to previous periods, domestic financial shocks tended to accentuate the recession, although their contribution was smaller than the impact of climate shocks. During the subsequent recovery, however, domestic financial contributions reverted to a counter-cyclical role again.

Figure 2 – Contributions to New Zealand growth cycles

Note: The solid black line is detrended domestic GDP (y). The dotted line represents the contribution of the respective components to detrended domestic GDP (y). International conditions include foreign real output (y^w ), foreign interest rates (i^w), foreign asset returns (q^w) and foreign currency prices for exports and imports (px^w and pz^w); domestic non-financial conditions include domestic demand (d), New Zealand supply of exports (x), domestic prices (pc) and initial conditions; and domestic financial conditions include the exchange rate (e), the domestic interest rate (i) and domestic equity returns (q). Climate conditions are captured by the domestic climate conditions (c) variable.