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A Comparison of the NZTM and FPS Models of the NZ Economy - WP 03/25

3  Simulation properties

In this section, the dynamic properties of the models are investigated by analysing the results of the model to various shock experiments. The rationale for the selection of the shocks is:

I. to draw out the significant differences between the two models in response to demand shocks. We have thus subjected the two models to two demand shocks. The first one is an increase in non-tradeable consumption demand, while the second is an increase in the tradeable export demand. These experiments illustrate that the dynamic paths of the economy following these two different demand shocks are quite different in NZTM. However, the responses to these shocks in FPS are similar, reflecting the one good paradigm;

II. to include those shocks that have been identified as some of the key drivers of the New Zealand business cycle over recent decades. Following the work of Wells and Evans (1985) and Buckle et al. (2002) who use VAR models to highlight the contribution of export and import price shocks, these experiments includes export and import price shocks; and

III. to understand the monetary policy transmission mechanism in the two models by looking at the effect that interest rates and the exchange rate have on the business cycle.

Graphs plot the responses of the endogenous variables to these shocks. These responses are expressed either as per cent or percentage point deviations from the control (the steady state level). The time scale is in years. Note that for FPS the real exchange rate is defined as the price of domestic currency in units of foreign currency adjusted for the ratio of domestic and foreign price levels. An increase in the real exchange rate represents an appreciation. For the NZTM, the real exchange rate is defined as the relative price of importables to non-tradables (RPM) or exportables to non-tradables (RPTEX). However, all the charts plot the inverse of RPM and the inverse of RPTEX for comparability with FPS except for Figure 3. Note also that the yield curve is the difference between short (90-day) and long (10-year) nominal interest rates. Any positive deviations from the equilibrium represent a tightening in monetary conditions and vice versa.

3.1  Consumption shock

In this shock private consumption is increased by 1% above the steady state for 1 quarter. While residential investment and private consumption are modelled separately in NZTM, in FPS residential investment is included in private consumption. For comparability, NZTM results reflect a combined 1% rise in residential investment and private consumption. The dynamic paths of eight principal variables are shown in Figure 1.

The 1% increase to private consumption results for both models in a positive output gap opening up of around 0.5% at its peak in the first quarter following the shock. The positive output gap then begins to close. In FPS the output gap turns negative after a year and a half while in NZTM the positive output gap persists for some time. Both gaps are closed after 6 years following the shock. The different profiles for the output gap are explained as follows.

With a positive output gap opening up, inflation pressures develop in both models. In NZTM there is a slight lag before inflationary pressures develop while in FPS this inflation response is quicker. Both profiles for inflation peak just after a year and then begin to dissipate. However, inflation pressures are more persistent in FPS with inflation back to the steady state after 4½ years. In contrast, inflation falls back to the steady state after 2½ years in NZTM. This reflects the greater persistence that inflation has in FPS through the modelling of inflation expectations. This greater persistence in FPS arises because current inflation has a greater impact on inflation expectations than in NZTM.

In response to these inflationary pressures, the monetary authority raises short-term interest rates. Due to the greater persistence of inflation, the increase in interest rates is considerably larger in FPS than NZTM. The timing of the peak in interest rates is similar in both models - 6 months after the shock with interest rates easing after that. In FPS, interest rates return to the steady state after 3½ years and then persist in a period of weaker rates. In contrast, interest rates in NZTM remain slightly above the steady state value and are not back to equilibrium until after 6 years.

Higher interest rates help to close the positive output gap in FPS through their impact on consumption and to a lesser degree on business investment. Higher interest rates drive consumption below the steady state as forward-looking consumers are encouraged to raise current saving. Business investment is also negatively impacted by higher interest rates.

In NZTM, consumption is still positively influenced by the momentum in the first few quarters after the shock. In the long run, consumption is determined by labour income and wealth. As the additional spending is achieved by running down financial assets relative to the steady state, consumption is gradually affected by the lagged impact of the deterioration in wealth.

In comparison with FPS, interest rates have less of an impact on consumption in NZTM. Higher interest rates also impact on business investment but not immediately and the impact of higher interest rates on investment is more than offset by the Tobin-q factor. As firms see higher future profits resulting from strong domestic activity, business investment is higher than the steady state and coincides with the level of domestic activity.

As demand increases, spending on imports rises, which helps to close the positive output gap as demand is satisfied to a degree via imported goods. In general, the response of imports reflects the profile of domestic activities for both models.

The path of the real exchange rate highlights another clear difference between the two models. In NZTM, as a result of the autonomous demand shock consumers have run up debt to finance spending. As such the net foreign debt position is higher than the desired steady state position. As a result, the real exchange rate depreciates. This depreciation puts exporters in a more competitive position, which sees a volume response. This helps to bring the net external position back into steady state through encouraging exports and discouraging imports.

In contrast, in FPS the real exchange rate appreciates as a result of a weak uncovered interest parity condition (UIP). Despite the appreciation of the real exchange rate there is minimal impact on exports. Thus, the net foreign debt position partly adjusts back towards equilibrium via adjustment in consumption and hence imports. This is partly why the level of consumption is required to fall below the steady state.

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