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3.2  Export demand shock

In this shock (summarized in Figure 2), export volumes are increased by 1% above the steady state for 1 quarter. In this experiment, the increase in exports is not due to supply shocks such as extreme climatic events or an increase in productivity. It is due to a greater foreign demand for our manufactured exports and export services. In this shock the reaction of FPS is similar to that of the previous shock, reflecting the one good paradigm. In other words, the response of the model to demand pressure does not depend on the source of change to aggregate demand. In NZTM, the dynamic adjustment of this shock is quite different from that of the previous shock. The consumption shock is a domestic demand shock that will adversely impact on the current account and hence cause real exchange rates to fall. On the other hand, the export demand shock will result in an improvement in current account and hence cause real exchange rates to rise.

Both models initially display a positive output gap, which peaks around 0.4% in the first quarter. The output gaps are closed after 1½ years. Again inflationary pressures build and while the peak in inflation is similar in the two models the persistence we saw in the consumption shock in FPS is again a feature. The monetary authority increases interest rates more aggressively in FPS and for a longer period of time. In NZTM, interest rates are actually lower than the steady state after a year as the output gap becomes negative and inflation drops below target.

The movement in consumption is fairly small because of the small magnitude of the shock. Both models initially have a fall in consumption below steady state and this is most pronounced in FPS. The fall in consumption in FPS results from an increase in interest rates as a result of inflation rising above target. This encourages households to save and postpone consumption today. Consumption returns to the steady state after 6 years.

In NZTM, after an initial fall in consumption resulting from higher interest rates, consumption then increases above the steady state. Unlike the consumption shock, higher export volumes lead to an improvement in financial wealth and income of the households, which results in higher consumption. Overall, there is a cumulative consumption gain following a shock, which raises export demand.

Like the consumption shock, business investment is negatively affected by an increase in interest rates in FPS. In contrast, business investment displays an opposite response to the consumption shock in NZTM. There are two main reasons why firms react differently. Firstly, an increase in export volumes does not translate into higher export prices in NZTM because New Zealand is a price taker. Secondly, an improvement in the net foreign debt position decreases the relative price of both exports and imports, which translates into a loss of competitiveness for export and domestic firms. Combined with higher interest rates, these two factors lead to a decline in business investment in response to an increase in export volumes.

The reaction of imports is different between the two models. Imports increase initially in FPS reflecting the increase in demand. However, the magnitude of the increase is small. Imports in NZTM do not react until further out in the period as both consumption and investment increase slightly above steady state. Again the magnitude of the increase is relatively small.

Once again the direction of the real exchange rate movement in FPS is the same as in the consumption shock but the magnitude differs. The driver of the real exchange rate appreciation in FPS is the UIP condition. In NZTM, the net foreign debt position is lower than the desired level because of the positive boost to exports. Thus the real exchange rate is required to appreciate to dampen exports and thus return the economy to the desired net debt position.

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