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3.3  Export price shock

For this shock, export prices (measured in foreign price terms) are increased by 5% above the steady state for the duration of 4 quarters. This experiment shows that export volumes are more responsive to price changes in NZTM than in FPS. Before we describe the dynamics of the shock, it is important to mention again that the real exchange rate takes a different form in the two models. In FPS, the real exchange rate (RER) is defined as:

where RER is the real exchange rate; e is defined as the price of domestic currency in units of foreign currency; Pd and Pf are the domestic and foreign price levels respectively.

In the NZTM, the real exchange rate is defined as the relative price of exports (RPTEX) or the relative price of imports (RPM):

and

where Px and Pm are the world prices of New Zealand’s exports and imports respectively. The inverse of RPTEX and of RPM are equivalent to RER if no distinction is made between traded and non-traded goods (i.e. Pf = Px = Pm).

In FPS, there is near-complete pass through into domestic prices of persistent shocks to world export and import prices. However, a temporary shock to world prices does not lead to complete pass through because of the model’s adjustment cost structure (which implies some temporary buffering through the margins of international distributors). In NZTM, world export and import prices are derived historically from domestic export and import price deflators adjusted for the trade weighted exchange rate index so a complete pass through is assumed. Therefore, there is a difference in the definition of world prices between the two models. This is partly why the response of FPS to world price shocks is smaller than that of NZTM (see Figure 4).

In this experiment, the path of the real exchange rate is a key difference between the two models. In NZTM, an increase in the world export price (Px), which has a direct impact on the relative price of exports (RPTEX), increases RPTEX instantly by less than the increase in Px. This is due to the fact that the impact of the shock is partially offset by a higher nominal exchange rate as the financial agents are forward looking. The higher nominal exchange rate is why the relative price of imports (RPM) appreciates gradually and peaks two years after the shock. When the export price shock comes off after a year, RPTEX converges immediately to RPM, which is about 3% above the steady state.

In FPS, there is no direct link between the world export price and the foreign price level. In addition, the nominal exchange rate does not respond to temporary price shocks. As a result, there is a negligible movement in the real exchange rate in FPS.

In NZTM, exports are boosted as resources move to the exporting sector in response to the increase in the relative price of exports. However, the nominal exchange rate responds immediately to the improvement in the current account. Hence, the expansion is gradually eroded by the higher nominal exchange rate, which lowers the relative price of imports and increases imports considerably over the forecast horizon. In FPS, export volumes react to the increase in price after 1½ years with the peak around 2½ years. In general, the reaction is more subdued and less immediate than in NZTM. A temporary 5% increase in the world export price for a year leads to a 0.8% increase in export volumes at their peak in NZTM while the same shock only leads to a 0.25% increase in export volumes at their peak in FPS.

Figure 3 shows that the profile of business investment follows mainly the profile of the relative price of exports in NZTM. An initial surge in the RPTEX leads to a small increase in business investment. With the world export price back to its steady state after a year, the appreciation of the real exchange rate makes both the domestic and export sector less profitable and competitive, which in turn dampens business investment for the next two years. However, business investment makes a significant rebound three years after the price shock, as firms attempt to achieve their desired capital stock levels and because of a fall in the short term interest rates. In FPS, again the reaction is more muted with business investment decreasing slightly reflecting the increase in the interest rate, as shown in Figure 4.

Figure 3 – Business investment and RPTEX responses to an export price rise in NZTM
Figure 3 - Business investment and RPTEX responses to an export price rise in NZTM.

Consumption reacts positively in both models to the boost in incomes following the increase in export prices with a quicker response in FPS reflecting the forward looking behaviour of consumers. In NZTM, consumers spend all their extra income arising from the increase in the world export price so that their desired net foreign asset ratio remains constant. The consumption response of FPS is smaller reflecting the slow adjustment of the (improved) net foreign debt position back to equilibrium.

As discussed earlier, in FPS the net foreign asset position re-equilibrates as consumers adjust spending to reach desired wealth positions. This happens considerably more slowly than the exchange rate led re-equilibration in NZTM: in fact, in FPS asset positions are still returning to equilibrium at the end of the simulation period.

Although the magnitude of the movement of consumption and exports is large in NZTM, the magnitude of the output gap is small. This is due to the fact that the overall increase in consumption is supplied by imports and the initial surge in exports is also offset by higher imports. In FPS, the magnitude of the output gap is negligible reflecting that the model is not responsive to temporary price shocks. Consequently, inflationary pressures are muted in both models.

3.4  Import price shock

In this shock import prices (measured in foreign price terms) are increased by 5% above the steady state for 4 quarters. One purpose of this shock is to investigate whether the impact of the world price shock is symmetric to the export price shock. As with the export price shock, there is an immediate impact on the real exchange rate in NZTM and once again the real exchange rate response is muted in FPS (see Figure 5).

In response to the 5% increase in the world import price, the relative price of imports in NZTM depreciates by more than 5%, as this price shock has an immediate and negative impact on the current account, which further lowers the real exchange rate. When the price shock comes off after a year, RPM converges back to RPTEX, which is about 2% lower than the steady state. It is interesting to note that the magnitude of the change in the relative price is smaller than that in the previous shock at the end of the price shock, reflecting the fact that the economy is more responsive to import price shocks than to export price shocks in NZTM.

As the relative price of imports rises, consumption falls in response to a decrease in both real income and wealth. The price shock leads to a 0.8% decrease in consumption at its peak in NZTM while the same shock only leads to a 0.4% decrease in consumption in FPS. Compared with the previous shock, households’ response to the import price shock is much faster in NZTM. On the other hand, there is no significant difference in responsiveness in FPS.

In NZTM, the impact of the shock on imports is augmented by the real exchange rate depreciation. Therefore, with lower consumption, the level of imports falls sharply, which reaches a trough of 2.5% below the steady state. This sharp fall in imports has a significant impact on the output gap. With the fall in imports greater than that in domestic demand, a small positive output gap is generated. For FPS, imports are less responsive to the shock which results in a 0.6% decrease in imports volumes. Once again there is a negligible change in the output gap in FPS.

Unlike the export price shock, higher import prices generate significant inflationary pressures in FPS. On the other hand, inflationary pressures are much weaker in NZTM. This suggests that the first round pass-through from import prices to consumer prices is much stronger in FPS than in NZTM.

Like the export price shock, there is an initial surge in business investment in NZTM but for different reasons. In NZTM imports are an intermediate input into the production function just like capital and labour. With an increase in the relative price of imports, firms switch to more capital. Furthermore, increasing the relative price of import enhances the competitiveness of the domestic sector. In contrast, increasing import prices has no significant impact on business investment in FPS.

Although there is a substantial depreciation in the real exchange rate in NZTM, the level of exports remains below the steady state. It is due to the fact that some components of our exports require intermediate imports and the impact of the real exchange rate depreciation on exports is offset by higher import prices, leading to a fall in production.

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