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3.5  Interest rate shock

In this shock the short-term interest rate is increased by 50 basis points above the steady state for the first 2 quarters. A reason for this shock is to look at the response of the exchange rate to a pure monetary policy shock. In NZTM, this is normally masked by the effects of the desired net debt constraint (see Figure 6).

One noticeable feature with this shock is that the effect of an increase in interest rates is not immediate in NZTM: real variables remain at equilibrium in the first period. In contrast, adjustment begins instantly in FPS. This reflects the forward-looking nature of consumers in FPS, where consumption spending drops immediately, leading to a negative output gap opening immediately. After two quarters a slightly larger negative output gap opens in NZTM.

While the size of the decline in consumption is very similar between the two models, exports also contract considerably in NZTM as the exchange rate appreciates, while the impact on exports in FPS is much smaller. With interest rates increasing, and consumption and exports both declining this sees business investment contract considerably in NZTM with a corresponding rebound further out as capital is increased back to the desired level. The investment cycle in FPS is more muted.

Inflationary pressures ease in both models but with the larger size of the negative output gap in NZTM, inflation falls more than in FPS. Once the shock to interest rates has been removed, the monetary authority in both models eases interest rates to allow inflation to return to target.

3.6  Exchange rate shock

In this simulation, the exchange rate is shocked to generate a 5% appreciation above the steady state in the first quarter (see Figure 7). The real exchange rate remains above the control over the first year and a half, reflecting similar persistence of the real exchange rate in both models.

After the first one and half years there is a substantial period in which the real exchange rate depreciates below the steady state in NZTM. This is because the shock has a negative impact on the net foreign debt position (with exports declining and imports increasing). In order to return the net foreign debt position to equilibrium, the real exchange rate must depreciate and overshoot its equilibrium. For FPS, the real exchange rate remains above the control over the entire simulation period because the net foreign debt position is not required to return to equilibrium.

The previous shocks have shown that exports and imports generally respond more in NZTM than FPS. Furthermore, there is a substantial delay in the export response in FPS in comparison with NZTM. The initial decrease in net exports generates a significant negative output gap in NZTM. The output gap becomes positive when the external sector responds to the exchange rate depreciation. In FPS, there is a small negative output gap for the first four years of the simulation period, reflecting the fact that net exports are lower than the steady state level for the corresponding period.

In FPS, monetary policy loosens over the simulation period reflecting the excess supply in the economy. For NZTM, monetary policy loosens initially to prevent inflation falling further when output gap is negative. The loosening is short-lived and is reversed when there is excess demand in the economy.

In NZTM, the profile of business investment is mainly determined by the profitability of firms, which in turn is driven by the real exchange rate cycle. When the real exchange rate appreciates, firms are reluctant to invest. On the other hand, the depreciation in the exchange rate causes renewed investment in capital goods. Like other shocks, the response of business investment is muted in FPS.

Consumption also follows the real exchange rate cycle in NZTM in this simulation. Initially, the real exchange rate appreciation lowers the price of imports which serves to stimulate demand for consumption. Similarly, the real exchange rate depreciation causes consumption to decrease.

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