1  Introduction

Roberta Piermartini and Robert Teh, two economists at the WTO, urge modellers to “demystify” their creations, making it clear to their audience what makes their models tick. A failure to do this, they argue, “risks bringing a useful analytical tool into disrepute and may even induce unwarranted cynicism…” (The Economist, 13 July 2006)

The New Zealand Treasury is mandated by section 26O of the Public Finance Act (1989) to prepare economic forecasts to be presented by the Minister of Finance each financial year. These economic forecasts are important, not only as a basis for forecasting tax revenue, but also in informing the government of the macroeconomic conditions in which proposed fiscal policy settings will operate. The New Zealand Treasury Model (NZTM) is an important part of the economic forecasting process at the Treasury. The purpose of this paper is three-fold. One is to provide an accessible introduction to NZTM without too much technical detail of the structure of a large computable general equilibrium (CGE) model. In describing the model, we have attempted to be as non-technical as possible, with a more technical description available in Szeto (2002). The second purpose of the paper is to provide an update of changes to the model since the last documentation (Szeto, 2002). The final purpose of this paper is to describe briefly the role NZTM has in the Treasury's economic forecasting process.

NZTM seeks to describe the behaviour of, and interactions between, four sectors of the economy:

• Households who consume goods and services from New Zealand and overseas firms and supply labour
• Firms who maximise profits subject to available technology by employing labour, importing intermediate goods, investing in capital and producing goods and services for the domestic market and export
• Trade and financial linkages with the rest of the world: the rest of the world buys New Zealand's exports, sells us our imports and lends to and borrows from New Zealand. Consistent with our small open economy status, New Zealand is a price-taker with respect to the rest of the world, and
• Government who consumes, invests, employs, taxes and transfers.

1.1  The evolution of NZTM

After a lengthy period of development, NZTM has become an integral part of the Treasury forecasting process. Szeto (2002) outlined the early history of NZTM which began as the New Zealand Model (NZM). NZM was based on the Murphy Model of Australia (Powell and Murphy, 1997), but adjusted to allow for differences in data and institutional structures.

The model was then renamed NZTM following a major redevelopment of the model. Key changes, according to Szeto (2002), were the introduction of:

• the relative price structure
• the inflation-targeting framework for monetary policy
• the analytical framework of real equilibrium exchange rate determination, and
• the demand-pull framework of inflation determination.

Following these developments, NZTM began to be used to produce forecasts. Initially, these forecasts were used for developing scenarios around the main forecast track (developed using other methods) and more recently to produce the main forecast track itself. The use of NZTM as a forecasting tool has spurred new developments which we will outline in this paper, notably the disaggregation of deflators into the various expenditure GDP components, the introduction of consumption and capital goods imports into the model (rather than just treating them as intermediate imports) and the disaggregation of the inflation equation into tradable and non-tradable components.

1.2  The remainder of the paper

The remainder of this paper is structured as follows. First, we give a high level description of the two-tiered structure of the model: the steady-state model, the dynamic model and how these two models interact. The structure of the steady-state and dynamic models, and their interaction, are crucial in understanding the properties of the model and therefore how the growth paths of variables evolve in the model. Once we have described the structure of NZTM at a general level, we look at the equations that describe the behaviour of the major sectors of the economy. Section 3 describes firms' production decisions. Section 4 describes how firms interact with the rest of the economy and how their production decisions feed through into firms' investment, exports, imports and the labour market. We then look at how the model determines monetary conditions and price deflators in Sections 5 and 6 respectively. Section 7 describes NZTM's role in the forecast process. Section 8 concludes.