2  The general structure of NZTM

NZTM consists of two parts: the steady-state model and the dynamic model. The growth path for the economy is determined by the interaction of the model's steady-state and dynamic equations. The steady state is a long-run state to which the key variables converge, while the dynamic equations describe how the economy moves to steady state. We outline these two components below.

2.1  The steady state[1]

2.1.1  General features

The steady-state model of NZTM provides an explicit estimate of the future long-run value that each variable normally converges to. The explicit statement of the steady-state level is a key point of difference from some other models where the level is not explicitly defined but rather variables are expressed as deviation from trend.

The steady state of the model can be broadly characterised as consisting of two parts, the production block (ie, the supply side) and the demand side. Later in the paper we will outline in more detail the steady-state structure of the production block and demand-side. However, for our current purposes, it is sufficient to think of the steady state as when the economy is on a balanced growth path in the Solow growth-model[2] sense, with output growth dependent only on productivity and population growth. The balanced growth path has the implication that the capital-to-output ratio is constant.

A second feature of the steady state in NZTM is that the economy is in internal and external balance. Internal balance is a condition that the values of all variables are such that the unemployment rate is equal to the non-accelerating inflation rate of unemployment (NAIRU) and the domestic goods market is in equilibrium (supply equals demand). External balance is the requirement that New Zealand’s net external indebtedness with the rest of the world is at a certain level as a share of GDP. These two balance requirements, sometimes called collectively macroeconomic balance,[3] play a key role in linking the supply and demand sides of the model.

2.1.2  The role of the real exchange rate in achieving simultaneous external and internal balance

In steady state, the real exchange rate has an important role in achieving internal and external balance simultaneously and thus achieving steady state. Simultaneous achievement of internal and external balance can be thought of as occurring in three steps:[4]

1. In steady state, both the real current account deficit (cad) and the real net foreign asset position (nfa) return to their steady-state GDP ratio. The steady-state growth rate of real GDP is the sum of the growth rate of working-age population and labour-augmented productivity. Therefore, the level of real net foreign assets will need to grow at the steady-state GDP growth rate to ensure its steady-state GDP ratio remains constant and at target. By definition, a decrease in net foreign assets implies net financial inflows (nff), which equals the current account deficit. Given the change in real net assets is known, we get the steady-state current account deficit (see equation 2.1.1).

2. If we decompose the current account deficit into the trade balance (nx), net income balance (nib) and net transfers (ntr) we get the following identity:

In steady state, the net income balance (nib) can be thought of as being “given” for this purpose, in that it is the target level of net foreign assets multiplied by the world interest rate plus a risk premium. We can also assume net transfers are given. Therefore, rearranging (2.1.2) and taking nib and ntr as given, we get the steady-state trade balance (nx^*):

3. To illustrate this, we divide the productive economy into two sectors: tradables (TR) and non-tradables (NT).[5] For a given level of resource use, the production of tradables and non-tradables can be shown by the production possibility frontier. In Figure 1, ppf* represents the production possibility frontier in a fully employed economy (such that unemployment is at its NAIRU level, one requirement of internal balance). This is opposed to ppf' with the unemployment rate higher than the NAIRU. Thus, to be consistent with internal balance, the economy will need to produce somewhere on ppf*. Where the economy produces on ppf* depends on the real exchange rate (the relative price of non-tradables to tradables, p^nt/p^tr). There is also the nation's mix of aggregate expenditure on tradables and non-tradables, which is represented by the national indifference curve in Figure 1. The amounts of tradables and non-tradables consumed also depend on the real exchange rate. By definition, a country's production and demand of non-tradables must be the same, while the difference between tradables production and consumption equals the trade balance. For external balance to hold, the real exchange rate must be equal to the negative of the slope of the two parallel lines evaluated at points A and B so that the trade balance is equal to the steady-state trade balance derived above, whilst ensuring that the economy is producing on the production possibility frontier where the unemployment rate is equal to the NAIRU.

Figure 1: Modified Salter-Swan diagram showing macroeconomic balance