2 The general structure of NZTM (continued)

2.3  The interaction between the dynamic path and the steady state

To illustrate the interaction between the dynamic path, the medium run and the steady state, Figure 2 shows the response of employment to a temporary increase in consumption. For the purposes of exposition, this can be thought of as occurring in three parts, outlined below:

• With higher demand, the profit-maximising level of labour demand from the dynamic production block (the medium-run variable) rises immediately from A to B. Although the firms would like to increase employment immediately to point B, the actual employment (the dynamic path) remains at point A at the time of shock owing to the unanticipated nature of the shock. Furthermore, the temporary nature of the shock means that the shock has no impact on the steady state in this simulation.
• In the medium run, increased consumption leads to excess demand, adding inflationary pressures. As a result, the monetary authority tightens monetary conditions, which eventually weaken demand. As demand weakens, the profit maximising level of employment begins to fall. Although the medium-run value begins to decrease, actual employment continues to increase and converges on its medium-run value because its current value is below the profit-maximising level.
• In the long run, the dynamic variable and the medium-run variable converge to the steady state. When the economy reaches the steady-state level, the dynamic variable will just grow at the steady-state rate (ie, productivity and population growth).

Figure 2: Stylised diagram of the impact on employment of a consumption shock

2.4  Assigning coefficient values in NZTM

Before we describe individual equations, we make one more general remark about how model coefficients are set. Given the difficulties involved in estimating empirically a model of this size (particularly in the presence of possible structural breaks), the majority of the dynamic equations and steady-state equations in NZTM are calibrated. The major exception is the production block, which is statistically estimated. While calibration means that parameter values may seem ad-hoc, it appears necessary to produce sensible dynamic properties. Calibration in NZTM is either based on theory (for example, the inflation expectations process, see later), empirical studies (for example, the consumption function is based on Goh and Downing, 2002) or something that gives sensible dynamic paths in response to shocks. The convention we have adopted through this paper is to denote coefficients as pa_ .

Having described the general structure of the steady-state and dynamic equations, we now start to describe various parts of the model in more detail. The first part is the equations that relate to the production block of the business sector.