3  The production block

3.1  The production block

In this section we examine the production block for the private business sector. The production block is the name given to the component of the model that determines the combination of the representative firm's inputs and outputs that will maximise profits within the private business sector of the economy. The advantage of dividing output into private sector output and public sector output is to give a more accurate picture of how the government sector affects the economy – that is, the government sector not only uses private sector goods and services but also absorbs resources, especially labour, directly. Coefficients in the production block are estimated. Szeto (2001) provides further details on the production block and how it is estimated.

The production block combines three inputs (capital k, labour n, and imported intermediates imo) to produce goods and services (gross output, t). All the goods and services produced by the private business sector are classified into two distinct groups: commodity export production (cexps) and non-commodity goods and services (“other goods”, ydo).

In the past, NZTM made the assumption that all imports were intermediate inputs in the production process. One of the key changes since Szeto (2002) is the disaggregation of imports into four different components: consumption goods and services, capital goods, household overseas spending and intermediates. Disaggregation of imports helps the Treasury to tell a more detailed forecast story, as well as being useful for the purposes of modelling inflation, which we will discuss more in Section 5.1.

Another change to the production block is that we do not aggregate commodity exports and non-commodity exports into total export goods. Instead, we treat commodity export goods as a separate output and aggregate the rest of the output as “other goods”, reflecting that it is more suitable to group non-commodity exports with other domestically produced goods because of the nature of the production process.

The production block is composed of two nested constant elasticity of substitution (CES) functions and a constant elasticity of transformation (CET) function. In order to maximise profits, the representative firm can be thought of as making three decisions (summarised in Figure 3):

1. the mix of capital and labour (known collectively as domestic factors) they use
2. the mix of domestic factor input (y) and imported intermediates they use
3. the mix of commodity exports and “other goods” they produce.

Figure 3: The production block of the business sector

3.1.1  The production block and the rest of the economy

For ease of exposition, we treat some variables as “exogenous” to the production block in this chapter. For reasons we will discuss below, these variables are not strictly exogenous as their values are dependent on what happens in the production block. The relative prices (real exchange rate) of imported intermediates and commodity exports are examples of such variables.

To explain this point, consider solving the steady state of the model as an iterative process (see Figure 4).[8] For a given real exchange rate, the production block will give us commodity export and imported intermediate volumes as well as the firms' demand for labour. These values may or may not be consistent with external balance and internal balance. If external and internal balance is not achieved with this real exchange rate, the real exchange rate will need to adjust until these critical balances are met (see Section 2.2 for explanation of the role of the real exchange rate in simultaneously achieving internal and external balance). Given the foreign price of the tradable goods is exogenous, it will need to be the nominal exchange rate or the domestic price level that adjusts. For example, if with the current real exchange rate, external debt is greater than target, the relative price of tradable goods to domestic goods will need to increase to encourage the production of exports and slow the use of imported intermediates. Therefore, the relative prices of imported intermediates and commodity exports (real exchange rates) are simultaneously determined within the whole model.

Figure 4: The production block and internal and external balance