4.6 Private consumption
In steady state, private non-housing consumption (conor) is related to real after-tax labour income (rincome), real wealth (rwealth) and the relative price of non-housing consumption goods and services (rpyd_c). The relative price term means that the higher the relative price of consumption, the lower is real consumption.
The elasticities on real income and wealth are currently set at 0.8 and 0.2 respectively.
The dynamic specification of the private consumption equations is based on the work of Downing and Goh (2002). Private consumption (conor) is assumed to adjust towards a level of medium-run consumption (conord; not to be confused with the steady-state value of consumption). The partial adjustment mechanism towards medium-run consumption is consistent with the Permanent Income/ Life-cycle Hypothesis (see Friedman, 1957;Modigliani and Blumberg, 1954) where consumers spread existing resource to achieve a smooth consumption profile over their life. Medium-run consumption depends on current net wealth, current after-tax labour income and households' desired debt level (pagdpr_eq, see section 4.6.1).
In addition to the partial adjustment towards medium-run consumption, other variables which affect the dynamics of consumption in the short-run are interest rates and the relative price of imports. Interest rates (specifically the yield curve, ycurve) negatively impact consumption with a lag of two quarters. The change in the price of imports relative to the price of domestic goods (rpm) also enters with lags of two and three quarters reflecting that cheaper imports will promote consumption. The yield curve and the relative price of consumption imports are lagged to reflect the fact that monetary policy and import price pass-through take time. There is also a lagged term (conor(-1)) to introduce habit persistence in consumption contributing to real rigidities in economic adjustment.
4.6.1 Desired debt
One of the major changes in NZTM since Szeto (2002) is it incorporates changes in the desired debt level in the determination of medium-run consumption. The motivation behind the desired debt level term is the observation that, in recent years, consumption has grown faster than labour income and wealth growth, implying that households are willing to borrow more. Changes in the desired debt level can be used to induce a temporary change in consumption in the short and medium term. However, there is no free lunch as any increase in consumption due to a change in the desired debt level will lead to less net wealth, reducing consumption in the long run.
4.6.2 The link between dynamic consumption and steady-state
There are two key mechanisms in getting dynamic consumption to equal steady-state consumption in the long run. The first is that consumption in the dynamic model depends on net wealth. In the dynamic equations, if the level of consumption is currently above its steady-state level and all other variables such as income and net wealth are at their equilibrium, households' net financial asset position must be in decline (ie, they are borrowing to fund their consumption). Declining net financial assets mean net wealth must decrease (net wealth = net financial assets + net non-financial assets) and therefore through equations (4.6.2) and (4.6.3) so must consumption growth in the dynamic model.
The real exchange rate also plays a role in the adjustment. Periods of consumption growth above steady-state growth will be funded by increased borrowing overseas. In order to keep external balance, the real exchange rate will need to depreciate, discouraging consumption as imports of consumption goods and services are now relatively more expensive.
Eventually consumption will have slowed through both the lower real exchange rate and lower net wealth. As consumption slows, the net financial asset position should improve, allowing consumption to grow at its steady-state rate.
4.6.3 Consumption of housing services
In both steady-state and the dynamic equations, consumption of housing services (conh) grows in proportion to the rate of growth of the housing stock (kh). However, as Figure 10 shows, the proportion of housing services to the housing stock over history has been falling, thus equations (4.6.4) and (4.6.5) are supplemented with a trend term (TF).
where ksratio and ksratio_eq are the ratios of consumption of housing services to the housing stock.
- Figure 10: Ratio of consumption of housing services to housing stock
- Sources: Statistics New Zealand, Treasury