5.3 Exchange rate
5.3.1 Steady-state exchange rate
In steady state, imports and exports are at a level so that the economy is in external balance. There is a level of the real exchange rate that will achieve this (see Section 2.1). In practical terms, the real exchange rate is expressed as the relative price of all tradable goods such as the relative price of imported intermediates (rpmo) and the relative price of commodity export goods (rpexc). This framework is based on Dornbush (1974), reflecting the importance of changes in the terms of trade faced by the New Zealand economy.
The identity in Section 2.1.2 states that net capital inflows should equal the current account deficit, is the key in determining the real exchange rate. Equation (5.3.1) is based on this identity. In steady state, net debt with the rest of the world (as a percentage of GDP, rfdebt) must be at its external balance level. The aggregate net debt with the rest of the world must therefore grow at steady-state GDP (ie, population and productivity growth, gr_1) and therefore so must the current account deficit (the expression of the right hand side of 5.3.1; see Table 4 for variable names). Thus the value of the real exchange rate must be such that the relative prices and quantities of exports and imports (which as we saw in sections 4.2 to 4.4 depend on relative prices) ensure the identity in equation 5.3.1 holds.
| Variable | Label |
|---|---|
| rfdebt | Real foreign net debt |
| exp | Exponential operator |
| gr_1 | Lag of the growth rate in productivity and population growth |
| rdos | Real net capital inflow |
| rpexc | Relative price of commodity export |
| cexp | Commodity exports |
| rpexnc | Relative price of non-commodity exports |
| ncexp | Non commodity exports |
| rpmo | Relative price of intermediate exports |
| pol5_eq | Customs tax rate (ie, tax on imports) |
| imsr | Profit-maximising level of intermediate imports from the production block |
| rpmc | Relative price of imported consumption goods |
| imc | Imported consumption services |
| rpmcs | Relative price of imported consumption services |
| imcs | Imported consumption goods |
| rpmca | Relative price of imported capital goods |
| imca | Imported capital goods |
| rtrospr | Real net transfers from the foreign sector to the private sector |
| rtrpuos | Real net transfers from the private sector to the foreign sector |
| ryospu | Real net transfers from the foreign sector to the public sector |
| rmtransfer | Real migrants net transfers |
In general, the relative price of each traded good/service is expressed as:
For example, the relative price of commodity export goods is given by:
where pexcf = foreign price of commodity exports, e = the nominal exchange rate and pydo is the price deflator of the other goods.
Given the foreign price is exogenous, the relative price is determined jointly by the nominal exchange rate and the domestic price level. Thus, equation (5.3.2) implies that the solution to equation (5.3.1) can be determined by the real exchange rate index (rer) where rer = e*pydo.
5.3.2 Exchange rates in the dynamic model
Equation (5.3.3) shows the medium-run value of the real exchange rate index (re) will adjust towards the steady-state value of the real exchange rate index (ere). The equation also contains an adjustment in the actual level of net foreign debt as a percent of real GDP (dgdpr) with the level of net foreign debt as a percent of real GDP that is consistent with external balance (fdgdpr). If actual debt (as a percentage of GDP) is above target, the real exchange rate will depreciate. eregr is a growth term that ensures convergence in the model.
where exp is the exponential operator.
Equation (5.3.4) states that the nominal exchange rate will adjust to close the gap between the lagged value of the real exchange rate index (rer) and the medium-run value of the real exchange rate index (re), with exchange rate dynamics also being influenced by uncovered interest parity (UIP). The UIP condition means if the New Zealand short-term interest rate (rcs) is higher than the sum of the world short-term interest rate (rcsf) and the sovereign risk premium (srp) for New Zealand 90-day bank bills, the magnitude of the expected depreciation in the nominal exchange rate (and therefore loss of profit on the investment in New Zealand dollar terms) is large enough to offset the increased return on New Zealand investment.
Exchange rate dynamics are not fully governed by UIP as theory would suggest given its mixed empirical success (see King, 1998 and Stephens, 2004). Stephens (2004) also found that interest rates may not be driving the exchange rate cycle in the early 2000s with dynamics being governed more by other factors. The assumption of UIP will hold in equation (5.3.4) if both pa4_1 and pa4_2 in the exchange rate equation are set to zero.
Equation (5.3.5) reconciles the model nominal exchange rate (e) with the nominal exchange rate on a trade weighted Index (etwti).
