4.1 The basic framework

The basic framework is introduced in Figure 3 below.In Panel 1, the saving (S₀^NZ) and investment (I₀^NZ) schedules for New Zealand are shown. The investment schedule decreases in the actual real interest rate (r), because a lower interest rate implies a lower cost of capital, all else equal. The saving schedule increases in the interest rate, because people are willing to save more, the higher the interest rate. Domestic saving is assumed here to be relatively inelastic in response to interest rates.

Figure 3 - The basic framework

New Zealand borrowers can also access a practically unlimited supply of foreign funds at the “world interest rate”, r₀^w. The domestic and foreign sources of funds can be added horizontally to give the aggregate saving schedule (bold and kinked at r₀^w).

In the long-run, where all factors of production are fully mobile across borders, and assuming no risk or uncertainty, actual real interest rates across countries are assumed to equalise at r₀^w. At r₀^NZ = r₀^w, aggregate (domestic plus foreign) saving equals domestic investment at I', and the excess domestic demand for funds over the domestic supply, is the current account balance (CAB) which is in deficit, that is, New Zealand invests more than it saves and is a capital importer.

Ignoring Panel 2 for the time being, any change in the world interest rate that leads to a decrease (increase) in domestic saving ex post and an increase (decrease) in investment ex post, will result in a larger (smaller) current account deficit. Moreover, any shift in the saving and investment schedules ex ante will not alter the world rate. New Zealand is a “price taker” on international capital markets.

However, the static model in Panel 1 is relatively unhelpful in explaining a range of dynamic effects that are taking place in the economy. More specifically, Panel 1 implicitly assumes that all factors of production, even capital and labour, are perfectly mobile across borders. In this scenario, a small, open economy like New Zealand would be subject to the (theoretical) price-homogenising effects of trade and cross-border flows in capital and labour.

In practice, however, factors of production are not perfectly mobile and prices appear to converge slowly across economies, even those that are very open to trade and capital flows. First, large deviations from the “law of one price” for traded goods appear to be pervasive, suggesting that frictions at the border, such as culture, languages and information asymmetries, continue to segment markets (Friberg, 2001). Standard estimates of price transmission speed suggest that the price-homogenising effect of trade operates very slowly - so slowly that many find the domestic-foreign price gap to be a random walk (Anderton et al., 2003). Some of these frictions can be reduced through a reduction in exchange rate variability, an increase in trade volumes or through monetary union (Friberg, 2001). Second, and perhaps more importantly, a large proportion of prices (of non-traded goods) are determined domestically and not on world markets.

It is these characteristics of any economy - risk, unexpected shocks and friction at the borders - that make autonomous monetary policy generally desirable. Simply put, r₀^NZ = r₀^w in Panel 1 may not actually be consistent with New Zealand internal balance (price stability) in the medium-term. This is because different interest rate levels have very different implications for domestic resource and inflation pressures.

Internal Balance

In order to capture the dynamic effects of this argument, Panel 2 introduces, what will be referred to as, the internal balance schedule, ē(AD,AS). This schedule is the combination of the real exchange rate and the real interest rate that is consistent with internal balance. By internal balance, we mean that inflation and inflation expectations are stable at the inflation target and the RBNZ does not need to take any action to constrain inflationary forces, or alleviate deflationary forces.

The internal balance schedule is a function of aggregate demand (AD) and aggregate supply (AS). Aggregate supply (potential output) is assumed to change quite slowly over time, which is consistent with the evidence for most countries. Aggregate demand includes consumption (public and private), investment and net exports (as per Box 1).

The real exchange rate is denoted in foreign currency units per one New Zealand dollar and so the internal balance schedule is downward sloping, that is a lower level of the real interest rate is consistent with a higher real exchange rate (an appreciation). A lower interest rate stimulates investment and consumption and in order for internal balance to be maintained, the higher exchange rate is needed to increase imports and decrease exports.

Traditional models, like Mundell-Fleming, have the real interest rates of small, open economies converging to the world rate because with open capital markets, capital flows from low-yield currencies to high-yield currencies until gaps are eliminated. In such models, imperfect capital mobility or country risk premia are the only reasons for a divergence in cross-country interest rates. The following scenarios will show however that it is possible for the real interest rate of a small open economy like New Zealand to deviate from the world real rate, even assuming perfect capital mobility and zero country risk premia.

The actual exchange rate and external balance

So, given open capital markets, what is the mechanism that determines whether r₀^NZ can deviate from r₀^wover a significant length of time? Simply put, it is the actual exchange rate and expectations regarding future exchange rate movements.

It is very likely that the actual exchange rate at any particular interest rate may not be the equilibrium exchange rate needed to achieve both internal and external balance.

The long-run equilibrium real exchange rate is a theoretical concept based on the idea that the real exchange rate will, in the long-run, tend to move towards a level that reflects fundamental factors in the economy. The equilibrium exchange rate is not observable in practice and there are several analytical approaches that can be used to estimate the level of the equilibrium real exchange rate (MacDonald, 2000).

One of these is the Macroeconomic Balance (MB) approach. This approach attempts to identify the level of the real exchange rate that would be consistent with both internal and external balance in the economy. Internal balance is achieved when the economy is operating at potential output and the inflation rate is stable. External balance is achieved when the current account deficit is being financed by a sustainable rate of capital flow. According to this approach, any internal or external imbalances in the economy will lead to an adjustment, in either the exchange rate or in the domestic economy, until balance is achieved. For example, because New Zealand has run persistent current account deficits for some time and has accumulated a large stock of net foreign liabilities, this should put downward pressure on the equilibrium exchange rate because a larger surplus on the balance of goods and services is required (Brook and Hargreaves, 2000).

Recent International Monetary Fund (IMF) estimates using the MB approach suggest that the New Zealand dollar could be overvalued by around 15 to 25 percent (the current deviation from its long-run equilibrium) (IMF, 2010). This is consistent with more recent evidence on New Zealand dollar misalignment in Cline and Williamson (2010) where the New Zealand dollar is included among the most overvalued of currencies in a group of more than 30 countries.

Historical evidence suggests that actual exchange rates may move away from the equilibrium level for long periods of time. The long-run equilibrium real exchange rate for New Zealand is likely to have been well below the average real exchange rate level for the past 20 years.

In the framework above, this deviation between the actual and equilibrium exchange rate is captured by the introduction of an upward sloping schedule e(r₀^w) in Panel 2. This upward sloping schedule is a depiction of the uncovered interest parity (UIP) hypothesis.

UIP is a no-arbitrage hypothesis that relates the expected change in the actual exchange rate to the interest rate differential. UIP predicts that high yield currencies should be expected to depreciate to eliminate any profitable opportunity (arbitrage) from holding the higher yield currency. UIP also predicts that, ceteris paribus, a New Zealand real interest rate increase should cause the New Zealand dollar to appreciate (Bekaert, Wei, and Xing, 2007).If the New Zealand interest rate increases, ceteris paribus, then capital should flow into New Zealand to exploit arbitrage opportunities. The New Zealand dollar would appreciate until the appreciation “forces” a change in expectations that eliminates arbitrage opportunities. That is, the currency is expected to depreciate enough to offset the gain from the interest differential. Even though the currency is expected to depreciate, this depreciation may not happen for some time (expanded upon later). Panel 2 in Figure 3 is drawn so that at r₀^w, the actual real exchange rate, e₀, determined along the UIP schedule, is consistent with internal balance along ē.