4.3 A foreign shock and New Zealand real interest rates
The previous section has shown that domestic saving and investment fundamentals can be responsible for driving a wedge between New Zealand real interest rates and the “world” rate and that this wedge may last for some time even without the existence of country risk premia. However, this section shows that foreign shocks that impact on the level of foreign real interest rates (the “world” rate excluding New Zealand), will impact on New Zealand real interest rates in the same direction, but not necessarily of the same magnitude. That is, while domestic economic fundamentals are important determinants of the level of New Zealand real interest rates, they are not independent of global factors.
Assume a foreign shock (such as an increase in the global supply of funds) that lowers the global actual real interest rate to r1w as in Figure 6. Assuming all else equal, in order for the New Zealand exchange rate to be unaffected at e0 and still meeting the UIP condition, the New Zealand actual real interest rate would have to adjust instantaneously to the new “world” rate. This would be represented by a downward shift of the UIP schedule. To put it another way, at every level of the exchange rate, a lower interest rate is needed to attract the requisite capital inflows because foreign interest rates are less attractive. But this exchange rate-interest rate combination (r1w, e0) would not be consistent with internal balance since nothing fundamentally has changed in the New Zealand economy, except that funds are now available at a lower rate. This would put upward pressure on domestic resources and inflation, as investment and consumption increase.
Similarly, r0NZ would no longer be consistent with internal stability. The gap between foreign and New Zealand interest rates would put upward pressure on the exchange rate which would be inconsistent with internal balance because of lower aggregate demand.
- Figure 6 - A foreign shock that lowers the global interest rate
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Instead, internal balance will be achieved through a combination of a higher exchange rate (e1) and an interest rate (r1NZ) somewhere between r0NZ and r1w. Thus, the RBNZ will lower the OCR (which will flow through to actual real interest rates in the economy), but the drop in New Zealand interest rates will not match the decline in foreign rates. Further reductions in the interest rate below r1NZ would be inconsistent with internal balance, because the exchange rate would be too low and inflation pressures would build up as described above.
The previous two sub-sections have highlighted that while foreign forces do drive the direction of domestic interest rate movements, the magnitude will be constrained by domestic saving and investment rates. That is, full convergence of domestic interest rates to the world level may not be possible.
