Examining the Elasticity of New Zealand's Current Account to the Real Exchange Rate (WP 14/12)

Abstract

The main purpose of this paper is to supplement the existing literature by quantifying the elasticity of New Zealand's current account to changes in the real exchange rate. The unusual composition of New Zealand's current account balance - particularly the large income deficit and the importance of the agricultural sector to the goods balance - suggests that this relationship for New Zealand may differ from that for other developed countries. As a result, we focus on modelling the relationship between New Zealand's exchange rate and the current account stripped of four main components: the net investment income balance, dairy exports, the value of both oil exports and imports, and education services exports: what we call the 'adjusted' balance.

We find that the responsiveness of New Zealand's current account to the real exchange rate is towards the lower end of most estimates used in other studies. Given that the trade elasticity is a key variable in macro-balance models of exchange rate valuation, we conclude that some previous studies may have underestimated the magnitude of the real exchange rate adjustment needed to help achieve external equilibrium in the long run.

Acknowledgements

We are grateful for many helpful comments from Tim Ng, Sam Direen, David Hargreaves and James Graham.

Disclaimer

The views, opinions, findings, and conclusions or recommendations expressed in this Working Paper are strictly those of the author(s). They do not necessarily reflect the views of the New Zealand Treasury or the New Zealand Government. The New Zealand Treasury and the New Zealand Government take no responsibility for any errors or omissions in, or for the correctness of, the information contained in these working papers. The paper is presented not as policy, but with a view to inform and stimulate wider debate