A macroeconomic study of the dynamic behaviour of output, prices and exchange rates in New Zealand

Abstract

The theoretical framework of this research is based on a hybrid New Open Economy Macroeconomic (NOEM) model which explains monetary transmission channels using an intertemporal general equilibrium framework based on a definite welfare criterion of the representative optimizing household in an open economy setup. The theoretical model allows both producer currency and local currency pricing of the international profit maximizing firms in an imperfectly competitive market configuration and thus justifies the 'hybrid' connotation. Prior empirical literature indicate that in the face of 'pricing to market' (PTM) activities of international profit maximizing firms in the imperfectly competitive market, monetary policy has limited potentials for maintaining low and stable price inflation in a small open economy under flexible exchange rate regime. In this context, the Reserve Bank of New Zealand confronts a constant challenge meeting its agenda of maintaining the low and stable domestic inflation rate since the inception of 'inflation targeting' policy stance in 1989. However, henceforth RBNZ is quite successful in maintaining the low and stable domestic inflation rate. Thus it may be said without much reservation that monetary policy has so far attained its objective in New Zealand with the implication that conventional 'monetary transmission channels' have worked in accordance with theoretical predictions.

This research has incorporated policy and non-policy macroeconomic variables of New Zealand and four of its most important trading partners suggested by the NOEM model and constructed a benchmark Vector Autoregressive (VAR) model suitable for the small open economy of New Zealand for empirical analyses. Monetary policy shocks are exactly identified using Choleski decomposition of the structural shocks. Thus it is assumed that RBNZ can observe price and output fluctuations at least within a quarter (due to quarterly data) and contemporaneously responds through an appropriate policy stance while the target variables show lagged responses.

Consequently, empirical evidence is found in support of the conventional monetary transmission channels. More specifically, it is found that domestic output falls on impact of a restrictive monetary policy stance on the part of RBNZ. On the other hand, both nominal and real effective exchange rates appreciate on impact due to a positive innovation to the bank discount rate reflecting a tight monetary policy implemented by the RBNZ. Besides, both consumer and producer prices decline due to the monetary contraction, whereas producer prices show more responsiveness to the restrictive monetary policy action compared to consumer prices, supporting the predictions of prior literature. Regarding the relative importance of the sources of variations in output, prices and exchange rates; monetary policy has a moderate influence explaining the movements of these variables. However, monetary policy is observed to explain a relatively significant proportion of the variations in producer and consumer prices in New Zealand and thus supports the inflation targeting nature of the RBNZ. This observation is also found robust as innovations to producer and consumer prices explain most of the variations in New Zealand bank discount rate. On the other hand, 'world commodity price index' explains most of the output variations in New Zealand, reflecting its open small economy nature.