Recent Reserve Bank discussion papers (with abstracts)
Reserve Bank discussion and research papers present the detailed scholarly research of staff economists and visiting scholars. The papers are published throughout the year mainly for academic and professional economists.
(NB. If you do not have the free Acrobat reader software necessary to read these discussion papers already installed, go to the Adobe website.)
Papers for 2006
DP2006/12
The Present Value Model and New Zealand’s current account
This paper tests the present value model of the current account on New Zealand data. There is some evidence in favour of the PVM – the current account tests as stationary and Granger-causes changes in national net income. However, the cross-equation restrictions implied by the model are rejected both individually and jointly. This result holds for both the linear and non-linear versions of the tests. The orthogonality test results are consistent with rejection due to the presence of a transitory demand shock. We conclude that a richer model is needed to understand current account dynamics.
DP2006/11
Assessing the fit of small open economy DSGEs
We describe a simple extension of the Monacelli (2005) small open economy model that incorporates a non-tradable good, habit persistence and price indexation. The empirical fit of eight different specifications of this model is then tested in a Bayesian framework using data for three small open economies: Australia, Canada, and New Zealand. The results show that the model with a non-tradable good fits the data better than the one-good model across all specifications considered. In contrast to Rabanal and Rubio-Ramarez (2005), we find that adding price indexation to either the one- or two-good model deteriorates overall empirical fit.
DP2006/10
A new core inflation indicator for New Zealand
This paper introduces a new indicator of core inflation for New Zealand, estimated using a dynamic factor model and disaggregate price data. Using disaggregate price data we can directly compare the predictive performance of our core indicator with a wide range of other ‘core inflation’ measures estimated from disaggregate prices, such as the weighted median and the trimmed mean. Predictive performance is assessed relative to a centred 2 year moving average of past and future annual inflation outcomes. The 2 year centred moving average is used as an analytical approximation of the inflation target from the PTA, which requires the Reserve Bank to keep annual inflation between 1 and 3 per cent on average over the medium term. We find that our indicator produces relatively good estimates of this characterisation of core inflation when compared with estimates derived from a range of other models.
DP2006/09
Uncovering the Hit-list for Small Inflation Targeters: A Bayesian Structural Analysis
We estimate underlying macroeconomic policy objectives of three of the earliest explicit inflation targeters – Australia, Canada and New Zealand – within the context of a small open economy DSGE model. We assume central banks set policy optimally, such that we can reverse engineer policy objectives from observed time series data. We find that none of the central banks show a concern for stabilizing the real exchange rate. However, all three central banks share a concern for minimizing the volatility in the change in the nominal interest rate. The Reserve Bank of Australia places the most weight on minimizing the deviation of output from trend. Tests of the posterior distributions of these policy preference parameters suggest that the central banks have very similar objectives.
DP2006/08
What do robust policies look like for open economy inflation targeters?
Typical New Keynesian open economy models suggest a limited response to the exchange rate. This paper examines the role of the open economy in determining robust rules when the central bank fears various model misspecification errors. The paper calibrates a hybrid New Keynesian model to broadly fit the economies of three archetypal open economy inflation targeters – Australia, Canada, and New Zealand – and seeks robust time-consistent policy. We find that policies robust to model misspecification react more aggressively to not only the exchange rate, but also inflation, the output gap and their associated shocks. This result generalizes to the context of a flexible inflation targeting central bank that cares about the volatility of the real exchange rate. However, when the central bank places only a small weight on interest rate smoothing and fears misspecification in only exchange rate determination, a more cautious policy is recommended for all but an exchange rate shock. It is also shown that the benefits of an exchange rate channel far outweigh the concomitant costs of uncertain exchange rate determination.
DP2006/07
How costly is exchange rate stabilisation for an inflation targeter? The case of Australia
This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linearquadratic formulation of inflation targeting, we append a term that penalises deviations in the exchange rate to the central bank’s loss function. For a simple forward-looking New Keynesian model, we show that the central bank can reduce volatility in the exchange rate relatively costlessly by aggressively responding to the real exchange rate. However, when we append correlated shocks – to better match summary statistics of the Australian data – we find that the costs associated with reducing exchange rate volatility are larger: output volatility increases substantially. Finally, we apply our method to a variant of a small backward-looking New Keynesian model of the Australian economy. Under this model, large increases in inflation and output volatility accrue if the central bank attempts to mitigate exchange rate volatility.
DP2006/06
Family trusts: ownership, size, and their impact on measures of wealth and home ownership
The number of family trusts has increased markedly in New Zealand over the last 15 years. This increase has implications for the measurement of household wealth and home ownership, since a significant proportion of dwellings are now held in family trusts. The Household Savings Survey (HSS), which was undertaken by Statistics New Zealand in 2001, collected data on household wealth, including the assets and liabilities of family trusts. HSS data is re-examined, with an emphasis on looking at the types of households that have family trusts, and also at the assets held in these trusts. The 2001 census, which included for the first time a question on whether a dwelling was held in a private trust, is also re-examined. It seems that many census respondents were confused by the census question, and results from the HSS suggest that the census total for trust dwellings is an undercount. HSS data, together with data on the number of tax returns from private trusts, is used to adjust the 2001 census tenure table. It was found that after adjustment for trust ownership, the home ownership rate still fell between 1991 and 2001. Furthermore, ownership rates fell for all age groups. Some of the difficulties that trusts pose when analysing surveys like the HSS at the unit record level are outlined, as are some suggestions for dealing with these difficulties.
DP2006/05
Should monetary policy attempt to reduce exchange rate volatility in New Zealand?
Previous research has suggested that including exchange rate stabilisation within the goals of monetary policy significantly increases the volatility of inflation, output and interest rates, and that the benefits of exchange rate stabilisation therefore do not justify the costs. The current paper tests whether this finding is robust when various alternative models of exchange rate determination are considered. The analysis is carried out in the context of optimal full-information monetary policy rules in a New Keynesian model that is calibrated to represent the New Zealand economy. For the models that feature rational expectations, we support the conclusion that seeking to avoid exchange rate volatility would have more costs than benefits. Indeed, a major cost of including the exchange rate within the goals of monetary policy is that inflation expectations become less anchored to the inflation target, meaning that larger movements in nominal interest rates are required to control inflation.
DP2006/04
We use the Reserve Bank of New Zealand’s macroeconomic model (FPS) to look at the feasibility of using monetary policy to reduce variability in output, the exchange rate and interest rates while maintaining an inflation target. Our experiment suggests that policy could be altered to increase the stability of interest rates, the exchange rate, inflation, or output, relative to the base case reaction function in FPS, but such a policy would incur some cost in terms of the variability of the other variables. In particular, we find that greater exchange rate stability would have relatively large costs in terms of the stability of all three other variables, primarily because monetary policy that leans too dramatically against exchange rate disturbances can create significant real economy variability. Relative to West (2003), we find larger costs of operating monetary policy to achieve exchange rate stabilisation. We attribute this finding to the relatively inertial inflation expectation process in FPS.
DP2006/03
A Small New Keynesian Model of the New Zealand economy
This paper investigate whether a small open economy DSGE-based New Keynesian model can provide a reasonable description of key features of the New Zealand economy, in particular the transmission mechanism of monetary policy. The main objective is to design a simple, compact, and transparent tool for basic policy simulations. The structure of the model is largely motivated by recent developments in the area of DSGE modelling. Combining prior information and the historical data using Bayesian simulation techniques, we arrive at a set of parameters that largely reflect New Zealand’s experience over the stable inflation-targeting period. The resultant model can be used to simulate monetary policy paths and help analyze the robustness of policy conclusions to model uncertainty.
DP2006/02
Forecasting Substantial Data Revisions in the Presence of Model Uncertainty
A recent revision to the preliminary measurement of GDP(E) growth for 2003Q2 caused considerable press attention, provoked a public enquiry and prompted a number of reforms to UK statistical reporting procedures. In this paper, we compute the probability of “substantial revisions” that are greater (in absolute value) than the controversial 2003 revision. The pre-dictive densities are derived from Bayesian model averaging over a wide set of forecasting models including linear, structural break and regime-switching models with and without heteroskedasticity. Ignoring the nonlinearities and model uncertainty yields misleading predictives and obscures the improvement in the quality of preliminary UK macroeconomic measurements relative to the early 1990s.
DP2006/01
Phillips curve forecasting in a small open economy
Stock and Watson (1999) show that the Phillips curve is a good forecasting tool in the United States. We assess whether this good performance extends to two small open economies, with relatively large tradable sectors. Using data for Australia and New Zealand, we find that the open economy Phillips curve performs poorly relative to a univariate autoregressive benchmark. However, its performance improves markedly when sectoral Phillips curves are used which model the tradable and non-tradable sectors separately. Combining forecasts from these sectoral models is much better than obtaining forecasts from a Phillips curve estimated on aggregate data. We also find that a diffusion index that combines a large number of indicators of real economic activity provides better forecasts of non-tradable inflation than more conventional measures of real demand, thus supporting Stock and Watson’s (1999) findings for the United States.
Discussion paper correspondence can be directed to:
Economics Department
Reserve Bank of New Zealand
PO Box
2498
Wellington
New Zealand
