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.
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Papers for 2008
DP 2008/19
The evolution of the Forecasting and Policy System (FPS) at the Reserve Bank of New Zealand
The Forecasting and Policy System model (FPS) has been a very useful tool for forecasting and communication at the Reserve Bank of New Zealand. In part, its success has been due to pragmatic use, and the evolution of the model to reflect changing views of the New Zealand economy. However, as economic theory and modelling technology have developed, it is likely that the next core model for producing projections at the Reserve Bank will be a DSGE model. This note looks forward to that possibility with two aims in mind. First, the paper discusses how FPS has been used at the Reserve Bank over the last 11 years. Second, we describe how the structure of FPS has changed over time.
DP 2008/18
Combining Forecast Densities from VARs and Uncertain Instabilities
Recursive-weight forecast combination is often found to an ineffective method of improving point forecast accuracy in the presence of uncertain instabilities.
We examine the effectiveness of this strategy for forecast densities using (many) VARs and ARs of output, prices and interest rates. Our proposed recursive-weights density combination strategy, based on the recursive logarithmic score of the forecast densities, produces accurate predictive densities by giving substantial weight to models that allow for structural breaks. In contrast, equal-weight combinations produce poor real-time US forecast densities for Great Moderation data.
DP 2008/17
Does natural rate variation matter? Evidence from New Zealand
Natural rates are an important concept within the new Keynesian models often used for monetary policy advice. However, many of these models rely on demeaned interest rate and inflation data. Thus, they implicitly impose the strict assumption that the natural rates of these series are constant. Using New Zealand data and a small open-economy new Keynesian model with time-varying parameters, we estimate the natural real rate of interest, inflation target, potential output, and neutral real exchange rate. We find that the model estimates of the natural real rate of interest and neutral exchange rate display noticeable time variation and considerable uncertainty, while the inflation target has been relatively stable over the sample period. We also compare the results of this model to a model with time-invariant natural rates. The comparison reveals the data prefers the fit of the timevarying model. It also shows that allowing the natural rates to vary over time has implications for the persistence parameters and impulse responses of the model.
DP 2008/16
Inheritances and their impact on housing equity withdrawal
Housing equity withdrawal (HEW) was very high in New Zealand. In fact it was at unprecedented levels between 2004 and 2007. It has been postulated that a significant proportion of this equity withdrawal could be the result of inheritances, which would have increased in value as house prices rose over the period. This report looks at how much of recent HEW might be due to the sale of inherited dwellings. It briefly surveys earlier work on inheritances in New Zealand, and reviews various sources of data on inheritances. It then uses data from household wealth surveys, together with mortality data, to estimate the value of inheritances in 2001 and 2006. Estimates of the equity withdrawn from inherited houses are also derived. The results suggest that transactions related to inherited houses probably accounted for no more than about one-seventh of the change in net HEW between 2001 and 2006. Clearly other factors more active forms of equity withdrawal accounted for most of the change in HEW over the period.
DP 2008/15
This paper investigates the theoretical implications of targeting average inflation or following a speed limit policy in a dynamic backward-looking model where monetary policy works with lags. Our findings reveal that the target horizon for expected inflation in the target rule must be correctly specified for the monetary policy strategies to achieve best results. Average inflation targeting dominates a speed limit policy for plausible values of society s relative aversion to inflation variability. The efficiency loss associated with average inflation targeting relative to optimal policy is very small if society values output stability. A speed limit policy becomes attractive only if society places great emphasis on inflation stability.
DP2008/14
Over the hedge? Exporters optimal and selective hedging choices
How do exporting firms manage currency exposures? We examine this issue at the firm level using comprehensive data from the prototype Longitudinal Business Database recently developed by Statistics New Zealand. We use these data to test both optimal and selective hedging theories. Optimal hedging theory hypothesises that firms hedging choices depend on the probability and cost of financial distress, underinvestment risks, scale, managerial risk aversion, information asymmetry, governance, ownership structures and tax rules. Recent literature suggests that some firms vary hedging positions relative to their optimal position in a selective attempt to beat the market . We examine whether hedging behaviour is consistent with hypotheses derived from optimal hedging theories, and test whether hedging positions change (possibly sub-optimally) when the NZD/AUD is perceived to be high or low relative to an historical average.
DP2008/13
Real-time Prediction with UK Monetary Aggregates in the Presence of Model Uncertainty
A popular account for the demise of the UK’s monetary targeting regime in the 1980s blames the fluctuating predictive relationships between broad money and inflation and real output growth. Yet ex post policy analysis based on heavily-revised data suggests no fluctuations in the predictive content of money. In this paper, we investigate the predictive relationships for inflation and output growth using both real-time and heavily-revised data. We consider a large set of recursively estimated Vector Autoregressive (VAR) and Vector Error Correction models (VECM). These models differ in terms of lag length and the number of cointegrating relationships. We use Bayesian model averaging (BMA) to demonstrate that real-time monetary policymakers faced considerable model uncertainty. The in-sample predictive content of money fluctuated during the 1980s as a result of data revisions in the presence of model uncertainty. This feature is only apparent with real-time data as heavily-revised data obscure these fluctuations. Out of sample predictive evaluations rarely suggest that money matters for either inflation or real output. We conclude that both data revisions and model uncertainty contributed to the demise of the UK’s monetary targeting regime.
DP2008/12
The relative size of New Zealand exchange rate and interest rate responses to news
This paper examines the relative size of the effects of New Zealand monetary policy and macroeconomic data surprises on the spot exchange rate, 2 and 5 year swap rate differentials, and the synthetic forward exchange rate schedule. We find that the spot exchange rate and 5 year swap rates respond by a similar magnitude to monetary surprises, implying there is little response of the forward exchange rate to this type of news. In contrast, the spot exchange rate responds by nearly three times as much as 5 year interest rates to CPI and GDP surprises, implying that forward rates appreciate to higher than expected CPI or GDP news. This is in contrast to standard theoretical models and US evidence. Lastly, we show that exchange rates but not interest rates respond to current account news. The implications of these results for monetary policy are considered.
DP2008/11
Limited Information Estimation and Evaluation of DSGE models
We advance the proposition that dynamic stochastic general equilibrium (DSGE) models should not only be estimated and evaluated with full information methods. These require that the complete system of equations be specified properly. Some limited information analysis, which focuses upon specific equations, is therefore likely to be a useful complement to full system analysis. Two major problems occur when implementing limited information methods. These are the presence of forward-looking expectations in the system as well as unobservable non-stationary variables. We present methods for dealing with both of these difficulties, and illustrate the interaction between full and limited information methods using a well known model.
DP2008/10
Incorporating judgement with DSGE models
Central bank policymakers often cast judgement about macroeconomic forecasts in reduced form terms, basing this on off-model information that is not easily mapped to a structural DSGE framework. We show how to compute forecasts conditioned on policymaker judgement that are the most likely conditional forecasts from the perspective of the DSGE model, thereby maximising the influence of the model structure on the forecasts. We suggest using a simple implausibility index to track the magnitude and type of policymaker judgement. This is based on the structural shocks required to return policymaker judgement. We show how to use the methods for practical use in the policy environment and also apply the techniques to condition DSGE model forecasts on: (i) the long history of published forecasts from the Reserve Bank of New Zealand; (ii) constant interest rate forecasts; and (iii) inflation forecasts from a Bayesian VAR currently used in the policy environment at the Reserve Bank of New Zealand.
DP2008/09
Analysing shock transmission in a data rich environment: A large BVAR for New Zealand
We analyse a large Bayesian Vector Autoregression (BVAR) containing almost one hundred New Zealand macroeconomic time series. Methods for allowing multiple blocks of equations with block-specific Bayesian priors are described, and forecasting results show that our model compares favourably to a range of other time series models. Examining the impulse responses to a monetary policy shock and to two less conventional shocks – net migration and the climate – we highlight the usefulness of the large BVAR in analysing shock transmission.
DP2008/08
A macro stress testing model with feedback effects
Stress testing is a tool to analyse the resilience of a financial system under extreme shocks. In contrast to single-bank stress testing models, macro stress testing models attempt to analyse risk for the system as a whole by taking into account feedback – i.e. the transmission of risks – within the system or between the financial system and the real economy. This paper develops a simple model of macro stress testing, incorporating two types of feedback: one between credit and interest rate risks and another between the banking system and the real economy. The model is tested using hypothetical banking sector data. The results from the exercise highlight the importance of incorporating feedback effects for the assessment of total risks to the system, and of recognising more than one type of feedback effect in a model for a robust assessment of risks to financial stability.
DP2008/07
Heterogeneous Expectations, Adaptive Learning, and Forward-Looking Monetary Policy
In this paper, I examine the role of monetary policy in a heterogeneous expectations environment. I use a New Keynesian business cycle model as the experiment laboratory. I assume that the central bank and private economic agents (households and producing firms) have imperfect and heterogeneous information about the economy, and as a consequence, they disagree in their views on its future development. I facilitate the heterogeneous environment by assuming that all agents learn adaptively. Measured by the central bank's expected loss, the two major findings are - (i) policy that is efficient under homogeneous expectations is not efficient under heterogeneous expectations; (ii) in the short and medium run, policy that is excessively responsive to infiation increases infation and output volatility,but in the long run such policy lowers economic volatility.
DP2008/06
The tax system and housing demand in New Zealand
This paper uses a simple model to illustrate the influence of the tax system on New Zealand’s housing market and analyses several alternative tax treatments. This analysis informed the Reserve Bank’s (2007) comments on the tax system and housing in a recent submission to the New Zealand Parliament’s Finance and Expenditure Committee. Reflecting present tax policy, two key tax distortions that encourage property investment are factored into our model. First, capital gains on property are often not taxed, but all interest earnings are (and interest payments are fully tax deductible for geared landlords). Second, owner occupiers do not pay rent out of their after tax income. All else equal, these distortions imply it is often more tax efficient to accrue capital gains than interest earnings, and it is tax efficient to own your own home if it is unmortgaged or lightly mortgaged. Moreover, inflation makes the distortions more significant as real assets like houses will tend to rise in capital value over time in an inflationary environment. In the simple model used in this paper, these distortions have important effects on house prices. However, various simplistic features of the model imply it likely overstates the implications of the distortions and no particular connection is made from these distortions to the recent housing cycle. That said, shifting to a system where only real (instead of nominal) interest flows are taxable or deductible would substantially reduce the tax distortions.
A range of other possible policies are examined, but they tend to either be less effective in reducing the distortion, or appear harder to implement.
DP2008/05
How do Housing Wealth, Financial Wealth and Consumption Interact? Evidence from New Zealand
This paper characterises the relationship between wealth and consumption in New Zealand.
We find that there exists a long-run cointegration relation between household consumption, income, housing wealth and net financial wealth. Permanent shocks account for most of the variation in wealth. This implies that our cointegration estimates accurately capture the effect of most wealth changes, in contrast with the findings of Lettau and Ludvigson (2004) for the United States. Our estimates suggest that consumption has adjusted sluggishly to restore longrun equilibrium, but also that consumption booms have anticipated equilibrium-restoring increases in housing wealth. Furthermore, we estimate two alternative econometric models which are more robust to instability in the long-run relationship. All three of our models suggest that permanent changes in wealth have economically important effects on consumption. The dollar-for dollar- effect of financial wealth exceeds that of housing wealth.
DP2008/04
'Automatic' cycle-stabilising capital requirements: what can be achieved?
This paper discusses the potential for lenders’ capital requirements to be used as ‘automatic stabilisers’ of the business cycle in New Zealand. The procyclicality of lending, and its importance for cyclical developments, motivates the consideration of regulation of lending for cycle-stabilisation purposes. This application of lenders’ capital requirements is distinct from, but complements, the prudential reasons for capital adequacy requirements. I set out a putative capital requirement on housing lending intended to have cycle-stabilising properties. I explore the likely degree of cycle stabilisation that could be expected from feasible calibrations of such a requirement. I conclude that the putative cycle-stabilising capital requirement might have some impact on the cycle at the margin, and that this impact is most likely on the downside of cycles. However, the highly developed and open nature of New Zealand’s housing lending markets is likely to limit the degree of cycle stabilisation that can be achieved with this approach.
DP2008/03
Changes in the transmission mechanism of monetary policy in New Zealand
Over the last few years, monetary policy in New Zealand has focused on reducing strong demand and infationary pressures. It has been commented that this task has been frustrated by a weakening of the monetary policy transmission mechanism in New Zealand. In this paper we draw upon a range of empirical models to assess whether monetary policy has lost its potency over the recent cycle, and to identify changes in the mechanism more broadly. Our main conclusion is that the overall impact of monetary policy has not obviously weakened, and in some respects has strengthened, over the past decade.
DP2008/02
We conduct a high frequency event analysis to estimate the effects of monetary policy surprises, data surprises, and central bank verbal statements on the New Zealand-US dollar and the New Zealand-Australian dollar exchange rates. We find data surprises and monetary policy surprises have significant and large effects on exchange rate movements. More importantly, RBNZ interest rate decisions have a largely permanent impact on the exchange rate. Significantly, the impact of the published interest rate track seems to explain some 10 per cent additional variation in the exchange rate.
DP2008/01
Some benefits of monetary policy transparency in New Zealand
The Reserve Bank of New Zealand (RBNZ) is regarded as one of the most transparent central banks in the world. Recent research suggests that one benefit of such transparency is that financial markets better anticipate a central bank's reaction to incoming data, and in relation, do not over-react to macroeconomic data surprises. In this paper, we provide some institutional details of how the RBNZ communicates its monetary policy decisions to financial markets and conduct an events analysis to test whether there are any transparency benefits in the pricing of New Zealand's yield curve. In line with the recent empirical literature, our results suggest that short-term interest rates tend to react appropriately to the data flow, while longer term interest rates are not unduly influenced. We also show that market reactions tend to be in line with the RBNZ's inflation target objective.
Discussion paper correspondence can be directed to:
Economics Department
Reserve Bank of New Zealand
PO Box 2498
Wellington
New Zealand
