An analysis of the open economy factors of New Zealand business cycles

Abstract

Within a growth cycle framework this thesis examines stylised open economy empirical facts associated with New Zealand business cycles over the period since 1965. It extends the bivariate stylised facts uncovered for New Zealand by Kim, Buckle and Hall (1994) into several areas. The roles of the current account balance and its components, foreign nominal interest rates, a nominal interest rate differential, and the role of the nominal exchange rate regime are now explored. The role of the terms of trade is also considered, in a somewhat different way and over a longer sample period, in the hope that the uncertain relationship presented in Kim, Buckle and Hall (1994) might be clarified further. Empirical results show that all three alternative definitions of the current account lag the New Zealand business cycle countercyclically by one quarter. Additional valuable insight is gained from exploring certain current account components. National investment deviations from trend appear to be the principal driving force behind the New Zealand current account, a finding that is consistent with our failure to observe J-curve regularity. On average a countercyclical current account is consistent with the presence of significant demand side shocks to the tradeable goods sector. Alternatively, it may be a case of significant supply side shocks to the non-tradeable goods sector where the intertemporal substitution effect dominates the temporal substitution effect. Thus, a key theoretical conclusion is that the sign of the relationship between output and the current account crucially depends on the source of the shock and the sector affected. A significant relationship between New Zealand's GDP and a number of foreign nominal interest rate variables is discovered. Thus, it is possible that economies like New Zealand, with a high external debt burden, will be strongly affected by fluctuations in foreign nominal interest rates. A significant domestic and foreign nominal interest rate differential is also found, and thereby suggests an important role along the business cycle for the capital account, where foreign capital flows for investment purposes impact on the current account and then onto output. With respect to the role of the nominal exchange rate regime, dynamic regularity testing has shown that New Zealand's floating nominal exchange rate period produced a lower volatility in output, and a slight increase in the relative volatility of the external balance. However, the individual components, real exports and imports, are less volatile. This emphasises that it is no easy task to systematically relate these adjustments in stylised facts solely to a change in the nominal exchange rate regime, or to the increase in the relative volatility of the nominal and real exchange rates that New Zealand experienced in the post float era. Finally, significant heteroscedasticity is detected for the net exports share, the three current account share, and the gross fixed capital formation variables. This casts a caveat over some of the business cycle stylised facts presented, in the sense that some of the associated hypothesis testing results, with respect to the role of the nominal exchange rate regime, may be biased and inconsistent.