Abstract
This paper assesses the impact of a disruption to capital inflows by examining past episodes of capital inflows in New Zealand and other countries. It also reviews the IMF’s Global Economy Model (GEM), which is used to provide some estimates of the equilibrium relationship between New Zealand’s real effective exchange rate and real commodity prices. The analysis also suggests that permanent changes in non-energy commodity prices can have a significant impact on New Zealand’s equilibrium exchange rate.
II. The Impact of Commodity Prices on New Zealand’s Equilibrium Real Effective Exchange Rate: Some Insights from GEM10
A. Introduction
32. Over the last several years, both New Zealand’s real commodity price index and real effective exchange rate have been rising. Although a variety of factors underlie these developments, an important question is how much of the currency appreciation is likely to be permanent if real commodity prices remain elevated. In this chapter, the IMF’s new Global Economy Model (GEM), is used to provide some estimates of the equilibrium relationship between New Zealand’s real effective exchange rate and real commodity prices.
33. The analysis suggests that permanent changes in non-energy commodity prices can have a significant impact on New Zealand’s equilibrium exchange rate. Under plausible assumptions about key behavioral parameters and a range of alternative factors driving commodity prices, it is possible to generate elasticities of New Zealand’s equilibrium real effective exchange rate with respect to permanent changes in real commodity prices in the range of 0.1 to 0.6. Consequently, understanding the source of the commodity-market imbalance as well as the ease with which New Zealanders’ can substitute between domestic and imported goods is necessary to determine where in the range the elasticity is likely to be. A consideration of worldwide developments that are most likely driving the current increase in commodity prices suggests that the impact on New Zealand’s equilibrium exchange rate is likely to lie in upper portion of the range.
B. The Global Economy Model and Commodities
34. Two key aspects of GEM make it particularly useful for examining the relationship between commodity prices and the real exchange rate.11 First, because of its multi-good structure, GEM can be configured to include a tradable commodity good that is used as an input into the production of other goods. This fully-specified structure for commodity supply and demand enables analysis of how the source of the commodity-market imbalance driving price developments influences the magnitude of the impact on the exchange rate. Second, because GEM is derived completely from optimizing foundations, it is possible to consider how key behavioral parameters influence the equilibrium impact of commodity prices on the exchange rate.
35. The model has been configured to contain three types of goods; a nontradable good, a tradable non-commodity good; and a tradable non-energy commodity good. For ease of exposition the tradable non-commodity good will be referred to as manufactures and the tradable non-energy commodity good will be referred to as commodities. The model has been calibrated to represent five regions: New Zealand; Australia; the United States; emerging Asia; and the rest of the world. To provide insights on the long-run relationship between commodity prices and the exchange rate, the focus of the calibration has been on the trading relationship among these blocks and the production and use of commodities.
36. In the regions considered, commodities are the most important for New Zealand from both the production and export perspectives. Table II.1 contains some key shares of GDP illustrating the importance of commodities in New Zealand. Exports of goods and services in New Zealand represented roughly 29 percent of GDP in 2006 and, as can be seen from the table, commodity-based exports accounted for over half of total exports.
Non-Energy Commodity Shares of GDP (in percent)
For New Zealand calculations are based on data from 2006 and commodities were defined to include agriculture, forestry, fishing and mining, plus: food, beverages, and tobacco; wood and paper; plastics and rubber; non-metallic minerals; and metal products. Traditional commodities account for 7.8 percent of GDP and adding food, beverages, and tobacco takes it up to 12.9 percent of GDP.
Non-Energy Commodity Shares of GDP (in percent)
| New Zealand1 | Australia | Emerging Asia | United States | Rest of World | ||
|---|---|---|---|---|---|---|
| Production | 18.1 | 11.0 | 2.8 | 1.6 | 2.2 | |
| Exports | 17.6 | 8.3 | 2.1 | 1.5 | 0.8 | |
| To NZL | 0.2 | 0.0 | 0.0 | 0.0 | ||
| To AUS | 2.3 | 0.1 | 0.0 | 0.0 | ||
| To E.A. | 4.1 | 3.3 | 0.3 | 0.3 | ||
| To U.S. | 2.8 | 0.3 | 0.3 | 0.5 | ||
| To R.W. | 8.5 | 4.5 | 1.7 | 1.2 | ||
For New Zealand calculations are based on data from 2006 and commodities were defined to include agriculture, forestry, fishing and mining, plus: food, beverages, and tobacco; wood and paper; plastics and rubber; non-metallic minerals; and metal products. Traditional commodities account for 7.8 percent of GDP and adding food, beverages, and tobacco takes it up to 12.9 percent of GDP.
Non-Energy Commodity Shares of GDP (in percent)
| New Zealand1 | Australia | Emerging Asia | United States | Rest of World | ||
|---|---|---|---|---|---|---|
| Production | 18.1 | 11.0 | 2.8 | 1.6 | 2.2 | |
| Exports | 17.6 | 8.3 | 2.1 | 1.5 | 0.8 | |
| To NZL | 0.2 | 0.0 | 0.0 | 0.0 | ||
| To AUS | 2.3 | 0.1 | 0.0 | 0.0 | ||
| To E.A. | 4.1 | 3.3 | 0.3 | 0.3 | ||
| To U.S. | 2.8 | 0.3 | 0.3 | 0.5 | ||
| To R.W. | 8.5 | 4.5 | 1.7 | 1.2 | ||
For New Zealand calculations are based on data from 2006 and commodities were defined to include agriculture, forestry, fishing and mining, plus: food, beverages, and tobacco; wood and paper; plastics and rubber; non-metallic minerals; and metal products. Traditional commodities account for 7.8 percent of GDP and adding food, beverages, and tobacco takes it up to 12.9 percent of GDP.
37. Given the fully specified structure for supply and demand, it is possible to generate a permanent increase in prices from two types of commodity-market imbalance. First, the imbalance can be generated from productivity growth increasing demand for the commodity input, which in the presence of a fixed factor in commodity production—land—drives up the real price of commodities. Two alternative growth scenarios are considered:
balanced growth, where productivity increases in all three sectors; and
unbalanced growth, where productivity increases only in manufactures.
The second type of imbalance could arise from negative supply shocks that reduce the quantity of land used in commodities production. For example, global warming could be reducing the quantity of agricultural land as it affects weather patterns, as suggested by the recent droughts in Australia.
38. In GEM, the real exchange rate is the key relative price that adjusts to ensure long-term external balance. In the short-run, domestic versus foreign interest rate differentials as well as risk premium can drive the exchange rate away from is long-run fundamental value. However, in the long run, real exchange rates adjust to stabilize current accounts and net foreign asset positions. In the simulation analysis below, when permanent changes in real commodities prices arise, the equilibrium real exchange rate adjusts to ensure that current accounts and net foreign asset positions return to their baseline ratios to GDP.
C. Simulation Results
39. Permanently higher commodity prices increase New Zealand’s equilibrium exchange rate, but the magnitude depends on the source of the commodity market imbalance (Table II.2).
If increased demand for commodities is widespread across sectors in New Zealand’s trading partners (balanced growth), the impact on the exchange rate will be the largest (column 1, row 1). When demand is driven by faster productivity growth in only manufactures (column 1, row 2), the relative price of New Zealand’s imports decline in foreign currency terms and there is less need for the exchange rate to appreciate to increase import demand to balance the current account.
If growth also increases in New Zealand, the impact on the exchange rate is smaller (column 2, rows 1, and 2). Increased domestic growth helps stimulate import demand, particularly in investment goods which are import intensive, leaving less need for currency appreciation to balance the current account.
If rising commodity prices are due to a reduction in land, then the required appreciation is close that when rising commodity prices are driven by growth outside of New Zealand. However, if land in New Zealand declines as well then the required appreciation is quite small.
Equilibrium Real Effective Exchange Rate Elasticity w.r.t. Commodity Prices
(Elasticity of Substitution for Manufactures = 1)
Equilibrium Real Effective Exchange Rate Elasticity w.r.t. Commodity Prices
(Elasticity of Substitution for Manufactures = 1)
| Extent of Global Economy Affected | ||
|---|---|---|
| Source of Imbalance | All regions but New Zealand | All regions including New Zealand |
| Economy-wide Growth | 0.6 | 0.3 |
| Growth in Manufactures | 0.4 | 0.3 |
| Reduction in Land | 0.5 | 0.1 |
Equilibrium Real Effective Exchange Rate Elasticity w.r.t. Commodity Prices
(Elasticity of Substitution for Manufactures = 1)
| Extent of Global Economy Affected | ||
|---|---|---|
| Source of Imbalance | All regions but New Zealand | All regions including New Zealand |
| Economy-wide Growth | 0.6 | 0.3 |
| Growth in Manufactures | 0.4 | 0.3 |
| Reduction in Land | 0.5 | 0.1 |
40. If the elasticity of substitution among factors of production in commodities production is higher, New Zealand’s real exchange rate is more responsive to commodity prices. For the scenario where growth is balanced, but concentrated in New Zealand’s trading partners (row 1 column 1 in Table II.2), the impact on the exchange rate increases from 0.6 to 0.7 if the elasticity of substitution among factors in commodities production is increased to 0.9 from 0.6. This increase occurs when the higher elasticity is just in New Zealand, or world wide, which reflects the high importance of commodities in New Zealand’s export basket.
41. The elasticity of substitution for manufactures has an important impact on the elasticities. All the scenarios from Table II.2 are repeated and presented in Table II.3 but with firms’ and households’ elasticity of substitution between domestically and foreign produced manufactures is increased to 2 from 1.12 The result is that the required increase in the real effective exchange rate in response to higher commodity prices declines. With demand between domestic and foreign manufactures much more responsive to price, the exchange rate needs to move by less to increase import demand sufficiently to balance the current account. Interesting, with the higher elasticity of substitution across manufactures, the Balassa-Samuelson effect becomes more evident and the downward impact on the elasticity when growth also occurs in New Zealand is smaller.
Equilibrium Real Effective Exchange Rate Elasticity w.r.t. Commodity Prices
(Elasticity of Substitution for Manufactures = 2)
Equilibrium Real Effective Exchange Rate Elasticity w.r.t. Commodity Prices
(Elasticity of Substitution for Manufactures = 2)
| Extent of Global Economy Affected | ||
|---|---|---|
| Source of Imbalance | All regions but New Zealand | All regions including New Zealand |
| Economy-wide Growth | 0.4 | 0.3 |
| Growth in Manufactures | 0.1 | 0.2 |
| Reduction in Land | 0.3 | 0.1 |
Equilibrium Real Effective Exchange Rate Elasticity w.r.t. Commodity Prices
(Elasticity of Substitution for Manufactures = 2)
| Extent of Global Economy Affected | ||
|---|---|---|
| Source of Imbalance | All regions but New Zealand | All regions including New Zealand |
| Economy-wide Growth | 0.4 | 0.3 |
| Growth in Manufactures | 0.1 | 0.2 |
| Reduction in Land | 0.3 | 0.1 |
42. Most econometric-based estimates of the impact of commodity prices on New Zealand’s equilibrium real effective exchange rate fall within the simulated range. In IMF (2006), pooled estimation across a large range of countries yields an elasticity of real effective exchange rates with respect to commodity prices of 0.4. Other New Zealand specific estimated elasticities include 0.5 in Wren-Lewis (2004), 0.8 in Reserve Bank of New Zealand (2007), 0.5 to 1.1 in Chen and Rogoff (2003), and 0.4 in Brooks, Edison, and Vitek (2008).13
43. Several factors suggest that assuming elasticities toward the top of the simulated range would likely be prudent. In the simulation analysis, three key factors drive the magnitude of the elasticity and considering each in turn provides some guidance.
First, if rising commodity prices are growth driven, the location of the growth is important, both in terms of sectors within countries and across countries. The more balanced is the growth across sectors within countries, the larger will be the elasticity, and the more growth is concentrated outside of New Zealand, the larger will be the elasticity. In New Zealand’s major trading partners, productivity growth has been faster in tradable goods than in nontradable goods which argues for elasticities lower than the top of the range. However, productivity growth has generally been faster outside of New Zealand, which argues for an elasticity toward the top of the range.
Average Annual Labor Productivity Growth 1995 to 2004
Source: Fund staff calculations.The Euro Area, the United Kingdom, and Japan are used to proxy the rest of the world.
Average Annual Labor Productivity Growth 1995 to 2004
Source: Fund staff calculations.New Zealand Australia Emerging Asia United States Rest of World1 Tradables 2.6 2.9 6.5 3.5 3.2 Nontradables 0.7 1.5 2.6 2.0 0.5 The Euro Area, the United Kingdom, and Japan are used to proxy the rest of the world.
Average Annual Labor Productivity Growth 1995 to 2004
Source: Fund staff calculations.New Zealand Australia Emerging Asia United States Rest of World1 Tradables 2.6 2.9 6.5 3.5 3.2 Nontradables 0.7 1.5 2.6 2.0 0.5 The Euro Area, the United Kingdom, and Japan are used to proxy the rest of the world.
Second, the easier it is for New Zealanders to substitute toward foreign produced manufactures, the lower will be the elasticity. The quickening pace of globalization has likely made it easier to substitute toward foreign-produced goods, which argues for an elasticity below the upper end of the simulated range.
Third, if negative supply shocks are driving the rising commodity prices, the elasticity will be toward the top of the range provided it is not affecting New Zealand as well.
References
Brooks, R., H. Edison, and F. Vitek, 2008, “Exchange Rate Assessments for Australia and New Zealand,” forthcoming IMF Working Paper.
Chen, Y., and K. Rogoff, 2003, “Commodity Currencies,” Journal of International Economics, Vol. 60, No. 1 pp. 133 -160.
Hunt, B., and A. Rebucci, 2005, “The U.S. Dollar and Trade Deficit: What Accounts for the Late 1990s?” International Finance Vol. 8, No. 3, pp. 399 -434.
International Monetary Fund, 2006, “Methodology for CGER Exchange Rate Assessments,” available on the web http://www.imf.org/external/pp/longres.aspx?id=3957.
Laxton D., and P. Pesenti, 2003, “Monetary Policy Rules for Small, Open, Emerging Economies,” Journal of Monetary Economics, 50, pp. 1109 -1146.
Macdonald, R., 2001, “Modelling the Long-Run Real effective Exchange Rate of the New Zealand Dollar,” Reserve Bank of New Zealand Discussion Paper, DP2002/02.
Reserve Bank of New Zealand (2007), “Monetary Policy Statement,” September.
Wren-Lewis, S., 2004, “A Model of Equilibrium Exchange Rates for the New Zealand and Australian Dollars,” Reserve Bank of New Zealand Discussion Paper, DP2004/07.
Appendix: Brief Overview of GEM
44. GEM is a multi-region, multiple-good model of the world economy that is derived completely from optimizing foundations.14 In each region there are households, firms, and a government. Households maximize utility derived from the consumption of goods and leisure. Firms combine capital, and labor, with either non-energy commodities or land to maximize the net income from goods production. Governments consume goods financed through non-distorting taxes and adjust short-term nominal interest rates to provide nominal anchors.
Households
45. Households are infinitely lived, consume goods, and are the monopolistic suppliers of differentiated labor inputs to all domestic firms. Households exhibit habit persistence in consumption contributing to real rigidities in economic adjustment. Monopoly power in labor supply implies that households’ wages contain a markup over the marginal rate of substitution between consumption and leisure. Because of adjustment costs in wage contracts, aggregate nominal rigidities arise through wage bargaining. Households own all domestic firms, the domestic capital stock, and the land, which they rent to domestic firms. The markets for capital and land are competitive. Capital accumulation is subject to adjustment costs that contribute to gradual economic adjustment. The supply of land is fixed.
Firms
46. Firms produce three types of goods: a nontradable good; a tradable non-commodity good; and a tradable non-energy commodity good. Goods are assumed to be differentiated, leading to market power that enables firms to charge a markup over the marginal cost of production. Goods prices are subject to adjustment costs that, along with slowly adjusting wages, give rise to the gradual adjustment of prices to economic disturbances. The characteristics of the final bundle of goods consumed in each region reflects the preferences of households and firms over all goods and, consequently, international trade is driven by the interaction of preferences and relative prices.
47. Capital, labor, and commodities are combined to produce the tradable non-commodity good and the nontradable good. The production process is given by:
where Y denotes the output of the non-commodity tradable good and the nontradable good, A denotes the level of productivity, K is the capital input, L is the labor input, QC is the domestically produced commodity input, and MC is the imported commodity input. The production technology, f, embodies constant elasticity of substitution. For this application, non-commodities goods production is calibrated to be Cobb Douglas. Producers have a very high elasticity of substitution between imported and domestically produced commodities (10) capturing the notion of a single world market for commodities.
48. Commodities are produced combining capital, labor, and a fixed factor, land. The production technology is given by:
where QC is domestically produced commodities, A denotes the level of productivity, K represents the capital input, L denotes the labor input, and Land is the fixed factor. The production technology, f, embodies constant elasticity of substitution. For this application, Land is calibrated to be the most important input into commodities production and the elasticity of substitution among land, labor, and capital is low (0.6).
Government
49. Government spending falls exclusively on non-tradable goods. Government spending is financed through a non-distorting tax. The government controls the national short-term nominal interest rate with the objective of providing a nominal anchor for the economy. The nominal anchors in New Zealand, Australia, the United States and the rest of the world are inflation rates. For emerging Asia, the nominal anchor is stability in the nominal exchange rate between the Asian currency and the U.S. dollar.
Prepared by Ben Hunt (Ext. 3-6361).
The Appendix contains a brief overview of GEM. For a complete descriptions of GEM’s structure and dynamic adjustment properties see Laxton and Pesenti (2003) and Hunt and Rebucci (2005).
A value of 1 would be the most often used calibration for this parameter in the literature. However, some studies have used values between 2 and 3.
Using the terms of trade rather than commodity prices, MacDonald (2001), reports an elasticity of 1.85.
For a detailed descriptions of GEM’s structure and dynamic adjustment properties see Laxton and Pesenti (2003) and Hunt and Rebucci (2005).