Thursday, August 9, 2012

What Explains the New Zealand Dollar?

The exchange rate is a very tough nut to crack.  The New Zealand dollar has been freely floating since 1985, but some small interventions took place in the past few years.  By contrast, the Bank did not intervene in the exchange rate market from 1985 to early 2000.  Freely floating currencies in general exhibit frequent swings, i.e., volatility, and that has been historically the case for the Kiwi and the Australian dollars.  There is an argument for that; freely floating exchange rates act as shock absorbers and insulate the real economy from shocks. High volatility makes them hard to explain by economic fundamentals , which have smaller variances.
We do not have a concrete explanation for exchange rate movements.  Many economists believe that exchange rates move around randomly, like other asset prices.  Models of the exchange rate from the 1970s and 1980s—such as the monetary model, the real interest rate differential model and the overshooting model— which include economic fundamentals as explanatory variables failed to predict the movements of the nominal and real exchange rates.[i]
Benigno et al. (2011) provide new answers and insights to exchange rate fluctuations by providing a general equilibrium theory. Their DSGE model includes an endogenous deviation from a UIP condition and that risk premium is driven by three uncertainties: monetary policy uncertainty, inflation target uncertainty and productivity shocks uncertainty.  Monetary policy uncertainty appreciates the currency in the medium-term through the hedging motive. Uncertainty improves hedging properties.  Agents search for relatively safer currencies in times when there is bad financial, economic or political news which increases demand for the currency and appreciates it.  A high volatility of TFP shocks depreciates the currency.[ii] 

The volatility of TFP shocks seems to explain large spikes in the TWI New Zealand exchange rate.[iii]  Volatility is the squared changes in TFP.  Figure 1 demonstrates.  The TWI is inverted for convenience (increase denotes depreciation) .  The spikes represent large depreciation.

Figure 1

For monetary policy shocks, the Reserve Bank of New Zealand changed its operating procedure in 2006. The description of this policy change is found in The Reserve Bank Bulletin article.[iv]  Essentially, the policy change increased the money supply.  The exchange rate depreciated first then significantly appreciated.  Then the international financial crisis hit. And the Kiwi dollar has been appreciating. Figure 2 plots volatility of the OCR (dotted black line) and the Overnight Interbank Cash Rate (solid black), and the level of the TWI (inverted, red dashed line).  These volatility measures are the monthly averages of daily squared changes in the interest rates. Again, there is an association between monetary policy volatility and the level of the TWI.  However, the volatility of interest rate is associated with large depreciation rather than appreciation as predicted by Benigno et al. (2011).  It may indicate net selling of New Zealand dollar dominated assets rather than net purchases. 

Figure 2

Although large spikes in the TWI are well captured by both monetary policy and TFP shocks volatilities, we do not have a robust explanation of the Kiwi dollar.

[i] See, among others, Obstfeld, M. and K. Rogoff, Foundation of International Macroeconomics, MIT Press, 1996.
[ii] Benigno, G., P. Benigno, and S. Nistico, Risk, Monetary Policy and the Exchange Rate, 2011.
[iii]  Data are quarterly The data source is the Reserve Bank of New Zealand and the International Labour Organization. TFP shocks are the squared change in the level of TFP.  TFP is simply equal to log GDP – share of capital* log capital – share of labour * labour . The share of capital, which I calculate from the National Income Account as the ratio of gross operating surplus / GDP ratio in 2011, and is fixed to 0.30 and the share of labour is assumed to be fixed at 0.70 such that the shares sum to unity.  There is no theoretical reason to assume this, but I just do so for convenience as it does not affect the results.  I calculate the initial stock of capital to be 2 times GDP in January 1999.  I assumed that capital grows according to the following law of motion, capital growth equal to the percentage of GDP invested in the economy* real GDP + the depreciation rate * current capital. I assumed that 20 percent of GDP is invested annually (0.05 per quarter); and the depreciation rate is 6 percent annually (0.015 per quarter).  And labour is working age population.  I use the ILO annual data, which I converted to quarterly data.  TFP is usually measured with a lot of assumptions.  The plot, however, is very robust to these assumptions.  I tried a lot of assumptions but the wrinkles remained the same.

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