The relative productivity performance in New Zealand explains why the real interest rate has been relatively high, which is an old nagging question. One has to keep in mind that this has nothing to do with the Reserve Bank of new Zealand. The concern is about the real the interest rate, which is beyond the control of the RBNZ. A number of explanations have been floating.
The key to understand why the real interest rate, in my opinion, is that (1) Productivity shocks affect both the aggregate demand and the aggregate supply.(2)It makes a great difference whether the shock is temporary or permanent.
Temporary Adverse Productivity Shocks
Consider a temporary adverse productivity shock that shifts the production function. Such shock shifts the aggregate supply curve to the left from AS to AS 1 in figure (1). For simplicity, do not assume any change in the slops of the production function, i.e., no change in the marginal productivity of labor and capital. This adverse shock reduces the supply of goods. Also, wealth will decline temporarily, thus income will fall temporarily. These temporary effects are captured by the smaller downward shift in aggregate demand relative to aggregate supply. At the initial level of real interest rate R, these shifts require the real interest rate to rise to restore equilibrium in the good market, hence R1. The correlation between real GDP (declining) and the real interest rate (increasing), which results from a temporary adverse productivity shock, is negative.
Figure (1)
Figure (2) plots the real interest rate on the vertical axis, which I measure with the inflation indexed 10 Year bond rate, and real GDP on the horizontal axis. The correlation is negative just as the theory predicts.
Figure (2)
Permanent Productivity Shocks
Permanent Shocks
A permanent adverse productivity shock shifts
the aggregate supply curve to the left, and shifts the aggregate demand down by
the same amount. The reason for that equal shift is that the wealth effect is
larger when the productivity shocks are permanent. It would induce a strong
negative impact on consumer demand and strong positive effects on work effort.
The shifts in aggregate demand and supply depicted in figure 2 show that the
real interest rate remains unchanged, which means net investment demand equals
desired savings. This means the real interest rate is acyclical.
