Macroeconomic Effects of Inflation Targeting Policy in New Zealand. Abstract

Transcription

1 Macroeconomic Effecs of Inflaion Targeing Policy in New Zealand Kyongwook Choi Deparmen of Economics, Ohio Universiy Chulho Jung Deparmen of Economics, Ohio Universiy William Shambora Deparmen of Economics, Ohio Universiy Absrac In his paper we analyze macroeconomic effecs of inflaion argeing policy in New Zealand using Markov swiching model wih one ime permanen break. Our resuls show ha he inflaion argeing policy has significanly changed he inflaion dynamics in he New Zealand economy. The Markov swiching model clearly deecs a srucural break dae ha is very close o he acual dae of he policy change. The volailiy in he inflaion rae shows a considerable reducion afer he srucural break dae. Our resuls also show ha he inflaion argeing policy led o a srucural change in real GDP growh rae. The policy change significanly reduced he volailiy of real GDP growh rae afer he break dae. We find ha here is a lag of abou one year and six monhs beween he moneary policy change and is acual effec on oupu growh. Ciaion: Choi, Kyongwook, Chulho Jung, and William Shambora, (2003) "Macroeconomic Effecs of Inflaion Targeing Policy in New Zealand." Economics Bullein, Vol. 5, No. 7 pp. 6 Submied: November 4, Acceped: November 23, URL: hp:// 03E50003A.pdf

2 . Inroducion In he 990s, several counries inroduced a policy ha concenraes on sabilizing inflaion raes, which is labeled inflaion argeing policy. Inflaion argeing is a moneary policy framework in which cenral banks se an inflaion rae arge, for example, 2% annual inflaion raes for 2 years, and make use of all available policy insrumens o aain he goal. Inflaion argeing policy has been adoped by a number of indusrialized counries such as New Zealand (990), Canada (99), Israel (99), U.K. (992), Sweden (993), Finland (993), and Ausralia (994). Among G7 counries, he U.S., France, Germany, Japan, and Ialy do no commi o an explici inflaion argeing policy. Bernanke, Laubach, Mishkin and Posen (999) show ha all counries using inflaion argeing significanly reduced boh he rae of inflaion and he volailiy of key macroeconomic variables, and argue ha inflaion argeing would be a beer choice for moneary policy in he U.S. In he lieraure, however, mos research regarding inflaion argeing uilizes a relaively less rigorous case-sudy approach raher han a rigorous economeric approach. I is he goal of his paper o analyze macroeconomic effecs of inflaion argeing policy in New Zealand using a more rigorous framework. New Zealand is an inflaion argeing pioneer and he firs counry o adop inflaion argeing policy. New Zealand, which had experienced high and volaile inflaion in he pas, has been successful in bringing inflaion in line wih oher OECD counries by adoping inflaion argeing. To accoun for he dramaic effecs of he adopion of inflaion argeing in New Zealand, we employ radiional parameer sabiliy ess and inroduce he more rigorous framework of Markov swiching srucural break model. The paper proceeds as follows. Secion 2 discusses he New Zealand economy before and afer he adopion of he inflaion argeing policy. Secion 3 presens he radiional parameer sabiliy esing resuls for he inflaion rae using he Chow es, CUSUM and CUSUM square ess. Secion 3 explains he Markov swiching srucural break model. Secion 4 analyzes he empirical resuls from he Markov swiching model, and secion 5 summarizes our conclusions. 2. Background New Zealand is a counry wih limied inernal resources, hus a large appeie for inernaional rade. However, i has a shor lis of expors and a small number of rading parners. This has led o a hisory of wide swings in he New Zealand economy wih amplified responses o boh inernal and exernal shocks. For example, while he oil price shocks of he 970s sen he US ino a recession wih abou 2% decline in oupu and Ausralia s growh slowed o abou %, New Zealand wen ino a 6% decline. In addiion o exaggeraed real oupu cycles, New Zealand has also experienced high volailiy in is overall price level. During he 970s and early 980s he counry was subjeced o inflaion raes in he eens wih peaks around 20%. The use of wage and price conrols was aemped hree imes during ha period, resuling in even higher inflaion once he conrols were eased. The failure of hese policies resuled in poliical pressure for moneary reform, reforms The adopion of an inflaion argeing policy in Ausralia was more gradual, and i is hard o deermine he exac dae of he adopion.

3 ha maerialized in he mid-980s. By he firs quarer of 985 New Zealand had insiued financial liberalizaion, which included a free-floaing NZ currency, disappearance of ineres rae conrols and reserve raios, and he esablishmen of he independence of he Reserve Bank of New Zealand [RBNZ]. Subsequenly, he RBNZ Ac of 989 mandaed ha he sole responsibiliy of he cenral bank was o esablish and mainain price sabiliy. Inflaion arges are se via a Policy Targes Agreemen [PTA] beween he Reserve Bank and he governmen. The Governor of he Reserve Bank is personally responsible for achieving he inflaion arge and can be dismissed for arge breaches. Alhough he arges have been violaed several imes since he signing of he firs PTA in March 990, he Governor 2 has been allowed o keep his job so far. According o RBNZ (200), in he pos-liberalizaion / pre-rbnz Ac of 989 period, he cenral bank embraced he monearis approach o aacking inflaion. They were concerned wih conrolling he moneary quaniies and mosly ignored ineres raes and exchange raes. Following a sharp drop in he exchange rae in lae 988, his focus gradually shifed from moneary aggregaes o inflaion argeing. Official inflaion arges did no emerge, however, unil he firs PTA was signed in 990. The PTA inflaion rae has been se as a range, usually abou 0 o 3%. A fixed range is deemed more credible han a poin or a floaing range. Targe ransparency and operaional ransparency are also seen as helping moneary policy o be more credible and effecive (see RBNZ (999)). The inflaion rae as measured by CPIX, consumer price index minus cos of credi, began subsiding in he lae 980s coinciding wih he adven of reforms. The firs PTA in 990 was se a 3 o 5%. I was reduced o 0 o 2% in 992. Acual inflaion, for he mos par, followed he argeed pah and hovered around 2% during he lae 990s 3. This has kep New Zealand s inflaion in line wih he average among OECD counries in recen years. Former Governor Don Brash (RBNZ (999)) credis he success of inflaion argeing in sabilizing prices wih reducing he volailiy of New Zealand s business cycle as well. Alhough New Zealand is sill highly sensiive o economic shocks, growh since 990 does indeed appear o be more sable han in he pas. 3. Parameer Sabiliy Tess In order o invesigae if he adopion of he inflaion argeing policy has effecively sabilized he inflaion rae of New Zealand and brough a change in he srucure of he New Zealand economy, we use some radiional parameer sabiliy esing procedures, i.e. he Chow es, CUSUM and CUSUM squares ess. We collec he daa of GDP deflaor for New Zealand from 997 OECD Inernaional Saisical Yearbook CD. The sample period is from he firs quarer of 982 o he las quarer of 996. We esimae he following AR(2) model for he inflaion rae of New Zealand because he Akaike s Informaion Crierion (AIC) and he Schwarz s Informaion Crierion (SIC) sugges he series follows an auocorrelaed process wih wo lags. This process akes he following form: π = α π + α π + ε () + π π2 + 2 Dr. Don Brash served as Governor unil April 2002 when he lef o run for poliical office. The curren Governor is Dr. Alan Bollard. 3 As of his wriing he PTA is se a -3% wih he las repored CPIX a 2.4%. 2

4 where π denoes quarerly inflaion rae using GDP deflaor. We es for he exisence of a srucural change in he model before and afer he firs quarer of 990 when he firs PTA was signed. In Table, he Chow es resuls show ha we should rejec he null hypohesis of no srucural change a he % level. 4 The es saisic, 4.86, is disribued as F 2,56 and he p-value is The CUSUM esing resuls are shown in Figure. 5 Figure shows ha he model of he inflaion rae of New Zealand becomes unsable in he middle of he 980s, which coincides wih he beginning of financial reform. In Figure 2, he CUSUM square esing resuls show ha he model became unsable beween 987 and 992. I is known ha CUSUM and CUSUM square ess can deec sysemaic and haphazard movemens in parameers respecively. 6 Combining CUSUM and CUSUM square esing resuls, we conclude ha he model is unsable boh sysemaically and haphazardly before and afer he adopion of inflaion argeing policy. In sum, he Chow es and he CUSUM and CUSUM squares ess show ha he parameers of he model are unsable over he sample period under consideraion. 4. Markov Swiching Model Since radiional parameer sabiliy ess do no provide enough informaion o analyze macroeconomic effecs of he inflaion argeing policy in New Zealand, we adop a more sophisicaed and general echnique. In he previous secion we performed he Chow es under he assumpion ha he srucural break happened in he firs quarer of 990. In pracice, however, we do no know when he srucural break occurred. In addiion, radiional parameer sabiliy ess canno provide any informaion on he volailiy reducion of he inflaion rae. We can solve hese problems using Markov swiching model wih one ime permanen break. 4 The Chow es saisic is given as follows: ( uu! '! u' u u' 2u2)/ k F = ( u' u + u' u )/( N 2 k) 2 2 where uu!! is he resriced sum of squared residuals and uu i i is he sum of squared residuals from sub-sample i, N is he oal number of observaions and k is he number of parameers in he equaion. 5 We examine parameer sabiliy using he CUSUM es. This es is based on he cumulaive sum of he recursive residuals and calculaes he following saisic. wτ τ = k + W =, = k+,, T s where w is he recursive residual defined above and s is he sandard error of he regression fied o all T sample poins. We can find he parameer insabiliy when he cumulaive sum goes ouside he area beween he wo criical lines. 6 See Brown, Durbin, and Evans (975) for deails. 3

5 Assuming an AR(2) process as in secion 3, we adop wo-sae Markov swiching break model using Hamilon filer (989) as follows 7 : π = µ + φ π + φ π + σ (2) 2 D 2 2, ~ (0, ) D D e e D iid N D µ = µ ( D ) + µ D (3) D 0 φ = φ ( D ) + φ D (4) D 0 φ = φ ( D ) + φ D (5) 2D 20 2 σ = σ ( D ) + σ D (6) where π is he inflaion rae and D is a laen variable and modeled as a firs order Markov process (wo regimes) wih ransiion probabiliies given by: PD [ = i D = i] = q, PD [ = j D = i] = q,0< q <, q =, i, j= 0, (7) ii ii 00 where D equals 0 before he srucural break a ime = τ and D equals afer he srucural break. 0for τ D = (8) for τ T The expeced duraion of a regime before a srucural break occurs is given by E( τ ) = q. 00 To esimae his model we derive he join densiy of π, D and D condiional on he pas informaion I : ( π µ D φdπ φ2dπ 2) [ ] f( π, D, D Ι ) = f( π D, D, Ι )Pr D, D I 2 = exp Pr 2 [ D, ]. 2 D I 2πσ 2σ D D (9) Nex we use equaion (9) o ge f ( π I ) as follows: 7 The model we use in his paper is similar o he one used by Kim, Nelson and Piger (2003). They use Bayesian Markov Swiching model o ess a srucural break a an unknown break dae. They find ha he srucural break dae of he U.S. real GDP volailiy is 984: and ha i is shared by is cyclical componen bu no by is rend componen. They also find ha he volailiy reducion occurs over broad secors of real GDP. We, however, apply he classical model insead of Bayesian model. 4

6 D= 0 D = 0 D= 0 D = 0 f( π I ) = f( π, D, D I ) = [ ] f( π D, D, I )Pr D, D I, (0) From equaion (0), we can find he following log likelihood: T ln L= ln f( D, D ) Pr D, D I = D= 0 D = 0 π [ ] () where Pr [ D j, D i I ] Pr [ D j D i] Pr [ D i I ] = = = = = =, for i, j = 0,. We can compue he weigh erm, Pr[ D, D I ], in equaion () by updaing i, once π is observed a ime, as follows: [ D j D i I ] Pr =, = = D= 0 D = 0 wih Pr[ D = j I ] = Pr [ D = j, D = i I ] [ ] f( π D = j, D = i, I )Pr D = j, D = i I D = [ ] f ( π D = j, D = i, I )Pr D = j, D = i I (2) and ierae equaion () and (2) for =, 2,, T, we will have appropriae weighing erms in f ( π I ). (For more deails, see Hamilon (989) and Kim and Nelson (999).) 5. Empirical Resuls Table 2 summarizes he resuls. The esimaed srucural break dae is he 4 h quarer of 989, which is very close o when New Zealand officially adoped he inflaion argeing policy in he firs quarer of 990, bu even closer o he poin where acual inflaion argeing mos likely began. Noe ha q = and i is saisically significan a he % level. Therefore, we conclude ha he inflaion argeing policy has significanly changed he inflaion dynamics in he New Zealand economy. Nex, he volailiy in he inflaion rae shows considerable reducion afer he srucural break dae. Before adoping he inflaion argeing policy, he volailiy, for which we use he sandard deviaion, is almos hree imes larger han aferwards. Those wo esimaed sandard deviaions, σ D 0 and σ D, are saisically significan a he % level. The consan erm also has undergone a large drop ha affecs he uncondiional mean of he inflaion rae. The uncondiional mean decreased from 7.5 o The esimaed AR parameers, however, are no saisically significan. Figure 3 plos he esimaed probabiliy of a srucural 8 We can calculae he uncondiional mean as c D = µ D φ φ. D 2D 5

7 break a each poin in ime. I is easy o see ha he unknown break dae is very close o he dae when New Zealand adoped he inflaion argeing policy. Figure 4 shows he effec of he inflaion argeing policy on real GDP growh rae. In Figure 4 he volailiy reducion can be clearly deeced afer he break dae compared o before he break dae. In Table 2 he srucural break dae of real GDP growh rae is found o be he hird quarer of 99, which means ha here is a lag of abou one year and six monhs beween he moneary policy change and is acual effec on oupu growh Conclusion We find from secion 5 ha he inflaion argeing policy has significanly changed he inflaion dynamics in he New Zealand economy. The Markov swiching model clearly deecs a srucural break dae ha is very close o he acual dae of he policy change. The volailiy in he inflaion rae shows a considerable reducion afer he srucural break dae. Before adoping he inflaion argeing policy, he volailiy of inflaion raes is almos hree imes larger han aferwards. The consan erm also decreases significanly afer he break dae. Our resuls also show ha he inflaion argeing policy led o a srucural change in real GDP growh rae. In fac he policy change significanly reduced he volailiy of real GDP growh rae afer he break dae. The resuls also show ha here is a lag of abou one year and six monhs beween he moneary policy change and is acual effec on oupu growh. Overall, we can conclude ha he inflaion argeing policy adoped by New Zealand was successful in sabilizing he inflaion and oupu growh raes of he New Zealand economy. However, we need o furher invesigae he cases of oher counries o draw a general conclusion on he effec of he inflaion argeing policy. 9 We employ he same Markov swiching model and esimaion mehod for real GDP growh rae. We collec he daa from 997 OECD Inernaional Saisical Yearbook CD. 6

8 Figure CUSUM es: Inflaion Rae CUSUM 5% Significance Figure 2 CUSUM square es: Inflaion Rae CUSUM of Squares 5% Significance 7

9 Figure 3 Probabiliy of Srucural Break: New Zealand Inflaion Rae INF_PROB INF Figure 4 Probabiliy of Srucural Break: New Zealand Real GDP Growh Rae GROWTH_PROB GROWTH 8

10 Table Chow Break and Forecas Resuls Variables F-saisic P-value Inflaion Rae Table 2 Markov Swiching Esimaion Resuls Parameers µ D 0 µ D φ D0 Inflaion.80 a (0.666) a (0.40) 0.34 (0.888) (0.52) 0.06 (0.90) (0.0).772 a (0.236) Real GDP b a a a Growh Rae (0.56) (0.356) (0.86) (0.49) (0.049) (0.000) (0.422) * SB denoes Srucural Break. Noe ha a and b denoes rejecion of he hypohesis a he % and 5% levels respecively. φ D φ 2 D0 φ 2 D σ D 0 σ D q SB* dae a a 89.IV (0.079).33 a (0.290) (0.033) a (0.027) 9.III 9

11 References Bernanke, B.S., T. Laubach, F.S. Mishkin, and A. Posen (999) Inflaion Targeing, Princeon Universiy Press: Princeon. Brown, R.L., J. Durbin, and J.M. Evans (975) Techniques for Tesing he Consancy of Regression Relaionships over Time Journal of he Royal Saisical Sociey, Series B 37, Hamilon, J. (989) A New Approach o he Economic Analysis of Nonsaionary Time Series and he Business Cycle Economerica 57, Kim, C. J., and C. R. Nelson (999) A Sae Space Models wih Regime-Swiching: Classical and Gibbs-Sampling Approach wih Applicaions, The MIT Press: Cambridge, Massachuses. Kim, C. J., C. R. Nelson, and J. Piger (2003) A Bayesian Invesigaion of Time, Breadh, and Poenial Explanaions forhcoming in Journal of Business and Economic Saisics. RBNZ (999) Moneary Policy over he Business Cycle, Reserve Bank of New Zealand. RBNZ (200) The Evoluion of Moneary Policy Implemenaion, Moneary Policy Review, Reserve Bank of New Zealand (hp:// Rudebusch, G.D., and L.E. Svensson (999) Policy Rules for Inflaion Targeing in Moneary Policy Rues, edied by J. Taylor, The Universiy of Chicago Press: Chicago,