# Economy

This section explains some of the economic terms you're likely to come across while participating in the Monetary Policy Challenge. It also provides some tips on understanding and using statistics.

## Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the value of all goods and services produced in New Zealand over a specified time. It is often referred to as total output.

Statistics New Zealand uses two approaches to calculate GDP.

• Production GDP: The dollar value of the sum of all value added in New Zealand.
• Expenditure GDP: The total dollar value of what is spent on New Zealand produced goods and services.

The measurement framework is such that production GDP equals expenditure GDP. That is, by definition, all goods and services that are produced are bought by someone - including foreigners (who buy New Zealand's exports). Where goods are produced but have yet to be sold to a final buyer, these are held as inventories.

## GDP - Real versus nominal

GDP figures are made up of two components - volume and price. GDP can increase because of a rise in the price of goods and services, even if the actual amount produced remains the same, this would be an increase in the value of goods and services produced. GDP can also rise because of an increase in the volume of goods and services being produced, that is the amount produced increases, even if prices remain the same.

The Reserve Bank is interested in the balance between what is being demanded and the economy's capacity to produce these goods - the output gap. For this purpose, we are more interested in the volume of goods produced, or the actual amount produced, not the value. Statisticians use price and volume data to work out how much of the growth in the value of goods and services is due to more being produced (volume increase), and how much is due to price increases. The value series is called nominal GDP, while the volume series is called real GDP. Real GDP is adjusted for changing prices (ie, inflation) and is calculated by using the value of output for that year and the change in the price of that output from some base year.

## Expenditure GDP

For the Monetary Policy Challenge we recommend you focus on expenditure GDP as a basis for analysing the current state of the economy, in order to help you make your interest rate decision.

Expenditure GDP can be broken down into various forms of activity. As a quick formula to remember, expenditure GDP is made up of:

GDP = C + I + G + X - M, where

C = Private consumption

I = Investment (private + government)

G = Government consumption

X = Exports

M = Imports

The following gives you an overview of the various activities that make up expenditure GDP.

## Consumer spending

Consumer spending is the spending of New Zealand households on everyday goods and services. This spending accounts for around 60 percent of expenditure GDP.

How much consumers spend is largely dependent on household income and wealth. If households have higher incomes and/or become wealthier, consumer spending also usually increases. Consumer spending can also be affected by factors such as the level of consumer confidence and the level of interest rates.

Household income is driven mainly by developments in the labour market. When unemployment is low or wage growth is high, household income growth tends to be strong. For this reason, recent trends in the labour market may indicate future trends in household consumption.

Household wealth mainly consists of financial assets (bank deposits, shares, etc) and real estate (eg, the family home). When the prices of these assets change consumer spending can be affected. In New Zealand, the majority of household wealth tends to be held in real estate. Therefore changes in house prices for example can significantly impact the future path of household consumption.

## Investment

Investment spending includes:

• spending by businesses on industrial and commercial buildings and on plant and equipment
• spending by households on housing (that is, the building of new houses, and on major alterations and additions)
• government spending on investment in infrastructure such as roads, schools, and hospitals.

The level of spending on investment is important for assessing both the current level of economic activity, (economists call this current output), and the future level of what the economy can sustainably produce (economists call this potential output). Increased investment causes the current level of demand for goods and services (from builders, and construction workers etc) to rise. It also affects future potential output because when the investment comes on stream, it increases what the economy can supply.

The amount of investment can change significantly from quarter to quarter. This is because some investment tends to occur in ‘lumps'. For example the construction of a new factory, or apartment building may involve a large spend in one quarter.

Investment spending tends to be more sensitive to economic conditions than household consumption. Households tend to maintain a reasonably stable level of consumption through varying economic circumstances, whereas firms can turn investment spending on or off depending on how they see the economic outlook.

Investment also tends to be related to the level of imports. This is because a large proportion of manufacturing equipment is not made in New Zealand, and therefore has to be imported. Increased levels of imports may indicate that investment will increase, although this is not always the case.

Business confidence surveys can sometimes indicate that investment is on the up. Companies will invest in new equipment because they want to produce more, but they will only do so if they believe they will be able to sell more. So businesses' beliefs about what consumers will spend in the future are a major driver of investment. One thing to take account of when looking at the relationship between business confidence and investment is the current level of capacity utilisation (which measures how much of the maximum productive capacity the current level of production uses).

Surveys of capacity utilisation measure how well existing capacity is being utilised. If existing capacity utilisation is low, then the current level of production will be well under the sustainable level of productive capacity and businesses can increase production without having to buy more machinery. On the other hand, if capacity utilisation is already high, current production levels will be near their sustainable level and, to produce more, businesses may need to invest in more machinery.

## Inventories

Inventories are goods held by companies as materials, components or finished goods to be sold later. They can be thought of as a form of investment because companies are spending now on goods that will earn revenue in the future.

Most companies deliberately store goods in order to smooth production schedules. This is why factory workers usually work the same number of hours each week even though sales fluctuate.

## Government expenditure

Government spending, like private spending, is categorised into consumption and investment.

1. Government consumption comprises spending on everyday goods and services, for example, the wages and salaries it pays to public sector employees such as public servants, school teachers, and nurses; and spending on goods such as pharmaceuticals used by hospitals. Outlays on social welfare benefits are not included, as these do not represent spending on goods and services, but instead are a transfer, from tax revenues, to the recipients of benefits. In New Zealand, government spending on goods and services makes up about 20 percent of expenditure GDP.
2. Government investment spending includes spending on things such as roads, and hospitals.

## Exports

Exports include goods such as New Zealand lamb (purchased by foreigners in their own country), and services such as hotel accommodation (purchased by foreigners while in New Zealand). Unlike the other components of GDP, the level of exports is directly affected by the state of the world economy. When the world economy is doing well, usually both the volume of sales and the price of the products New Zealand sells are higher.

As a large proportion of our exports are primary commodities (such as dairy, beef and forestry) the weather can often be a factor when predicting export earnings – both current and expected future weather conditions must be considered. Droughts and other extreme weather conditions can dampen production of primary exports, therefore even if world prices are high and demand is strong, export earnings growth may not necessarily be high.

Weather conditions in other economies may also affect the price and demand for our primary exports. For example, recently very dry conditions in the US and Australia have lowered dairy production in these economies – with less available on the world market, the world price of dairy products has increased, increasing the export earnings of our dairy farmers.

## Imports

Spending on imports is not included in GDP because imports are produced outside New Zealand and therefore do not contribute to production within New Zealand.

However, this doesn't mean economists don't look at imports when trying to work out what the economy is doing, and what it will do in the future. The level of imports is directly affected by the state of the New Zealand economy. So, generally when import levels are high, the domestic economy is buoyant. Also, as already mentioned, increased imports, particularly imported machinery and equipment, usually signify increased investment spending.

## The exchange rate

Export earnings and spending on imports are influenced by the exchange rate. When the exchange rate appreciates, export earnings in NZ dollar terms fall and import prices decrease.

For example, if the NZ dollar (NZD) appreciates against the US dollar (USD) from NZ\$1=US\$0.40 to NZ\$1=US\$0.50 then one USD buys fewer NZD than previously (or alternatively, one NZD buys more of a USD than previously).

When the NZ dollar appreciates, New Zealand export earnings tend to fall. The fall in export earnings can occur in two ways:

1. If the USD price of our export remains the same, then NZ exporters receive less for every US dollar earnt.
2. If the USD price of our export is increased, so that the NZ exporter receives the same earnings in NZ dollars as previously, then our products become relatively more expensive for US consumers. It is likely in this case that the quantity demanded of our more expensive product will fall.

Conversely an appreciation of the NZ dollar will (all else constant) lead to the price of imported goods being lower. This means imported goods and services will be relatively cheaper in New Zealand and New Zealanders may demand more comparatively of these goods and services.

Clearly exchange rate movements can have a significant effect on both the volume and price of exports and imports, thereby affecting GDP and also inflation (see the inflation section for further details).

## Summary

GDP is measured and reported on a quarterly basis, but there is a time lag involved with the release of GDP. For example, GDP for the quarter ending March 2007 only becomes available at the end of June 2007.

For the purposes of the Monetary Policy Challenge, teams will need to provide a view of how they think expenditure GDP will change in the period ahead in order to make an informed monetary policy decision. Like the economists working at the Reserve Bank, each Monetary Policy Challenge team will need to look closely at GDP, identify any trends and formulate a view on what GDP will be in the future.

## Using statistics

### Official data

Most of the official data for the New Zealand economy is produced by Statistics New Zealand. A summary of some of the core statistics you may require for the Monetary Policy Challenge is provided in the forecasting section. Time series data is available in the Data section. When looking at the time series data, it is important to know whether the series have been seasonally adjusted, and whether you are best to look at growth rates or levels in completing your analysis. Below we explain some of these basic concepts.

In some time series data, we can observe fluctuations that occur at roughly the same time each year, this is know as a seasonal pattern. For example, consumer spending is almost always higher in the December quarter than the June quarter of any given year – a reflection of higher spending at Christmas. Often statisticians adjust economic data for this normal seasonal variation, to allow sensible comparisons to be made between different periods.

Seasonally adjusted data is not needed when annual comparisons are made (eg tourist spending in the same month of two different years) as we will be comparing like with like so long as the seasonal pattern of the data is consistent across years.

### Growth rates

Economists often focus their analysis on how things have changed, and on rates of change, called growth rates. These are almost always represented as a percentage change. There are four different types of growth rates that are normally discussed and it is important to be clear on which is being referred to:

1. Quarterly (Q%), or monthly (M%), percentage growth is the percentage change between one quarter or month and the next quarter or month. If a seasonal pattern exists, a seasonally-adjusted series is provided to calculate this growth rate.

2. Annualised quarterly, or monthly, growth is the quarterly percentage growth rate multiplied by four, or correspondingly the monthly percentage growth rate multiplied by 12. It shows how much the series would change if it kept growing at the same rate for a year that it grew at for the latest quarter/month. Annualised growth rates are not used much in New Zealand, because New Zealand economic data tends to be quite volatile over short periods, reflecting that New Zealand is a small economy in which single events can have a significant impact on the aggregate data. The volatility in the quarterly/monthly data means that annualising those data can give a misleading picture.

3. Annual percentage growth (A%) is the percentage change from one quarter or month of a year to the same quarter or month of the preceding year. Since the same two periods within the calendar year are being compared, seasonally adjusted data is not needed.

4. Annual average percentage growth (AA%) is the percentage difference between the average quarterly or monthly value in a year and the average quarterly or monthly value of the next year. This is equivalent to the percentage difference between the sum of the data for one year and the sum of the data for the next year. Since two entire years are being considered, seasonal patterns are not a problem and seasonal adjustment is not needed.

### Economic surveys

In addition to official statistics, the Reserve Bank of New Zealand also considers a range of economic surveys when it sets monetary policy. These surveys are published by several business organisations. Examples are the National Bank Business Outlook, the NZIER Quarterly Survey of Business Opinion, and the Colmar Brunton/One Network News Consumer Survey. Surveys measure the responses of households and firms to questions about their economic perceptions or intentions.

When using survey information it us important to recall that surveys typically measure intangible things such as sentiment. The advantage of surveys is that they can provide early indications of changes in the economy, by asking about respondents' view on where the economy may be going or expectation for future spending, hiring or investment. Official statistics on the other hand often measure things that have already happened, such as actual levels of spending or production in the previous month or quarter. Official statistics show where the economy has been. If we can understand the factors that have shaped those past developments, the official data can provide us with a platform for forecasting prospective developments.