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Counterfactual experiments with the Reserve Bank of New Zealand's core model provide some insight into the implications for New Zealand's economic performance over the 1990s, had it credibly fixed its currency to the Australian dollar. If New Zealand had faced the relatively more stimulatory Australian monetary conditions prevailing over the 1990s, then output growth may have been temporarily boosted. However, demand pressures would have probably been greater and inflation higher. In particular, results suggest that over the latter part of the 1990s annual inflation would have been approximately 1% point higher on average. Stochastic simulation experiments provide a vehicle to analyse what the implications of currency union might be more generally. Results suggest that if New Zealand were to lose its ability to set monetary policy independent of that set in Australia, then the variability of inflation and output would increase over the business cycle.

In a period when countries are becoming increasingly linked to one another through trade and capital flows, the management of the exchange rate regime is a critical factor in economic policy making, and the choice of regime is always controversial. The debate over whether New Zealand should continue to maintain an independent currency, or form a currency union with a larger country, such as Australia, has recently taken on prominence.1 The initial impetus for this debate came from observing international trends in exchange rate regimes: in particular, the formation of a currency union by the European countries that use the Euro; the contemplation of dollarisation by several Latin American countries; and the adoption of full dollarisation in Ecuador. The key motivating factor behind currency union in Europe was the general move towards tighter political union, while in Latin America it was dissatisfaction with floating exchange rates, and a lack of monetary and inflationary control. However, neither of these reasons applies to the New Zealand situation. The debate in New Zealand is really about the conduct of monetary policy and improved overall performance of the economy in the longer run, rather than the exchange rate regime itself. Despite the fact that floating exchange rate regimes have not had any detectable ill effects upon economic performance, advocates of currency union for New Zealand have criticised monetary policy for being overly stringent and not taking sufficient risks to allow growth to occur. For example, it has been suggested that New Zealand's growth performance over the last decade would have been better had it adopted Australian monetary conditions.2 However, a-priori, it would be surprising if monetary policy designed for the Australian economy produced superior results for New Zealand. Notwithstanding the similarities of the two economies, the New Zealand economy at times is subject to different shocks, and an ability to set monetary policy independently of that set in Australia may help offset these differential shocks. Even where shocks are similar the transmission of them through the economies may differ, again suggesting superior outcomes may result from an ability to set monetary policy independently. The contribution of this paper is the use of a general equilibrium approach to directly assess whether the New Zealand economy could have performed better in the 1990s with Australian interest rates and currency movements. It utilises the core model of the Reserve Bank of New Zealand's Forecasting and Policy System (FPS) to examine the potential effects of adopting Australian monetary conditions on key New Zealand macroeconomic variables such as output and inflation.3 The empirical results are therefore counterfactual in nature, and should be seen as complementary to other contributions on whether New Zealand should or should not adopt a common currency with Australia. Our results can be seen as fitting with the traditional analysis of optimal currency areas started by Mundell (1961). That is, when an economy faces mostly real shocks, such as changes in its terms of trade, a floating exchange rate is the most effective regime choice. Indeed, the principal benefit attributed to a floating exchange rate regime is that it facilitates a smooth adjustment to real shocks. In contrast, countries in a currency union have to rely on the adjustment of domestic prices to absorb real shocks that are specific to that country, particularly if other adjustment mechanisms such as labour flows or fiscal transfers are unavailable or limited. Such adjustment can be quite slow and painful, potentially prohibitively so as seen in the case of Argentina in early 2002. At the other end of the spectrum it can lead to problems of ‘overheating’, as seen in several Euro area countries, most notably Ireland. The remainder of the paper is set out as follows. Section 2 examines the implications of New Zealand having Australian monetary conditions over the 1990s. Using deterministic simulations in FPS, counterfactual inflation and output outcomes are measured against the outcomes that actually occurred over the 1990s. Section 3 expands the analysis to include a much wider range of economic shocks than was the experience over the 1990s by using stochastic simulation methods. Section 4 provides a summary of specific results, and some broader conclusions.

Deterministic simulations show that New Zealand's output gap measure would have been on average 0.3% points higher than New Zealand's actual historical experience, if the more stimulatory Australian monetary conditions had been applied to New Zealand during the 1990s. By 2000, though, output would have been approximately back to baseline. This greater excess demand pressure would have led to, on average, 1% higher CPI inflation. This implies that the Reserve Bank's original 0–2% inflation target band would have been exceeded by a greater amount, and for a greater number of periods than was actually the case. Moreover, the 0–3% band (in place from December 1996 to September 2002) would have been exceeded over the last two quarters of 1996. These outcomes eventuate despite the advantage of a conservative exchange rate pass-through assumption. Stochastic simulation results show that the volatility in output and inflation are the lowest under the case where the New Zealand economy experiences domestic shocks and operates its own monetary policy. In contrast, volatility is the highest when domestic and world shocks occur, and New Zealand's monetary policy is controlled offshore. Moreover, irrespective of the shock scenario considered, model results show the volatility in output and inflation to be greater under a common currency policy environment than with New Zealand operating its own monetary policy. In utilising these counterfactual model-based outcomes to assist judgement on whether New Zealand should consider adopting some form of common currency, our research suggests it is necessary to consider: • outcomes from a representatively wide range of possible stochastic shocks, as well as from the shocks which have occurred during one specified historical period, and • results not just for output and inflation, but also for their relative variability. It follows, therefore, that any summary conclusion from the above system-wide macroeconomic evidence will depend on the relative weighting placed on the degree of variability of inflation and output. If a high weight is placed on avoiding such variability, then our results imply New Zealand should retain its ability to set monetary policy independent of that set in Australia.