Nineteenth Colin Clark Lecture: November 2009: What Have we Learnt? The Great Depression in Australia from the Perspective of Today

This lecture examines the lessons learnt from Australia’s experience in the 1930s, and how these lessons have informed more recent economic policy decisions including the policy responses to the current global financial crisis. The lecture argues that the lessons learnt from the Great Depression have informed the macroeconomic frameworks of today. While Australia’s policy frameworks of the 1930s were tragically ill equipped to cope with anything other than small, inconsequential macroeconomic or financial market shocks, the policy frameworks put in place in the modern era have rendered the economy much more resilient to such shocks.

The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?

A risk-averse US investor adjusts the shares of a portfolio of short-term nominal domestic and foreign assets to maximize expected utility. The optimal strategy is to respond immediately to all new information which arrives weekly. We calculate the expected utility foregone when the investor abandons the optimal strategy and instead optimizes less frequently. We also consider the cases where the investor ignores the covariance between returns sourced in different countries, and where the investor makes unsystematic mistakes when forming expectations of exchange rate changes. We demonstrate that the expected utility cost of sub-optimal behaviour is generally very small. Thus, for example, if investors adjust portfolio shares every three months, they incur an average expected utility loss equivalent to about 0.16% p.a. It is therefore plausible that slight opportunity costs of frequent optimization may outweigh the benefits. This result may help explain the failure of uncovered interest parity.

How Should Monetary Policy Respond to Asset-Price Bubbles?

We present a simple macroeconomic model that includes a role for an asset-price bubble. We then derive optimal monetary policy settings for two policymakers: a skeptic, for whom the best forecast of future asset prices is the current price; and an activist, whose policy recommendations take into account the complete stochastic implications of the bubble. We show that the activist’s recommendations depend sensitively on the detailed stochastic properties of the bubble. In some circumstances the activist clearly recommends tighter policy than the skeptic, but in others the appropriate recommendation is to be looser. Our results highlight the stringent informational requirements inherent in an activist policy approach to handling asset-price bubbles.

Financial Market Volatility and the World-wide Fall in Inflation

Inflation in the 1990s in most industrial countries is lower and less variable than at any time in the past quarter of a century. Economic theory predicts that, other things equal, this decline in inflation variability should lead to less volatility in both bond and foreign exchange markets. The paper tests these theoretical predictions and finds some evidence that lower inflation variability leads to less volatility of bond yields, but almost no evidence that it leads to lower volatility of floating exchange rates.

Why Does the Australian Dollar Move so Closely with the Terms of Trade?

The paper is motivated by two empirical results. Australia’s terms of trade exhibit temporary fluctuations around a slowly declining trend, and movements in Australia’s real exchange rate tend to follow those in the terms of trade. Together these results imply predictability in Australia’s real exchange rate as well as the presence of predictable excess returns that are sometimes quite large. Using a simple econometric model, with the terms of trade as the sole explanator, the paper demonstrates the forecastability of Australia’s real exchange rate over horizons ranging from one to two years. It then quantifies the magnitude of the predictable excess returns to holding Australian dollar denominated assets over such horizons, finding them to be highly variable and sometimes quite large in magnitude. The results suggest a relative scarcity of forward-looking foreign exchange market participants with an investment horizon of a year or more.

Macroeconomic Policies and Growth

While economic theory is largely mute on the question of whether macroeconomic policies affect long-run growth, an examination of the experience of different countries over various periods and the policies they pursued, lends strong support to the idea that macro policies do play a role in the growth process. A macroeconomic policy framework conducive to growth can be characterised by five features: a low and predictable inflation rate; an appropriate real interest rate; a stable and sustainable fiscal policy; a competitive and predictable real exchange rate; and a balance of payments that is regarded as viable. Countries with these macroeconomic characteristics tend to grow faster than those without them, though there are many individual cases of both developing and developed countries suggesting that satisfying only some of these conditions does not sustain strong growth. It is also important to recognise that the direction of causation is somewhat ambiguous: while good macro outcomes should be conducive to growth, strong growth is also conducive to good macroeconomic outcomes. The paper presents a wide-ranging examination of both theoretical and empirical evidence on the many ways macroeconomic policies may influence economic growth. Given monetary policy’s crucial role in determining the inflation rate in the longer run, there is a particular emphasis on the relationship between inflation and growth. The following five broad conclusions are drawn. First, although growth models assign a major role to capital accumulation, there is little evidence that aggregate investment yields excess returns, and so special policy incentives to boost aggregate investment appear inappropriate. Second, countries with low national saving invest less and grow more slowly than they would if saving were higher. Ultimately, the extent to which a country can rely on foreign savings to fund domestic investment and growth depends on the rate of capital inflow the market accepts as sustainable. For Australia, with abundant natural resources and a stable political environment, this may be higher than for many other capital importing countries. Third, declining national saving rates in many industrial countries are primarily a consequence of lower government saving, suggesting a need for reduced fiscal deficits. In Australia, however, private savings have also fallen substantially, suggesting a possible role for specific incentives to boost private savings. Fourth, when economies are near potential, short-run rises in output seem to be more inflationary than falls in output are disinflationary. This implies that macroeconomic policy acting pre-emptively to counter expected future demand pressures and quickly mitigating the effects of unexpected shocks has a positive effect on the level of output, compared with a more hesitant approach acting only when demand pressures have appeared. Further, provided inflation is kept close to its target in the medium term, policy which tolerates some short-term deviations of inflation from its target reduces fluctuations in real output and generates a higher long-run output level than a policy with the sole goal of keeping inflation close to its target. Finally, although most economists believe even moderate rates of inflation adversely affect growth, unambiguous evidence has been difficult to come by. There is still professional disagreement on the robustness of the empirical evidence, but it does appear that higher inflation, and the associated increased uncertainty about future inflation, adversely affects growth in the industrial countries. The gains from lower inflation appear to exceed the initial costs of reducing inflation within about a decade.

Are Terms of Trade Rises Inflationary?

This paper explores the relationship between the terms of trade and inflation. It shows, both analytically and empirically, that the exchange rate response to a change in the terms of trade is crucial to the inflation outcome. It suggests the existence of a ‘threshold’ exchange rate response. Our best estimate is that (other things being equal) a rise in the terms of trade is inflationary if the associated rise in the real exchange rate is less than about 1/3-1/2 of the rise in the terms of trade. However, if appreciation of the real exchange rate is larger than this, the consequent fall in the domestic price of importables is large enough that the terms of trade rise reduces inflation, at least in the short run.

Australia’s Real Exchange Rate – Is it Explained by the Terms of Trade or by Real Interest Differentials?

We use time series techniques to examine the behaviour of Australia’s real exchange rate from 1969 to 1990. The real exchange rate exhibits non-stationary behaviour over this period, in contrast to simple purchasing power parity theory. We find weak evidence that the real exchange rate exhibits a stable long run relationship with the terms of trade. There is no stable long run relationship between the real exchange rate and either short or long real interest differentials between Australia and its major trading partners. Since the float of the Australian dollar and the world-wide deregulation of financial markets, we find some evidence that the real exchange rate exhibits a stable relationship with the terms of trade alone, and with long real interest differentials alone. The evidence for a stable relationship is clearest with long real interest differentials. After the float, we also find evidence that the terms of trade and long real interest differentials together help to explain the Australian real exchange rate. We estimate the number of independent long run relationships between the real exchange rate, the terms of trade and long real interest differentials and, for some specifications, find evidence of two independent relationships. Since the float, our best estimates are that a 1 per cent improvement in the terms of trade leads to an appreciation of the Australian real exchange rate of about 0.3 to 0.5 per cent, while an increase of 1 percentage point in the differential between Australian and world long real interest rates is associated with an appreciation of the Australian real exchange rate of about 2 to 3½ per cent.

Explaining Forward Discount Bias: Is it Anchoring?

Anchoring is a well-documented behaviour pattern. It occurs when agents form their expectations of an objective variable by only partially adjusting from some given starting value. We present a model of the foreign exchange market in which there are two types of traders: those who are fully rational and those whose expectations are anchored to the forward exchange rate. Under plausible conditions, a significant proportion of the anchored traders survive in the market in the long-run. The model explains both forward discount bias in the direction consistently observed in foreign exchange markets and the results of surveys of market participants’ exchange rate expectations.

The Lags of Monetary Policy

The length of the transmission lags from monetary policy to output has been the subject of much research over the years, but there are serious problems in isolating the lags with any precision. This paper uses a simple model of Australian output to estimate the length of the lags, and then examines how attempts to grapple with the estimation problems might change the results. We estimate that output growth falls by about one-third of one per cent in both the first and second years after a one percentage point rise in the short-term real interest rate, and by about one-sixth of one per cent in the third year. This implies an average lag of about five or six quarters in monetary policy’s impact on output growth. Each of these estimates is, however, subject to considerable uncertainty. We discuss the implications for policy of these relatively long and uncertain lags. Finally, we find no evidence that the average lag from monetary policy to output growth has become any shorter in the 1990s.