RDP 7703: Price and Quantity Responses to Monetary Impulses in a Model of a Small Open Economy 1. Introduction

The nature of price, output and balance of payments responses to domestic monetary and budgetary disturbances has received much attention in recent years. This paper explores the issue using a relatively small structural model of the Australian economy, with particular emphasis on the role of price and exchange rate expectations. The use of such a model is designed to avoid the abstraction of analyses with overly simple theoretical models and the complexity of studies using large econometric models.

For relatively closed economies, the classic view, supported by much of the previous empirical work reported in Section 2, is that the price and output responses occur with “long and variable” lags, with the output response generally preceding the price response. Recent evidence, however, suggests that under some conditions price responses may be relatively more important than output responses. A separate strand of analysis relates to small open economies; some of the existing results imply that almost all of the adjustment to domestic monetary fluctuations take the form of monetary offsets through the balance of payments, although other work also allows domestic price arid quantity effects.

Unfortunately, the analysis of the interactions in closed and open economies is hot highly integrated, a point which is especially surprising in view of the recent world-wide move to more flexible exchange rates. The model used in the current analysis, which is discussed in Section 2, integrates the mechanisms stressed in open and closed economy analysis more than most previous macro-econometric models. Section 4 presents some simulation experiments with the model and Section 5 draws the threads together, with emphasis on the work remaining to be done.

The results presented in this paper should be regarded mainly as illustrating the properties of a particular model; there are several questions which need further investigation before the work could be regarded as being of much practical relevance. Investigation of the implicit price expectations generating mechanism in the model is required in particular, and it is also necessary to test alternative specifications of the balance of payments, the financial sector, and policy reaction. Nevertheless, the results may be of interest, particularly in comparison with those generated by other macroeconometric models.