RDP 1977-06: Interest Rates and Exchange Rate Expectations in the RBA76 Model 1. Introduction

In many macroeconometric models interest rates on bank lending and on government securities are assumed to be exogenous variables, or else a representative rate is determined by a policy reaction function. Such models contain several channels by which changes in such interest rates, and in particular the yield on government securities, influence real and financial decisions, and officially determined interest rates are therefore seen to have important effects on economic activity and prices.

It is clear that in practice many other rates of return are relevant for private sector decisions; the use of the bond rate (for example) as a representative interest rate may reflect partly a desire for analytic simplicity, and also the fact that reliable data on market determined interest rates are not readily available for a long enough period for economic modelling. The standard approach to modelling assumes a fixed relationship between yields on private and government securities. On this assumption, variations in official yields induce changes in yields on private financial assets and thus in the costs of finance to final users. The extent to which interest rates can, over time, be influenced in this way is an important issue. There is widespread agreement that the influence of price expectations on the yields of financial assets and the implications of international mobility of capital are such that the authorities in a small open economy cannot, in the long run, exert a direct control over nominal interest rates. There is less agreement on the extent to which official actions in the securities markets affect interest rates on private sector paper in the shorter-term; this is a matter about which this paper attempts to provide fresh evidence. It does this by including, in addition to the bond rate, a measure of company debenture rates in the RBA76 model, and by examining the goodness of fit and simulation properties of several versions of the model which include the additional interest rate and implement alternative hypotheses about its interaction with bond rates and interest rates determined in the rest of the world.^[1]

A supplementary issue is the representation of exchange rate expectations. In the basic RBA76 model exchange rate expectations are proxied in the asset demand functions by variables representing the relationship between domestic and world prices and the build-up of expectations prior to each of the large discrete exchange rate changes of recent years. In the current paper, which models interest rates in linear rather than log-linear form, it is possible to solve for the equation for exchange rate expectations, and to thereby derive a measure of exchange rate expectations over the sample period.

The conclusions of the study are tentative, partly because data on the company debenture rate are probably not as reliable as the official bond rate statistics and partly because the tests are conditional on the hypotheses in the remainder of the RBA76 model. Furthermore, the results are far from being decisive. Despite these problems, the study has the methodological advantage that the estimation technique allows for the simultaneous determination of bond rates and debenture rates and it is possible to examine alternative specifications of the interactions between them.

The remainder of the paper is organized as follows. Section 2 discusses four models which include the debenture rate. Section 3 outlines the measurement and modelling of the debenture rate in the models. The influence of the debenture rate on asset demands in the models is discussed in Section 4. Section 5 contains a discussion of exchange rate expectations in the models, and Section 6 presents the results of simulations which illustrate some of their properties. Section 7 concludes, with emphasis on the further research suggested by the results of the current paper.

Footnote

In this study the bond rate is represented by the redemption yield of Commonwealth government securities with ten years to maturity. Interest rates in the rest of the world are proxied by an average of yields on U.S. government securities with ten or more years to maturity. The definition of the debenture rate is discussed in Section 3, and the series is in the appendix. [1]