RDP 1977-06: Interest Rates and Exchange Rate Expectations in the RBA76 Model 2. The Alternative Models
October 1977
In order to address the question of the extent to which changes to interest rates, such as the yield on Commonwealth government securities, which are set by government decision, influence the economy, it is necessary to relax the usual assumption of Australian models, that these rates are proxies for all nominal interest rates of importance for private sector decisions. It is also necessary to examine alternative hypotheses about the interaction between bond rates and interest rates on private sector assets.
In this paper this is done by comparing the estimation and simulation performance of four models, each of which includes a private sector interest rate, a measure of the rate of return on company debentures. The first model, denoted Model A in this paper, is a version of the standard RBA76 model, with the debenture rate equation in addition to the bond rate equation. This model provides a benchmark against which the other models are evaluated.
Since the debenture rate equation allows for adjustment towards the bond rate and interest rates in the rest of the world, as discussed in Section 3, the estimates of the parameters of this equation in each model provide evidence about the extent to which company debenture rates are determined by bond rates.
Model B has the debenture rate in the asset demand functions of the model, in addition to the bond rate. Model C is the same as Model B except that the parameters measuring exchange rate expectations are constrained to be identical in each function in which the implicit exchange rate expectations equations are included.[2] These models provide evidence about the relative importance of bond rates and debenture rates in asset demands.
In Models A, B and C there is a version of the bond rate policy reaction function from the RBA76 model. In this function, bond rates adjust towards a target rate determined in the current model by the monetary growth rate, a proxy for an equilibrium nominal interest rate,[3] with the adjustment influenced by the usual stabilization policy variables. It is,however, possible that bond rates adjust towards market rates, and this can be tested by replacing the target bond rate in the standard model by the debenture rate, and by constraining the equilibrium debenture rate to be the world rate. This gives Model D, which effectively reverses the direction of causation from bond rates to debenture rates suggested by Models A, B and C.
Footnotes
The representation of exchange rate expectations is discussed in detail in Section 5. [2]
The target bond rate could be defined in several ways; for example, as a constant real rate, equal to equilibrium rate of growth of real product, plus the rate of inflation; or, in this paper, as the growth rate of nominal income, equal to the monetary growth rate. [3]