RDP 7902: Financial Modelling in Australia 1. Introduction

The 1970's have produced many studies of the Australian financial sector^[1] and its links with the rest of the economy. In this survey these studies are analysed and an attempt is made to assess their contribution to our knowledge about how the economy works.

The analysis begins with a discussion of the portfolio studies of particular groups. These studies have explicit theoretical underpinnings although the most general of them suffer from serious statistical difficulties. The ways that have been used to overcome these difficulties are discussed. The empirical evidence from these studies relates mainly to rate of return and quantity links between expenditure, and financial and real asset demands. The evidence here can, in principle, provide valuable insights into the links between the real and financial sectors.

Full models combine studies of individual groups. In general, the models have used simpler structures than those of the single sector studies, and do not base them on explicit theoretical underpinnings. Combining sectors, however, does allow for the interaction of different sectors to determine both the price and quantity of financial assets. The full models have also addressed other issues such as the specific roles of money, wealth, interest rate expectations, and the influence of international financial markets and the exchange rate. All these issues and the empirical evidence that has been provided are discussed.

Finally there is a detailed assessment of what we have learnt from these studies. Some suggestions for future work are provided.

1.1 The Sectors

It is difficult to divide the different agents in the Australian economy into homogenous sectors. From the viewpoint of financial interactions, one reasonable division is:

1. the government (including the central bank);
2. the financial institutions;
3. the corporate (non-financial) sector;
4. the household sector.

Each of these sectors borrows from and lends to the others, and the liabilities of one sector are the assets of another. Although each group faces a distinct balance sheet identity because of this interdependence only three of the four identities are independent.

Models of the financial system attempt to explain how these sectors adjust their financial portfolios over time. These adjustments respond to influences such as interest rates, expectations, wealth, the income flows of the corporate and household groups, and the expenditure patterns of the government.

The choice of categories for the agents in the financial system varies according to the type of study. Most of the single sector portfolio studies have been of the household sector, whereas the full model studies have generally considered three sectors – the government, the banks and the non-bank groups.

Neither approach is perfect. The single sector studies cannot use the information that the assets of one sector are the liabilities of another to help model the interaction of supply and demand which determines asset prices and quantities. The full model studies, in not distinguishing the corporate and household sectors, have so far failed to model the role of the equity and debenture markets.

Footnote

One of the bulkiest literatures is the single equation studies of the demand for money. This literature has been recently reviewed by Davis and Lewis (1978) who conclude that the studies have not been very successful in explaining the volatile fluctuations in money holdings during the 1970's. One important aspect of the types of studies discussed in this paper is that they provide an alternative way to explain money holdings. [1]