RDP 8710: Transmission of External Shocks in the RBII Model 1. Introduction

This paper gives an overview of recent work in the development of the RBII macroeconomic model, focussing on adjustments designed to reflect the post-deregulation financial environment. The original version of the model. called RBA76, was presented by Jonson, Moses and Wymer (1976); that model and subsequent versions presented by Jonson and Trevor (1981). Jonson, McKibbin and Trevor (1981 and 1982) and Fahrer, Rankin and Taylor (1984), have been extensively used in simulation analysis. The latter version of the model was estimated using a data period ending at 1980; the structure of the model was thus designed specifically for the pre-deregulation environment.

In the period since deregulation of the financial sector and the floating of the Australian dollar, interest rates and exchange rates have become highly flexible in response to news concerning both domestic and external conditions. This transition to flexibility of financial prices poses a problem for the macroeconomic modeller. Equations estimated using data prior to the beginning of 1984 are unlikely to be reliable in predicting the behaviour of key financial variables in the post-float, post-deregulation period. At the same time, we do not yet have sufficient data to estimate the new structural relationships.

In a recent attempt to address these problems in the context of the RBII model, Fahrer and Rankin (1984) advocated the selective use of imposed parameter adjustments in the financial sector of the model in order to illustrate the possible impact of financial deregulation on the economy as a whole. Their adjustments included a market clearing mechanism for the exchange rate, a respecification of the bond rate equation, and a small number of parameter adjustments in the monetary sector. This approach assumes that parameters in the real sector of the model have been unaffected by financial developments, an assumption which seems reasonable at least as a first approximation. Less easily defended are the specific parameter adjustments which are imposed, and to which we will add in the present paper. All are more or less arbitrary in the sense that they are not econometrically estimated (for the reason already described), being based instead on “sensible guesses” about the parameters concerned. But we argue that if we wish to have a model which remains relevant for forecasting and policy analysis, such an approach is preferable to retaining financial sector equations which are known to be outdated.

In this paper the work of Fahrer and Rankin is extended by considering structural adjustments to the RBII model in two main areas. First, a much greater degree of interest rate flexibility is introduced through a clearing market for short-term funds, representing recent developments in the domestic cash market.^[1] Secondly, the accumulation of public and external debt is endogenised, as are interest payments on both debts. Taken together, these changes have important implications for the way in which external shocks are transmitted to domestic variables in the model, as well as having implications for the long run effects of fiscal policy. The paper investigates these implications.

The remainder of the paper is set out as follows. Section 2 describes in detail the most important changes to the structure of the model. Section 3 investigates the simulation properties of the adjusted model, paying particular attention to the transmission of shocks arising from changes in external conditions. Some conclusions and issues for further work are set out in the final section.

Footnote

For a discussion of developments in the cash market in the post-float period see Macfarlane (1986). [1]