RDP 8711: Deviations from Purchasing Power Parity: The Australian Case 5. A Digression on Competitiveness and Commodity Prices Under Floating Exchange Rates in Australia

The Australian dollar has sometimes been referred to as a commodity currency. The model of the real exchange rate underlying our test of PPP adds some weight to this view. Since the exchange rate was floated – and not before – the real exchange rate appears to be influenced by commodity price developments. To illustrate the predictive power of a model based solely on these considerations we simulate (dynamically) the monthly model of the real exchange rate from the beginning of 1985. The results are illustrated in Chart 4. The real exchange is predicted well, particularly in 1986 when the real exchange rate fell sharply by about 15 per cent in the middle of the year and subsequently rose again. Commodity prices (in foreign currency) fell 14 per cent from January to August 1986. From August 1986 until mid 1987 they rose by 30 per cent.

The dynamics of a commodity price shock are illustrated in Chart 5. A 10 per cent increase in commodity prices leads to an immediate real appreciation of about 8 per cent. The dynamics however are complicated, with fluctuations within the range of a 4 to 8 per cent appreciation during the first nine months. Subsequently, the appreciation settles down at around 5–1/2 per cent in the longer run.