RDP 8713: Estimating the Inflationary Effects of Depreciation 1. Introduction

In the two years following December 1984, the Australian dollar depreciated by around 34 per cent against the trade-weighted index, and by around 23 per cent against the U.S. dollar. When the exchange rate is expressed in terms of units of domestic currency per unit of foreign currency the depreciation is larger – around 51 per cent on a TWI basis and around 30 per cent against the U.S. dollar. Such a large depreciation in a relatively short period provides further experience to sharpen estimates of the effect of exchange rate changes upon the domestic price level.

The Australian Statistician has estimated the effect on the Consumer Price Index of changes in the prices of wholly or predominantly imported goods. For the two years to December 1986, these effects came to 2.6 percentage points. In addition, the Commonwealth Treasury has estimated the effect of the depreciation on the prices of petroleum products at around 1 percentage point over the same period. But these effects are not the total effects of the depreciation. Rather, they are measures of the direct effect, mostly reflecting the weight of certain imports, and petrol, in the Consumer Price Index.^[1]

This paper adopts a simple econometric approach to estimating both the “direct” and “indirect” effects of exchange rate changes. It uses a “mark-up” model of price determination, in which output prices are determined by input costs. Most previous Australian studies have concentrated on labour costs, proceeding then to specify equations for wage inflation, and ending by addressing questions such as the existence or otherwise of a short or long-run trade-off between unemployment and inflation.^[2] Our aims, however, are simply to investigate the extent and the timing by which increases in input costs, and import prices in particular, are reflected in the prices of final goods and services.

A fact which is not often appreciated in discussions of the recent depreciation is that, exchange rate influences aside, the export prices of Australia's major suppliers actually fell over the year and a half to the end of 1986. This means that the effect of the depreciation on import prices is larger than the actual increases in import prices would suggest.

Section 2 of the paper outlines the data, and introduces a measure of the export prices of Australia's major suppliers which suggests that world prices actually fell through much of 1985 and 1986. Section 3 presents the model of price determination. The model is estimated in Section 4, with equations for both domestic prices and import prices. Section 5 presents some counterfactual simulations which suggest that the effect of the depreciation upon domestic prices has been considerably more substantial than is commonly argued.

A general caveat is in order. While a study such as this can expect to go beyond the so-called “direct effects” of depreciation, it cannot measure accurately all the direct and indirect “full-system” effects. These cannot be determined without reference to a host of other factors which impinge on prices in ways not adequately captured by a single equation. For an early attempt to capture the full-system effects of depreciation for Australia, see Jonson (1973).

Footnotes

For a further discussion on these points see the Commonwealth Government's Submission to the September 1985 National Wage Case, and Treasury Round-Up, November 1985. For the March and June quarters of 1987 the Statistician has estimated the effects of increases in the prices of wholly or predominantly imported goods and services at a further 0.64 percentage points. [1]

Previous work in this area includes Parkin (1973), Jonson, Mahar and Thompson (1974), Nevile (1977) and Carmichael and Broadbent (1980). [2]