RDP 8903: The Relationship Between Financial Indicators and Economic Activity: Some Further Evidence 5. The External Sector

To this point, the discussion has focussed on the interaction of the financial system and domestic economic activity. In this section, the scope is broadened, to allow explicitly for external linkages.

In an open economy, the impact of monetary policy comes partly through the exchange rate. Most treatments of this begin with some sort of interest-parity condition:

where i_t is the interest rate at time t, is the foreign interest rate of equivalent maturity, e is the log of the exchange rate and E( ) and d denote, respectively, the expectations (conditional on information available at time t) and difference operators.

This condition says that properly-functioning financial markets keep the domestic interest rate aligned with the foreign rate (assumed to be exogenous), allowing for expected changes in the exchange rate over the relevant period. A change in monetary policy which alters the domestic interest rate will, other things equal, alter the exchange rate so as to preserve the equality of exchange rate-adjusted expected returns across countries. For example, higher domestic interest rates will, other things equal, result in an instantaneous appreciation of the exchange rate so as to generate an expected depreciation of the exchange rate back towards the given “fundamental” level, which will offset the interest differential over the life of the asset. Were this not so, opportunities would exist to make large expected profits.

Now there are some practical difficulties with equation (5), mainly because other things will not always be equal. For example, the behaviour of risk-averse market participants may allow deviations from interest parity to occur. Indeed, there is good reason to suppose that there is an additional term driving a wedge between foreign and domestic rates, representing a currency risk premium.^[7] As long as this premium is constant, then the statements made above about monetary policy changes still hold. But if the premium varies through time, then this approach, as it stands, is not entirely adequate.

In addition, a change in domestic interest rates may come at a time when “fundamental” factors in the economy are causing a reassessment of expectations about the likely course of the exchange rate. This may make a clear connection between changes in monetary policy and the exchange rate difficult to observe in practice.

Nevertheless, it seems a reasonable starting point for analysis to accept that a change in domestic monetary policy will have implications for the exchange rate, and therefore for those sectors of the economy which are sensitive to exchange rate changes. Under this maintained hypothesis, the channels through which such effects might be observed are the price elasticities of demand and supply for imports and exports. A tightening of domestic monetary policy, for example, will tend to raise the exchange rate, and lower the domestic currency price of tradeable goods. This will encourage the substitution of imported for domestically produced goods in domestic expenditure, discourage the production of domestically produced tradeables both for domestic consumption and export, and discourage absorption of Australian exports by the rest of the world. In testing for these channels empirically, it will also be necessary to control for domestic and foreign price developments, since it is the real exchange rate which is important, and changes in foreign and domestic absorption^[8].

The other part of the story, of course, is that a rise in domestic interest rates should also reduce domestic expenditure and incomes, and therefore imports (especially as business investment, usually thought to be interest-sensitive, has a high imported component). There are therefore two effects of a change in monetary policy on the real trade balance, which operate in different directions. The empirical tests will therefore need to control for changes in private domestic expenditure.

This section uses VAR models to look at some of these channels. The first set of models includes real GDP, the bill rate, one monetary aggregate, the trade-weighted index of the Australian dollar, a term representing the difference between foreign and domestic prices (PDIFF, the log difference between the GDP deflators for Australia and the major seven OECD economies) and private expenditure in the major seven OECD economies (M7PFD).

The second set of VAR models includes exports instead of GDP. The third set of models includes imports and real PFD rather than the bill rate.

As in Section 4, all the models use variables in log-differences, apart from the bill rate which is simply differenced^[9]. The availability of OECD data restricted the sample period to 1972:2–1988:2, which imposed a fairly tight constraint on degrees of freedom. With respect to financial aggregates, we confined attention to M1 and M3, since there are really too few observations available on the broader aggregates to estimate these large models.

The results are presented in Table 5. The interpretation of these is similar to that of the earlier tables. Results are presented using both M1 and M3 as the monetary aggregate.

The first panel shows results for models including real GDP and the range of financial and foreign variables. There is no evidence of Granger-causality from any of the other variables to GDP. There is evidence again of a dynamic relationship between the monetary aggregates and the bill rate (the test statistic for lags of M1 or M3 affecting the bill rate are significant at the 5 per cent level or less, and the statistics for the reverse relationship would be significant at levels only slightly higher than the 5 per cent level used as the critical value in the tables).

In the second panel of the table, real exports of goods and services replaces GDP. When the price differential and foreign absorption are controlled, lags of the TWI are significant in explaining exports in the equation with M1.

M1 and M3 again help explain the bill rate, though the reverse is not true in this case.

In the third panel, real imports of goods and services is the activity variable, and real private final demand replaces the bill rate. The TWI is significant in explaining imports. Real PFD is also significant when included with M3 (and would be significant at the 10 per cent level with M1). M3 also helps in explaining imports.

There also appears to be a relationship between the price differential and M7PFD. In five out of six models, lags of PDIFF help explain M7PFD, and the reverse is true in three out of six cases. Given the definition of PDIFF, this could be interpreted as a proxy for effects of changes in the major countries' terms of trade on absorption in those countries. In only one instance does M7PFD have a significant relationship with a variable other than itself or PDIFF^[10].

One important point in all this is that while the discussion of the external-sector impacts of changes in monetary policy was motivated in a floating exchange rate context, the long sample period required by the VAR techniques (because of the number of parameters to be estimated) covers more than just the floating rate period. It also covers the period of fixed exchange rates (although the parities were altered in this period) until November 1976, and the crawling peg from then until December 1983.

Of course changes in the exchange rate, under whatever regime, would still be expected to have subsequent developments on the economy, but the dynamic interaction between monetary policy, the exchange rate and the economy may differ between exchange rate regimes.

Accordingly, the results in this section should be regarded as quite preliminary. That said, the results do suggest that there is some evidence of both exchange rate and expenditure effects on components of the real trade balance. The relative size and timing of these effects is, naturally, a separate question.

Footnotes

For a discussion of empirical issues in general, see Goodhart(1988); for Australian evidence, see Tease(1988) and Kearney and MacDonald(1988). [7]

A more formal model of an open economy can be found in Genberg (1988). [8]

Statistical tests reported in Appendix A suggest that the trade-weighted index (TWI) and major seven private final demand (M7PFD) series may also have a trend component. Models using detrended variables show results similar to models without detrended variables. Results are available from the authors on request. [9]

Models estimated without M7PFD, however, show a weaker relationship between the TWI and the trade variables. See Appendix B, Table B.5. [10]