RDP 9009: An Empirical Model of Australian Interest Rates, Exchange Rates and Monetary Policy 5. Conclusions

Using a dynamic reduced form model, we have examined the relationships between Australian and U.S. interest rates, and the $A/$US exchange rate. On the basis of the evidence uncovered by this model, we make the following conclusions:

1. In the period from January 1985 to October 1987, the principal reaction of domestic monetary policy was to unexpected changes in the exchange rate and expectations of future inflation. Subsequently, these influences became much less important.
2. unexpected changes in the expectations of future inflation have had a significant effect on the exchange rate, especially in the post October 1987 period. However, shocks to cash rates have had very little discernible effect on the exchange rate.
3. Consistent with (ii), inflationary expectations appear to be largely unaffected by innovations to monetary policy, even up to six months afterwards.

It is well-recognized that a monetary policy which is aimed at singularly reducing the rate of price inflation will be relatively costless only if inflationary expectations are reduced commensurately. Conclusion (iii) implies that, given the apparent stickiness of these expectations, the real costs of reducing the rate of inflation will be considerable, and will have to be factored into any benefit-cost calculus of such a policy.