RDP 9212: Changes in the Characteristics of the Australian Business Cycle: Some Lessons for Monetary Policy from the 1980s and Early 1990s 1. Introduction

Since the early 1980s, business cycle dynamics and the transmission mechanisms of monetary policy have been subject to important changes in Australia. To a large extent, these changes derive from the deregulation of financial markets. But the floating of the Australian dollar, and the increased integration of the Australian economy in world trade generally, and in the Asian region in particular, have also played an important role.

During the late 1970s and the first half of the 1980s a number of OECD countries liberalised their financial markets. In Australia's case this was carried out over a relatively short period of time in the early 1980s. Such changes should reduce the vulnerability of economies to business cycles. This is because financial regulations impose liquidity constraints on the behaviour of the private sector, making it more vulnerable to transitory shocks to the real economy, often considered to be the main source of cyclical fluctuations in business activity. In Australia's case, fluctuations in the terms of trade, government outlays, taxes, world demand, and rural sector output (due to weather conditions), would impact on current income. In the presence of regulations which inhibit the capital markets, the private sector's current spending would be strongly affected, thereby amplifying the disturbance. As financial markets are liberalised, expenditure is more easily smoothed by borrowing and lending. Views about expected future income and wealth, given relative financial prices, should be more important determinants of current spending than income or cash flow in the current period.

At first glance, Australia's experience in the second half of the 1980s and the early 1990s gives few grounds for confidence about this view of the working of free financial markets. Financial liberalisation did not appear to be associated with a reduction in the frequency or amplitude of the business cycle. Only the broad characteristics of the cycle seemed to change. Thus, the sharp upswing in economic activity and investment in the late 1980s had three unusual features:

1. strong asset price inflation;
2. rapid growth in corporate borrowing from financial intermediaries; and
3. the absence of any upsurge in goods price inflation, despite the strength of demand.

Subsequently, the asset price inflation was reversed, creating severe problems for financial intermediaries that provided the flood of credit in the 1980s. Credit growth slowed, and then became negative. The economy experienced a relatively deep recession, and an unusually slow recovery from it in the early 1990s, during which time inflation fell to historically low levels.

These broad patterns were not unique to Australia. Indeed, the United States, Japan, the United Kingdom, Canada and some of the Scandinavian countries have all experienced strikingly similar developments. All had relatively strong real growth, asset price inflation and increased gearing in the second half of the 1980s, while asset price deflation and high outstanding levels of debt appear to be major factors inhibiting recovery during the 1990s. These countries had in common important moves to liberalise their financial systems during the late 1970s and 1980s.

The reduced constraints on the behaviour of financial intermediaries and the increased role of asset prices, therefore, seem to be important for understanding the changed characteristics of the business cycle in recent years. There is a need to review this experience with a view to identifying major influences on asset prices and borrowing, and to draw lessons for the future conduct of monetary policy. Of particular interest is the question of whether the difficulties in recent years are endemic to free markets, and might be expected to continue. Alternatively, were the problems more period-specific, resulting from the release in pent-up demand during the transition from regulated to deregulated financial markets?

Historically, the terms of trade has been a major source of cyclical fluctuations in the Australian economy. As a mainly commodity-exporting country, the world commodity price cycle dominates large movements in Australia's terms of trade. Prior to the floating of the Australian dollar ($A) in December 1983, income effects generated by these fluctuations contributed to major inflationary and deflationary episodes. In theory, the floating of the $A should have greatly reduced this source of business cycle disturbance, acting as a shock absorber in the face of such real shocks. A rise in the terms of trade, for example, increases real incomes, generating excess demand for non-traded goods. The exchange rate appreciates, causing substitution in demand towards imports, thereby offsetting the inflationary pressure.

In this way the floating $A should greatly facilitate the role of monetary policy in achieving a low-inflation outcome. Sometimes, however, the “cost” of this is severe movements in competitiveness of the Australian traded-goods sector. When the exchange rate appreciates in response to a strong rise in world commodity prices, the commodity sector is less affected because it benefits from strong demand and prices for its products. But the loss of competitiveness may be much more damaging for the manufacturing and services sectors. Thus, it has been argued, while floating helps to contain the terms of trade as a source of inflation cycles, it is likely to inhibit the development of non-commodity exports. Such diversification might be important from the perspective of longer-run growth and welfare. Furthermore, exchange rate movements have a direct impact on prices, and may themselves lead to wage-price interactions. There is, then, a need for some assessment of Australia's experience with floating exchange rates in the conduct of monetary policy.

Section 2 examines Australia's experience with asset price inflation and borrowing during the most recent cycle in economic activity and inflation. The role of the exchange rate in changing business cycle and inflation dynamics is reviewed in Section 3. Finally, some concluding remarks are offered in Section 4.