RDP 9607: Towards an Understanding of Australia's Co-Movement with Foreign Business Cycles Appendix C: Channels of Transmission of Business Cycles

Nicolas de Roos and Bill Russell

November 1996

Existing empirical work Aims and theoretical implications Actual results
(1) Terms of trade
Gruen and Shuetrim (1994) Higher terms of trade increases exports through a supply response and increases demand through higher national income. Some evidence that the terms of trade impacts on GDP but the impact appears small.
Downs, Louis and Lay (1994) As above Finds TOT impacts on GDP and GNE. Impact on GDP is smaller, particularly post 1993.
(2) Exports
Menzies and Heenan (1993) Considers hysteresis effects due to sunk costs of exporting. Find some empirical support for the existence of sunk costs.
  Looks also at the effect of domestic activity on exports. Finds evidence that the recession in 1989/90 increased exports.
Gruen and Shuetrim (1994) Positive impact of world business cycle on exports Finds that the US business cycle has greater impact on Australian business cycle than trading partners business cycle. Concludes that it is not exports which explains the correlation.
Downs, Louis and Lay (1994) Same as above Asserts no ‘strong linkage between output and export volumes’. Concludes changes in world activity will also have little effect.
Debelle and Preston (1995) Same as above Little evidence that world business cycle impacts on exports (or any of the other components of GDP).
(3) Share market
Canova and De Nicolo (1995) Looks at linkages between European and US business cycles through stock markets.
Lagged foreign share market returns help explain Australian GDP. Alternatively, foreign share markets impact on Australian share market which in turn impacts on Australian growth. 		Shows European stock returns explain both US and European GNP growth.
(4) Confidence effects
Debelle and Preston (1995) Positive impact of foreign business cycle on business and/or consumer confidence. Found US investment growth and real US Fed funds rate impact on Australian business confidence. However, they acknowledge that the impact of business confidence on investment is small.
(5) Foreign ownership of Australian companies
Froot and Stein (1991) Cost of internal funds less than external finance
(a) The size of foreign business cycle on Australian business cycle is, in part, dependent on ownership.
(b) Investment in Australia dependent on overseas share prices. 		Finds high relative wealth of foreign companies induces increased foreign direct investment.
(6) Worldwide shocks
Backus, Kehoe and Kydland (1993) Based on business cycle models, when different countries are subjected to stochastic shocks (using historical correlations between productivity shocks), cross-country consumption correlation should be high and cross-country output correlations low or even negative.
If productivity shocks are perfectly correlated across countries, then so too should be consumption and output. 		Cross-country data reveals output correlations are higher than consumption correlations. This is inconsistent with the underlying model.
(7) World interest rates
MacDonald (1988), Bernanke and Blinder (1992), Gagnon and Unferth (1993), and Pigott (1994). ‘World’ real interest rates determine cost of capital and therefore activity. Alternatively, foreign real interest rates influence domestic real interest rates which in turn determine the domestic business cycle. Business cycles determined more by short rates than long rate. Interest parity tests tend to fail but are still consistent with close international interest rate linkages.
Blundell-Wignall, Brown and Tarditi (1995) Negative impact on consumption. Some evidence real interest rates reduce consumption in the US, UK and Australia.
Lowe (1992) Positive impact of yield curve on activity. Positive impact of the yield curve on GDP, consumption and investment