RDP 9607: Towards an Understanding of Australia's Co-Movement with Foreign Business Cycles 1. Introduction

The strong correlation between the Australian and foreign business cycles both before and after the floating of the Australian dollar is well documented. Two graphical representations of this correlation are shown in Figure 1.

In the top panel, the year-ended growth in Australia's GDP is compared with that in Australia's export markets, and in the OECD. In the lower panel, corresponding output gaps are compared. The contemporaneous nature of the business cycles is clear in both representations, but is dealt with more formally in Table 1, which reports the correlation coefficients between the Australian and foreign business cycles.

Gruen and Shuetrim (1994) use a cointegration framework to examine more closely the relationship between the Australian and foreign business cycles. They show that the impact of foreign activity on the Australian economy is large and immediate. They also show that a long-run relationship exists between Australian GDP and various measures of foreign activity. The purpose of this paper is to examine some of the linkages which underlie the relationship between the Australian and foreign business cycles since the early 1980s.

We begin in Section 2 by briefly reviewing the empirical literature on the correlation in business cycles and explanations of this correlation. Two explanations appear particularly relevant. They are the impact of foreign activity on Australia's exports and the influence of foreign share markets on Australian investment and activity. Given Australia's increased openness to trade and integration with foreign financial markets, these explanations merit attention and are, in turn, dealt with in more detail.

Existing empirical work on exports has been less than convincing. In part, this is because the influence of domestic activity on exports has not been adequately modelled. Section 3 of this paper models separately the influence of domestic and foreign activity on exports. In doing so, we find that foreign activity has a large and significant impact on Australia's exports. At times, this channel of foreign influence has had a sizeable impact on Australian GDP.

Section 4 considers the explanation for the business cycle co-movement based on the concept of integrated world financial markets. This section follows the work of Fama (1990) and Canova and De Nicolo (1995) to see if foreign share markets influence Australian activity. Using a variant of the Gruen and Shuetrim (1994) model of Australian GDP, US and domestic share market variables are introduced to find that they have a large impact on Australian activity.

This result in itself does not explain the close correlation in business cycles. If developments in the US share market impact quickly on the Australian share market then, for the business cycles to be highly correlated, both economies must respond to their share markets in similar ways. Section 5 looks at how the influences of the US share market propagate through the US and Australian economies. We find evidence that the propagation is through investment and not consumption and that the response of investment to the sharemarket in each country is remarkably similar. Finally, Section 6 concludes.

Before we look more closely at the interaction between the Australian and foreign business cycles, we should question the cause of the correlation in business cycles. Australia may cycle with foreign activity because of direct foreign influences on the domestic economy. Several possibilities come to mind: direct effects on either the demand or price of Australian exports, or perhaps the direct influence of foreign asset markets on Australian asset markets. If effects like these are the dominant foreign influences on the domestic business cycle, then one may have success in a search for the channels of influence.

Alternatively, countries may cycle together primarily because they are subject to similar ‘underlying influences’, like similarly evolving technologies and capital stocks, or similar responses to common shocks. In this case, it would be misleading to think foreign business cycles are ‘transmitted’ to the domestic cycle and any identifiable interaction between business cycles will appear too weak to be responsible for the cycle in each country. At best, all that can be explained is the component of the correlation in business cycles that is not due to the common ‘underlying influences’. Given this limitation, we now turn to the literature which identified the correlation and provided explanations for its existence.