RDP 9702: The Implementation of Monetary Policy in Australia 4. Conclusions

We draw three broad conclusions about the transmission lags from the short-term real interest rate to output in the Australian economy.

First, there is strong econometric evidence that the level of the short-term real interest rate has a sizeable, and statistically significant, impact on output in the Australian economy. Ordinary least squares estimation suggests that a one percentage point rise in the short-term real interest rate lowers output growth by one-fifth to one-quarter per cent in the first year, one-third per cent in the second year and one-sixth per cent in the third year, although these estimates are subject to considerable uncertainty.

Second, we examine the implications of monetary policy being based not only on past information, but also on current and expected future developments in the economy. We show that, as a consequence, the strength of monetary policy's impact on output is underestimated by ordinary least squares estimation, while the length of the monetary policy lags are overestimated. Under plausible assumptions, the underestimation is concentrated in the first year, while the estimated impact on output growth in the second and third years is largely unaffected. This leads us to conclude that the effect of a one percentage point rise in the short-term real interest rate on output growth is probably similar in the first and second years – at about one-third per cent in each year – declining to about one-sixth per cent in the third year. These results imply an average lag of about five or six quarters in monetary policy's effect on output growth. All these estimates are, however, subject to considerable uncertainty.

Third, we look for evidence of changes in the lags of monetary policy over the 1990s. Our results, based on both ordinary least squares and instrumental variable estimation, do not suggest any shortening in these lags. If anything, they suggest that the lags of monetary policy may have become slightly longer over time, although our estimates are not sufficiently precise to be very confident of this conclusion.