RDP 9702: The Implementation of Monetary Policy in Australia 1. Introduction

Good policy-making requires an appreciation of the dynamic relationship between the monetary policy instrument – the overnight cash rate – and the final objectives of policy – inflation and output. A thorough analysis of this relationship between instrument and objectives is a large task, however, because of the many transmission channels through which monetary policy influences the economy. Rather than examining each of these channels, this paper has the more modest aim of estimating the aggregate impact on Australian economic output of changes in the domestic short-term real interest rate.

The task of isolating the impact of monetary policy on output would be made much easier if we had a good explanation for the underlying business cycle. While this is obviously complex, we do have good empirical evidence over the past 15 years that Australian output is strongly influenced by economic activity in the United States. US output is clearly ‘exogenous’ to the Australian economy since it is not affected by either Australian output or Australian monetary policy. But the presence of this powerful exogenous influence on Australian output makes it easier to identify econometrically the dynamic effect of monetary policy on Australian output.

Despite this econometric benefit delivered by the exogenous influence of the US, estimating the lags of monetary policy in Australia is not without its difficulties. As a rule, short-term real interest rates change only gradually, so that the current real interest rate is quite strongly correlated with interest rates in the recent past. As a consequence, it is hard to separate the effect on output of the current real interest rate from the delayed effects of the real rate in earlier periods. This problem leads to fairly wide margins of error in our estimates of the dynamic effect of monetary policy on output. Nevertheless, despite these wide margins of error, there is still strong evidence of an impact on output growth in the first, second and third years after a change in the domestic short-term real interest rate.

Another difficultly in isolating the dynamic impact of monetary policy on output arises from the forward-looking nature of policy. As well as responding to data about the past, policy-makers also act on information about current and future economic developments that is not part of any simple aggregate analysis of the relationship between monetary policy and output. This paper will show that this implies that standard estimation techniques underestimate the strength of monetary policy's impact on output, and overestimate the length of the lags of monetary policy.

The next section of the paper begins with an analytical discussion of the sources of the lags of monetary policy. It then turns to single equation models of Australian output which provide good empirical descriptions of the domestic business cycle over the past 15 years. The main focus of the section is to estimate the effect of a one percentage point change in the short-term real interest rate on output growth over the subsequent three years.

The following section, Section 3, discusses the implications of policy-makers responding to information that is not available to the econometrician estimating the relationship between monetary policy and output. Under plausible assumptions, this is likely to result in an underestimation, using standard techniques, of the impact of monetary policy changes on output growth in the short run.

Making some allowance for this bias, we conclude that output growth falls by about one-third of one per cent in both the first and second years after a one percentage point rise in the short-term real interest rate and by about one-sixth of one per cent in the third year. Section 3 also finds that there is no evidence that the lags of monetary policy have become any shorter over the course of the 1990s. Finally, Section 3 discusses the policy implications of the relatively long and uncertain lags of monetary policy.

The paper ends with a brief summary of the main results.