RDP 2001-01: The Decline in Australian Output Volatility 7. Conclusion

Australia's output growth has shown a marked smoothing in the 1990s compared to previous decades. Part of this smoothing can be attributed to a moderation of the inventories cycle. Nonetheless, after removing the inventories cycle from the data a significant smoothing remains. The source of this smoothing was traced to a reduction in the volatility of productivity shocks. Importantly there does not seem to be a significant role for changes in the propagation mechanism.

The relative influence of shocks found in this paper is in line with previous Australian findings. Otto (1995), in a study that did not look for structural changes, found that terms of trade shocks were relatively insignificant in explaining output volatility and that productivity shocks were the primary factor.

The finding that the reason for reduced volatility is not changes in the structure of the economy is also similar to the findings on the US economy in Simon (2000). Nonetheless, there are some contrasts to the results from the US. There, the prime cause of the fall in volatility is found to be in demand shocks. Nonetheless, productivity shocks also play some role in the observed decline in US volatility, just as demand shocks play a role in Australia. The difference is in the relative importance of the shocks in the two countries; productivity and demand shocks both declined in the 1990s in the two countries. As such the findings are more easily reconciled.

There is also evidence from the US that inventories have some part to play in the reduction of overall volatility. Nonetheless, it is not clear whether inventories are a causal factor or are merely responding to lower volatility in other areas of the economy. Hopefully, future research will clarify this question.

More practically, the results suggest that terms of trade shocks can have a much greater effect on output volatility than in the past. Furthermore, future research is needed to identify the nature of productivity shocks hitting Australia to provide a basis for more confident forecasts and understanding of future output fluctuations. Section 6 provides some speculation as to potential explanations for the findings so far. If the primary cause of the reduction in output volatility is the combination of sectoral shifts and changing skills of the workforce we should expect that output volatility will continue to remain low in the future. Continued low output volatility should enhance the prospect that the business cycle will be milder than in earlier periods. Similarly, provided there is no deterioration in the financial system, it seems likely that consumers' ability to smooth their consumption should remain. It is hoped that further research can answer the questions raised in this paper and confirm (or refute) the ideas of Section 6.