RDP 2001-01: The Decline in Australian Output Volatility 6. The Source of the Volatility

The facts detailed in this paper fall into a much larger worldwide picture. In most industrialised countries the volatility of output growth has been falling fairly consistently.^[11] The figure below shows this pattern in the US, UK, Canada and Australia by way of illustration.^[12] This suggests that there is a common force affecting industrialised nations or, perhaps additionally, that the observed patterns have an overseas source. In the case that there is a common force affecting nations it is unsurprising that TOT shocks have a limited role in Australia. Other countries have experienced a similar decline in output volatility despite widely varying sensitivity to TOT shocks.

Panel data regressions run by Blanchard and Simon (2001) on the G7 minus Japan reveal that output volatility is well characterised by a steady downward trend that is interrupted in the 1970s and 1980s when inflation volatility was high. That is, a regression with a time trend and inflation volatility provides a good fit for output growth volatility in the G7 less Japan. Interestingly, the level of inflation is not found to be significant while the volatility of inflation is highly significant. This fact suggests that inflation volatility is capturing the effect of general uncertainty rather than an effect specifically related to the rate of inflation.

These additional findings suggest the following explanation for the specific results found in this paper. Temporary demand shocks had a larger role in explaining output volatility in the 1970s and 1980s when inflation volatility was also higher (see Table 5). This coincidence suggests that the demand shocks identified in Australia are related to economic uncertainty of the sort associated with high and variable inflation. With inflation having been brought under control, this particular source of shocks makes very little contribution to overall volatility in the 1990s. This also suggests that monetary policy may play a useful role in the reduction of general economic uncertainty and thereby achieve simultaneous reductions in output and inflation volatility. Previous theoretical research has suggested that monetary policy may involve a trade-off between the two. However, the simultaneous reduction in output and inflation volatility is a robust characteristic of the data. It is hoped that further research can reconcile the theoretical and empirical findings.

The supply or productivity shocks seem more closely linked with the trend component of the decline in output volatility. The causes of the trend decline worldwide have yet to be identified but several suspects present themselves. General structural change in output towards services production, which is generally smoother, can explain some, but certainly not all, of the pattern. A potentially larger force is the effect of this trend on individual incomes in combination with the increased skill of the workforce. In addition to moving towards services production, the workforces of the industrialised world have become more highly skilled over the past decades. Australia has been no exception. Skilled workers generally experience smoother income paths than unskilled workers. They also have better employment prospects in the event that they lose their current job. Thus, a general compositional shift towards more skilled workers in combination with a shift towards services may result in a smoother overall profile for earnings, employment, consumption and, finally, output. The verification of this hypothesis requires the analysis of micro data on individual earnings. This is the next natural step in this research program.

An additional suspect is the increased financial sophistication and development that has occurred around the world over the past decades. A greater ability of consumers to borrow and smooth their consumption could have a large effect on the overall volatility of demand and, consequently, total output. One specific manifestation of this would be a reduction in the number of credit-constrained consumers. Research on the permanent income hypothesis and consumption smoothing has found some support for the idea that less consumers are credit-constrained now than in the past. One beneficial consequence of this financial development could then be reduced output volatility.

Finally, a comment on the low contribution of the terms of trade to overall output volatility. If the Australian pattern of output, and in particular exports, is moving towards products whose output is less volatile this could show up in either the terms of trade or the productivity shocks. By making the identification assumption that the terms of trade shocks have no long-term effects the sustained shifts in the pattern of production and trade would be excluded. Thus, the terms of trade shocks may capture those shocks to the pattern of production that are separate from the general, and permanent, trend towards less volatile products. Given the large presumed size of the trend in production this could lead to most of the shocks being identified as productivity rather than terms of trade shocks. Furthermore, given that the shocks are very much a product of domestic changes they should not necessarily be identified with terms of trade shocks. Only if Australian domestic production remained in volatile industries while our exports shifted towards smoother industries would these effects be identified with terms of trade shocks.

Footnotes

See Blanchard and Simon (2001) for a discussion of the G7. [11]

The line for Australia is based on GDP rather than the series used in this paper to ease the comparison across countries, hence, the data broadly match those mentioned in footnote 2. [12]