RDP 2001-01: The Decline in Australian Output Volatility 3. Structure or Shocks?

I consider two possible explanations for stabilisation. The first is that the shocks hitting the economy have changed; the second is that the structure of the economy has changed. The structural explanation focuses on changes in the propagation of shocks through the economy rather than the shocks themselves. Within the explanation based on shocks I focus on the different kinds of shocks that could affect the economy.

3.1 Shocks

Following on from the distinctions made in Blanchard and Watson (1986) we can separate shocks into large, identifiable shocks and small, noise shocks. Large, identifiable shocks include exogenous events such as the OPEC oil shocks of the 1970s as well as policy shocks such as the disinflation of the late 1980s. The periods of focus in this paper have been chosen around the major shocks. Periods of investigation are chosen around the four cycles that have occurred over, approximately, the 1960s, 1970s, 1980s and 1990s in Australia. The rationale for this is the research that finds that recessions are times of accelerated reorganisation. If there is any structural change in the economy it is most likely to show up around recessions. Thus, the 1970s is defined by the economy's reaction to the OPEC I oil shock and wage breakout, the 1980s by reaction to OPEC II and by the Accord and deregulation and the 1990s by low inflation. In line with the findings of Blanchard and Watson (1986), that an accumulation of small shocks does not lead to significant economic change, I assume that the economy is relatively stable within periods.

Turning attention to smaller, within episode, shocks we can divide these on the basis of their source. Following the seminal work of Blanchard and Quah (1989) we can think of demand and supply shocks as the most basic shocks to hit an economy. Simply put, supply shocks are those that have a permanent effect on output while demand shocks are those that have no permanent effect on output. I shall use the terms ‘supply shock’ and ‘productivity shock’ interchangeably. These can most easily be thought of as fluctuations around some trend rate of growth depending on how production innovations arrive and affect output.

In the context of an open economy we might also want to think about shocks to world prices and the competitiveness of the export sector through exchange rate changes. It is possible to conceive of these as being quite long-lived. Nonetheless, it is hard to think of shocks that could have permanent effects as these sorts of shocks are, at heart, just a change in prices. Thus, another sort of temporary shocks to consider are relative export and import price changes. In this paper I will focus on the terms of trade as the appropriate measure of these influences.

3.2 Structure

Structure is the way given shocks propagate through the economy. Thus, productivity shocks may have little initial effect on output, but when investment decisions respond and embody the new technology, output may change substantially in the medium and long run. If the pattern of the impulse response to given shocks changes, this is an example of structural change. For example, if a given shock causes overshooting and oscillation in one economy yet has a smooth damped effect in another we would characterise the first as being less structurally stable.

A more concrete example of structural change would be a change in the openness of an economy. Changes in an economy's trading relationships and the importance of trade in overall GDP could have an effect on how trade-related shocks were transmitted to the economy. One might expect that economies are now more sensitive to movements in their terms of trade than they used to be due to the greater international integration that has occurred in the past decades. A countervailing influence would be the stabilisation benefits of floating exchange rates. Until the results are generated it is difficult to guess which of these might be more important.

To separate structure from shocks I will make use of a VAR. Estimates of the structural VAR parameters will be used to capture the structure of the system while the structural residuals will, clearly, be the shocks. The following section deals with the estimation of the VAR and how I will use it to identify shocks and structure.