RDP 2005-11: A Small Model of the Australian Macroeconomy: An Update 4. Simulations

We now illustrate the properties of the model by showing impulse responses for selected endogenous variables under a range of scenarios. In this section we show these responses for five simulations: a sustained 1 percentage point increase in the real cash rate; a sustained 10 percentage point increase in the real exchange rate; and one-off 1 percentage point shocks to the level of the output gap, unit labour cost growth and consumer price inflation (both underlying and headline). For each simulation we report the results in terms of the deviation of relevant variables from their baseline values absent the given shock.

To illustrate different feedbacks within the model, we treat monetary policy differently across these scenarios. For the sustained cash rate increase scenario and the one-off shock to the output gap, the real cash rate is held fixed (relative to baseline) over the 10-year forecast horizon. For the sustained increase in the real exchange rate and one-off shock to underlying and headline consumer prices, the nominal cash rate is instead held constant, thereby allowing the real cash rate to vary in line with changes in underlying inflation. Finally, for the one-off shock to unit labour cost growth, the cash rate is set in accordance with an optimal policy recommendation, to illustrate features of the model when monetary policy is set so as to drive consumer price inflation (and hence also import price and unit labour cost inflation) back to their baseline values in the long run. Note that, for all scenarios, bond market inflation expectations are assumed constant throughout the simulations (although this could easily have been varied, if desired).

A Sustained Increase in the Real Cash Rate

The contractionary effect of a real monetary policy tightening is marginally greater in the current model than was the case in Beechey et al (2000), with the long-run elasticity of output with respect to the real cash rate now around 1.0 (compared with 0.8 previously). The decline in the output gap following a sustained real cash rate increase of 100 basis points is reasonably rapid, with the bulk of this adjustment occurring within three years (Figure 8).

The opening-up of a permanent output gap in turn initiates an ongoing decline in the levels of unit labour costs and prices, relative to baseline. Year-ended underlying inflation is just under 0.4 percentage points lower than baseline after three years, and continues to decline thereafter. The permanently lower output gap also lowers year-ended unit labour cost inflation, which declines rapidly during the second and third years after the real cash rate shock, and also continues to fall thereafter. Finally, higher domestic real interest rates result in ongoing appreciation of the nominal exchange rate relative to baseline – initially through their direct impact on the real exchange rate, and subsequently reflecting lower domestic consumer price inflation. This in turn reduces import price inflation, placing further downward pressure on consumer prices.^[38]

A One-off Shock to the Output Gap

A one-off 1 percentage point shock to the output gap, with no change in the real cash rate, leads to higher rates of consumer price, import price and unit labour cost inflation, which persist for an extended period (Figure 9).

The effect of the shock on the gap itself dissipates smoothly and fairly rapidly over time. However, the initially positive gap quickly spurs both higher underlying inflation and even stronger additional unit labour cost growth – resulting in an uptick in the level of real unit labour costs during the first year after the shock. The rise in underlying inflation also triggers a gradual depreciation of the nominal exchange rate, since the real exchange rate remains unaffected, so driving an increase in the rate of import price inflation (which in turn acts to hold up consumer price inflation).

Eventually, consumer price, import price and unit labour cost inflation do turn out to re-equilibrate to their baseline rates in the long run – and hence so does the level of real unit labour costs (due to the static homogeneity constraints built into the model's consumer and import price equations) – but this process is very prolonged.

A Sustained Increase in the Real Exchange Rate

A sustained 10 percentage point real exchange rate appreciation corresponds to the nominal exchange rate initially jumping by 10 per cent, and thereafter continuing to appreciate gradually, just sufficiently to offset the decline in the real exchange rate which would otherwise result from declining inflation (Figure 10). Such a shock flows directly into correspondingly lower import price inflation, so generating rapid downward pressure on consumer price inflation. It also causes an immediate decline in the output gap, which further contributes to lower consumer price inflation and, with the nominal cash rate held constant, initiates a cycle of higher real cash rates, lower output growth and still lower inflation. Year-ended unit labour cost inflation also falls comparably to the decline in underlying consumer price inflation, but with mild (and rapidly decaying) oscillations in this variable over the first few years.

In this scenario, with the nominal cash rate constant there is nothing forcing the model to re-equilibrate in the long run. As a result, the output gap, consumer price inflation and unit labour cost growth all continue to decline indefinitely – albeit extremely slowly – as does the level of real unit labour costs (not shown).

A One-off Shock to Consumer Prices

Simultaneous one-off 1 percentage point shocks to headline and underlying consumer prices, with the nominal cash rate held constant, initially lower the real cash rate. This leads to an increase in the output gap, which is affected both directly and via the real exchange rate (Figure 11). The real exchange rate declines by a little over 1 per cent in the first few quarters after the shock. This corresponds to a somewhat steeper nominal depreciation (which in turn drives up import price inflation in the near term), partially offset by the higher near-term rate of underlying inflation. The real exchange rate then recovers most of its initial fall over the second year following the shock. The associated recovery of the nominal exchange rate, to a level a little under 1 per cent below baseline, results in a small fall in import prices during this second year, which partially offsets the rise generated during the first.^[39]

A One-off Shock to Nominal Unit Labour Costs

Figure 12 shows the effect of a one-off 1 percentage point shock to the model's smoothed measure of unit labour cost growth, with the model's nominal cash rate set according to optimal policy (as described in Section 3.3 with weights λ₁ = λ₂ = 1 and λ₃ = 10).

The shock initiates oscillatory behaviour in year-ended (smoothed) unit labour cost inflation, with this variable sharply higher in the first year, but then below baseline in the second year. This induces corresponding oscillations in both headline and underlying consumer price inflation, albeit with both of these rates remaining persistently above baseline in year-ended terms. In all cases, however, these fluctuations die away fairly quickly, becoming almost imperceptible after three to four years.

Policy-makers react to the added inflation induced by the shock by raising the nominal cash rate, although the peak response is quite muted at only 25 basis points. Since the cash rate initially increases by less than underlying inflation, the real cash rate briefly declines, causing a small rise in the output gap. However, this situation later reverses, causing the non-farm output gap to slip slightly below baseline for a period, before slowly reverting to baseline. Finally, after an initial jump, the level of real unit labour costs also gradually returns to baseline in the long run, although this re-equilibration is very drawn out.

Footnotes

Holding bond market inflation expectations constant is likely to be particularly important for these results. If bond market inflation expectations were allowed to adjust (say) in line with changes in underlying inflation, such a real cash rate shock would have a still larger effect on consumer and import price inflation and wages growth. [38]

If the real cash rate were instead held constant in this scenario then there would be no response of the output gap (or the real exchange rate) to such a shock to consumer prices. However, there would still be an effect on unit labour cost growth, due not only to the initial shock to headline inflation, but also to the flow-through from changes in the nominal exchange rate to both import prices and the Australian dollar price of oil. [39]