RDP 2007-01: A Structural Model of Australia as a Small Open Economy 5. Conclusion

This paper presents a small structural model of the Australian economy estimated using Bayesian techniques and based on a standard New Keynesian small open economy specification similar to that used by numerous other studies. However, there are four aspects in which the estimation of the model deviates from previous studies.

The first is that the export demand and export income equations are amended with exogenous shocks to control for the prominent role played by commodities in the Australian export sector. When the model is estimated, the export demand shock appears to play a larger role than the export income shock in explaining the variance of domestic variables.

Second, a larger number of time series were used to estimate the model. In particular, data on import and export volumes were used in addition to the standard aggregate variables to ensure that the data span the open economy dimension of the model.

Third, flat prior distributions were used for the variances of the structural shocks. This reflects the fact that most of the structural shocks are defined jointly by the model and the data with little or no role for economic theory nor independent sources of information to help determine the magnitude of these shocks.

Fourth, the magnitude of measurement errors in some of the time series were estimated together with the structural parameters of the model. This acknowledges the fact that not only is error sometimes introduced through the data collection process, but also that the model variables do not always have clear-cut counterparts in observable time series.

The estimated model provides a good fit for most of the observable variables and appears to be able to capture the open economy dimensions of the data reasonably well. The model can match the evidence from reduced-form studies on the importance of foreign shocks to the domestic variance of output, inflation and interest rates. The model also relies much less than other estimated structural models on a persistent UIP risk premium shock to explain movements in the nominal exchange rate. Given the simplicity of the model, these results hold promise for the usefulness of these types of open economy models as analytical tools. However, there are other dimensions in which the model performs less well. Particularly, movements in the terms of trade are not well captured by the model and the reasons for this should be a subject of future investigation.