RDP 2007-01: A Structural Model of Australia as a Small Open Economy 1. Introduction
February 2007
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This paper presents and estimates a small structural model of the Australian economy with the aim of providing both a theoretically rigorous framework as well as rich enough dynamics to make the model empirically plausible. The economics of the model are simple. Households choose how much to consume and how much labour to supply. Firms choose prices and then produce enough goods to meet demand. A fraction of the domestically produced goods are exported and a fraction of the domestically consumed goods are imported, with the size of the fractions determined by the relative price of goods produced at home and abroad. This is the minimal structure needed to capture the open economy dimension of the Australian economy, and it is similar to that used in many other studies, for example Lubik and Schorfheide (forthcoming), Galí and Monacelli (2005) and Justiniano and Preston (2005). In addition to this basic structure, the model is amended to account for the importance of the commodities sector for Australian exports by adding exogenous export demand and income shocks.
Estimated models derived from micro foundations have become popular tools at central banks around the world. One often-cited reason for this is that structural models can be used to produce counterfactual scenarios, as well as to make predictions about how macroeconomic outcomes would change if alternative policies were implemented. Nessén (2006) provides a useful perspective on how small structural models can be used in the policy process. She argues that a model is not a tool that provides answers to questions, but rather a framework of principles in which a structured and transparent analysis can be conducted.
For any model to be a useful analytical tool, however, one first needs to establish whether it provides a reasonable description of the data. In a series of papers, Smets and Wouters (2003, 2004) show that medium-scale models can fit the dynamics of a large (closed) economy well. Some recent papers have asked whether structural open economy models can provide a similarly good fit.[1] Particularly, Justiniano and Preston (2005) question whether these models can account for the influence of foreign shocks on the domestic economy. This paper shows that the influence of foreign shocks can indeed be captured by the dynamics of a small structural model. In addition to matching the magnitude of the influence of foreign shocks found by reduced-form methods, the model presented here can also explain a larger fraction of the nominal exchange rate variability endogenously than previous studies.[2]
The model is estimated using Bayesian methods that exploit information from outside the data sample to generate posterior estimates of the structural parameters. The number of time series used is larger than in most other studies to ensure that the data span the open economy dimension of the model. The magnitude of measurement errors in some of the observable time series used is also estimated. This not only allows for errors in the data introduced through the data collection process, but also recognises the fact that some of the theoretical variables of the model do not have clear-cut observable counterparts. This approach also allows something to be said about how well these time series fit the cross-equation and dynamic implications of the model.