RDP 2008-07: A Medium-scale Open Economy Model of Australia 1. Introduction

Dynamic stochastic general equilibrium (DSGE) models are relatively new, but increasingly popular additions to the tool kits of practical macroeconomic modellers. The main motivation for developing DSGE models reflects the appetite for frameworks that place emphasis on sound micro foundations and theoretical consistency. For instance, at the central banks of Canada, Finland, Norway, Sweden and the United Kingdom, DSGE models play an important role in support of their forecasts and policy analysis.

Some work has been done on constructing DSGE models for Australia, with examples being Buncic and Melecky (2008) and Nimark (2007). These are relatively small-scale models that, for instance, do not include a role for physical capital and assume a perfectly competitive labour market with flexible nominal wages. There are advantages in terms of tractability of using small models, but also obvious disadvantages as a simple model may be silent about important aspects of the macroeconomy.

This paper estimates a more richly structured open economy DSGE model with a sizeable number of frictions and rigidities, using Bayesian techniques on Australian data. It can be seen as an extension of the earlier work cited above. We use data on output, inflation, employment, consumption, real wages, investment, interest rates, the real exchange rate, exports, imports, commodity exports and prices to estimate structural parameters of the model and identify structural shocks that explain Australian business cycle fluctuations. One feature of the model is the assumption that the economy grows along a stochastic path (as in Altig et al 2005), which has an attractive implication for the estimation of the model: there is no need to pre-filter the data, instead unprocessed ‘raw’ data can be used. The Australian studies mentioned above all estimate models on pre-filtered data.

The model follows closely that of Adolfson et al (2007), though we add features to the model that are potentially important for modelling the Australian economy. The model differs from Adolfson et al in two regards.^[1] First, there are two productive sectors in the economy: a domestic intermediate tradable sector and a commodity exporting sector. It is assumed that the demand for the exported commodity good is completely exogenous, and its price is determined in the foreign market. Second, wage indexation depends (among other things) on the steady-state growth rate of technology (rather than on current technology growth).

Key model parameters are estimated by applying Bayesian estimation techniques. An advantage of this approach is that even a relatively large model can be estimated as a system. The estimated model can be used to give quantitative answers to several interesting questions. For instance, which shocks are important in driving the Australian business cycle? How important are shocks emanating from outside Australia? We can also use the model to trace out the effects of particular shocks, like a commodity demand shock or a monetary policy shock, on macroeconomic variables like GDP growth, inflation and real wages. As a robustness check of the impact of the priors, we also estimate the model with truncated uniform priors.

The estimated model is used to decompose the business cycle fluctuations of the observed variables into the unobserved shocks that drive them. Our results show that foreign shocks are important drivers of the Australian business cycle, but we also find that domestic shocks explain a significant fraction of the variance of the domestic observable variables, such as inflation, real wage growth, employment and the nominal interest rate. The significant contribution of the domestic shocks is somewhat in contrast to the findings by Nimark (2007), who attributes most of the domestic business cycle fluctuations to the foreign shocks.

The paper is organised as follows. The next section discusses the key features of the model. Section 3 discusses some measurement issues and estimation strategy. Section 4 presents and discusses estimation results. Section 5 makes some tentative conclusions.

Footnote

It has the following ‘standard’ features: prices and wages are sticky and partially indexed to past inflation and productivity; the pass-through of the exchange rate to import and (non-commodity) export prices is imperfect; new investment and changing the utilisation rate of the existing capital stock are both costly; and households form consumption habits. [1]