RDP 2014-08: The Effect of the Mining Boom on the Australian Economy 4. Aggregate Responses

The following sections discuss how our baseline differs from the counterfactual described above.

4.1 National Income

The effect of the mining boom on living standards can be gauged by the change in real household disposable income per capita. As shown by the green line in Figure 4, this measure is estimated to be about 13 per cent higher in 2013 than it would have been without the boom. In subsequent sections, we discuss in detail how this estimate arises and some of its implications. The effect can largely be decomposed into increases in the relative price (or purchasing power) and volume of output, which are also shown in Figure 4.

An estimate of the direct relative price effect or trading gain is shown by the blue line in Figure 4. Higher commodity prices translate into higher terms of trade, which directly boost the purchasing power of domestic income. This effect is commonly measured by the change in ‘real gross domestic income’, where nominal exports are deflated by import prices, rather than export prices. This trading gain boosts real gross domestic income (GDI) by about 6 per cent in 2013.^[1] Sheehan and Gregory (2012, Figure 3) discuss the construction of estimates such as these. Their baseline estimate of the trading gain is 11 per cent of GDP, larger than ours because their estimate refers to the doubling of the terms of trade from 2002 to 2011, whereas ours refers to the terms of trade being 39 per cent higher in 2013 than in our counterfactual. As we discuss in Section 5.2, the change in real GDI overstates the increase in the purchasing power of national income, because some of the benefit accrues to foreign investors.

The pink line in Figure 4 represents an estimate of the increase in the volume of goods and services produced arising from the boom. Higher mining investment directly contributes to higher aggregate demand. Furthermore, higher national purchasing power boosts consumption and other spending components. Higher mining investment also increases the national capital stock and hence aggregate supply. There are many further compounding and offsetting effects which are discussed below. However, the estimated net effect is to increase real GDP by 6 per cent (Figure 4).

The increase in the volume and value of domestic production, noted above, account for most of the increase in household disposable income shown in Figure 4. There are also minor contributions from changes in taxes, in foreign income, in population, and so on. We discuss the more important of these issues below.^[2]

4.2 The Exchange Rate

Many of the effects of the mining boom estimated by AUS-M reflect changes in the exchange rate. However, estimating exchange rate responses is difficult. Much of the variation in the data seems to be noise. And systematic responses to macroeconomic variables largely reflect changes in expectations, which are not observable. This makes estimated time series correlations difficult to interpret. In AUS-M the exchange rate is assumed to gradually move to a level that reconciles the trade balance with the savings and investment decisions of households, business and government. This means it increases with the terms of trade, and expected rates of appreciation match interest differentials. These effects are calibrated to be consistent with common views, available research and the long-run equilibrium implicit in the model. They are discussed further in Douglas, Thompson and Downes (1997).

Because of its central importance, we decompose the exchange rate change into responses to the different elements of our counterfactual in Figure 5. As can be seen, the exchange rate responds in somewhat similar amounts to the slowing in world growth, the further reduction in minerals prices and the zeroing out of investment residuals. The latter effect reflects the need to offset the long-run effect on exports and the trade balance. The sum of these effects is that the real exchange rate is estimated to be 44 per cent higher in 2013 than it would have been in the absence of the boom. That is, the exchange rate would not have appreciated but would have remained on average around the same levels as the previous 20 years.

Although precise estimates depend on the details of the experiment, the long-run elasticity of the exchange rate with respect to the terms of trade (as implemented in Appendix B) is 0.8 in AUS-M. The response in Figure 5 is somewhat larger than this, mainly because there is an extra response to mining investment. The AUS-M elasticity compares with an elasticity of 0.9 in the MMRF model (see Table B1) and 0.6 in Stone, Wheatley and Wilkinson (2005, Table 2).

4.3 Unemployment

The stronger activity arising from the mining boom, shown in Figure 4, results in lower unemployment. As shown in Figure 6, the mining boom is estimated to have lowered the unemployment rate by 1¼ percentage points in 2013. Some of this change represents a reduction in long-term unemployment, which in AUS-M is an important determinant of the non-accelerating inflation rate of unemployment (NAIRU). However, most of the fall in the unemployment rate represents a reduction in economic slack.^[3]

4.4 Inflation

The lower unemployment gap (Figure 6) and higher oil prices that accompany the mining boom place upward pressure on inflation. However, these effects are initially more than offset by the appreciation of the exchange rate (Figure 5), which lowers import prices. As shown in Figure 7, the net effect in the first few years of the mining boom is to lower the inflation rate by an average of about half a percentage point. However, in AUS-M, the effect of a change in the exchange rate on inflation is temporary, whereas the effect of a change in the unemployment gap is highly persistent. So, by 2008, the unemployment effect begins to dominate and inflation is higher.

4.5 Interest Rates

Short-term interest rates, represented by the 90-day bank bill rate, are determined by a modified Taylor rule. In the first few years of the boom lower inflation offsets stronger activity and interest rates are slightly lower than they otherwise might have been (Figure 8). However, as the deviation in inflation diminishes, interest rates increase in reaction to the tight labour market. By 2013, interest rates are almost 2 percentage points above their estimated levels without the boom. Interestingly, interest rates are estimated to remain positive in the counterfactual. That is, even without the strong growth in Asia and its effects on minerals prices, and without the surge in mining investment, Australia would still have escaped the zero lower bound on interest rates that has constrained monetary policy in many other countries. The strong fiscal stimulus at that time may be one reason for that.

Our estimated response of interest rates differs from Plumb et al (2013, Figure 3), who suggest that, in theory, interest rates might initially rise in response to an increase in world mining prices. One possible explanation for the difference is that we estimate a larger weight on the response of interest rates to lower inflation arising from the exchange rate appreciation.

Footnotes

We weight the trading gain using volume weights from the historical baseline. The estimate is not sensitive to this choice of weights. [1]

Our estimate of the increase in income arising from the mining boom is greater than that of Edwards (2014). One important reason for the difference is that we consider the trading gain arising from the higher terms of trade to be an increase in real domestic income. Our estimates of the growth in the volume of GDP encompass the effects of this increased income being spent in line with historical correlations, after allowing for the effects of taxes, net income transfers and so on. [2]

In the absence of the mining boom, AUS-M suggests that the unemployment rate may have remained well above the NAIRU for an extended period of time. This persistence partly reflects asymmetries and non-linearities in the model's Phillips curve, which make inflation relatively insensitive to weak activity. [3]