RDP 2014-11: Exchange Rate Movements and the Australian Economy 1. Introduction

Over recent decades, the Australian economy has experienced significant swings in the value of its real exchange rate (Figure 1). Economic theory would suggest that these exchange rate movements, by altering the relative prices of domestic- and foreign-produced goods and services, should lead to changes in production, inflation and interest rates. To the extent that industries differ in their trade exposure and in their price sensitivity of demand and supply, exchange rate movements will also have compositional effects, causing some industries to expand and others to contract.

But to what extent do these effects depend on the economic factors that have driven movements in the exchange rate? Which sectors are most sensitive to exchange rate movements? And how would the real exchange rate and the broader Australian economy have behaved if Australia's economic environment had evolved differently? In this paper we present some answers to these questions.

To do so, we estimate a structural vector autoregression model of the Australian economy. We identify exchange rate shocks as any movement in the exchange rate not explained by other economic factors, such as interest rates or the terms of trade. At an aggregate level, our model allows us to quantify the macroeconomic effects of exchange rate shocks. Our results suggest that a temporary 10 per cent appreciation of the exchange rate that is unrelated to the terms of trade or interest rate differentials reduces the level of real GDP by 0.3 per cent and year-ended inflation by around 0.3 percentage points over the subsequent eighteen months and is typically followed by a decrease in the cash rate of around 40 basis points.

At an industry level, we find that the most trade-exposed industries, including the mining and manufacturing industries, are the most responsive to exchange rate movements. But large responses are not confined to industries that export or compete with imports. Some industries, such as business services, have little direct trade exposure but produce inputs into the production processes of trade-exposed firms. We find that these industries also respond to exchange rate movements. In contrast, the responses of industries with little direct or indirect exposure to foreign trade, such as social services, are generally smaller.

Our model indicates that foreign sector variables, including the terms of trade, are the major cause of movements in the real exchange rate. In contrast, exchange rate shocks themselves are a minor contributor to the volatility of domestic economic variables. This is consistent with the idea that exchange rate movements typically serve as a shock absorber for the Australian economy, rather than acting as a source of shocks in their own right.

To investigate the role of the exchange rate further, we analyse two scenarios. In the first, we ask how the Australian economy might have evolved over the past decade if it had experienced the same macroeconomic shocks but the nominal exchange rate had not appreciated. We find that, even if the nominal exchange rate had remained constant in an environment in which the terms of trade was increasing rapidly, the real exchange rate would still have appreciated. However, this real exchange rate appreciation would have been accompanied by a large increase in domestic inflation and higher nominal interest rates. Moreover, output growth is largely unaffected by this scenario because real activity ultimately depends upon the real, not the nominal, exchange rate. This scenario provides a practical illustration of how exchange rate flexibility helps to cushion the Australian economy from foreign shocks.

In the second scenario, we examine the contribution of international economic developments to the level of the real exchange rate and Australia's economic performance more broadly over the past decade. Our model suggests that, without a rising terms of trade and strong growth in overseas economies, the real exchange rate would not have appreciated. But a weaker real exchange rate would not have resulted in faster economic growth, as it would merely have reflected a weaker external environment. This scenario emphasises the point that what causes exchange rate movements determines their effect on the Australian economy.

This paper contributes to two strands of the existing literature. First, it is related to papers that examine the sectoral and industry implications of macroeconomic shocks on the Australian economy. Examples of this include Lawson and Rees (2008), who examine the effects of monetary policy shocks, and Cagliarini and McKibbin (2009), who describe the impacts of foreign shocks. In a similar spirit, Battersby, Kouparitsas and Munro (2013) decompose variation in sectoral employment growth into sector-specific shocks and common economy-wide shocks. Our contribution to this literature is to document the industry-level effects of exchange rate shocks, which are an important source of macroeconomic volatility for small open economies. Second, our paper complements other papers that describe the effect of exchange rate movements on open economies. Examples of this include Karagedikli et al (2013), who examine the sectoral impacts of exchange rate shocks in New Zealand, and Hahn (2007), who investigates how exchange rate shocks affect sectoral activity and prices in the euro area. Voss and Willard (2009) also include an exchange rate shock in a vector autoregression (VAR) model of the Australian economy, although they do not quantify the effects of this shock on output or inflation. Finally, Kohler, Manalo and Perera (2014) summarise the impact of exchange rate movements on economic activity across a range of Australian economic models, including the one in this paper.

The rest of the paper is structured as follows: Section 2 describes our empirical model and data; Section 3 outlines our core results; Section 4 uses our model to present a number of counterfactual scenarios of how the Australian economy might have evolved if the exchange rate or global economy had behaved differently; Section 5 provides robustness checks; and Section 6 concludes.