THE SECTORAL IMPACT OF MONETARY POLICY IN AUSTRALIA
A Structural VAR Approach
Claudia Crawford (200308097)
Thesis submitted in partial fulfilment for Honours in the
B. Commerce (Liberal Studies)
University of Sydney,
October 2007
Supervised by Dr. Tony Aspromourgos and Dr. David Kim
ABSTRACT
In recent years, the global resources boom has had a major impact on the Australian economy. In the mining rich state of Western Australia, rapid commodity price growth has contributed to strong economic conditions. However, state economies that rely heavily on manufacturing industries have fared less well, forced to cope with higher input costs as well as the effects of a stronger exchange rate. The resulting 'two-speed economy' presents a challenge for monetary policy, which must manage the diverging performances of different sectors and regions. In light of these issues, this thesis develops a small, open economy structural vector autoregression (SVAR) model of Australia in order to examine the impact of monetary policy on sectoral output.
The results suggest that monetary policy shocks have uneven impacts across different sectors. The construction and manufacturing sectors show the most sizeable and rapid responses, while the mining sector is not as interest rate sensitive as the existing literature would suggest. This thesis also adds to our understanding of the transmission mechanism of monetary policy in a small, open economy. In particular, while the results indicate that global economic conditions account for a large proportion of the variation in mining sector output, there is evidence that the exchange rate channel of monetary policy does not play a dominant role in influencing output in this sector. One implication of these findings is that the Reserve Bank of Australia will find it difficult to stabilise output across regional economies in the face of a resources boom. The model also indicates that changes to monetary policy have long, non-trivial real impacts, and there is some suggestion that the credit channel of monetary policy has an important influence in propagating monetary policy shocks.
TABLE OF CONTENTS
CHAPTER 1: INTRODUCTION
1.1 Monetary Policy in a Two-Speed Economy
1.2 The Monetary Policy Transmission Mechanism
CHAPTER 2: OVERVIEW OF CONCEPTUAL ISSUES
2.1 SVARS: A Tool for Modelling Monetary Policy
2.1.1 Monetary policy shocks in SVAR models
2.2 SVARS: Australian Studies
2.3 SVARS: Sectoral Analysis
2.3.1 Methodological issues
2.4 Evidence on Australian Sectors
2.4.1 Responses to monetary policy
2.4.2 Induced sectoral effects
CHAPTER 3: MODELLING APPROACH
3.1 Data and variables
3.1.1 Sector selection
3.2 Transformation of variables and stationarity
3.3 Estimation period
3.4 Structure and identification issues...... 30
CHAPTER 4: AN OPEN ECONOMY SVAR MODEL OF AUSTRALIA...... 33
4.1 Block structure...... 33
4.2 Specification of contemporaneous relationships...... 33
4.3 Estimation...... 36
4.3.1 Impact of a contractionary monetary shock...... 40
4.3.2 Assessment of the policy reaction function...... 42
4.3.3 Alternative specifications...... 43
CHAPTER 5: APPLICATION OF THE SVAR MODEL TO AUSTRALIAN SECTORS....44
5.1 Summary of results...... 49
5.2 Disscussion of results...... 51
5.2.1 Impulse responses and variance decomposition...... 53
5.2.2 The role of the exchange rate...... 57
5.2.3 Sectoral characteristics and the effects of monetary policy...... 58
5.3 Robustness tests...... 61
CONCLUSION...... 66
BIBLIOGRAPHY...... 68
APPENDIX 1: Data...... 76
APPENDIX 2: Sector classifications and definitions...... 78
APPENDIX 3: Australian sectors – features and characteristics...... 84
A3.1 Sectoral contributions to GDP and concentration in Australian states
and territories...... 84
A3.2 Sources of interest sensitivity...... 85
APPENDIX 4: Unit root testsfor SVAR variables...... 90
APPENDIX 6: Reduced form diagnostics...... 91
APPENDIX 6: Parameter estimates for each sector SVAR...... 92
TABLES AND FIGURES
TABLES
Table 2.1 A taxonomy of monetary policy…………………………………………………………… 11
Table 3.1 Sector selection…………………………………………………………………………….. 24
Table 4.1 Structural parameter estimates for contemporaneous restrictions…………………………. 38
Table 5.1 Size of monetary policy shocks across sectors…………………………………………….. 45
Table 5.2 Forecast error variance decomposition for sectors………………………………………….48
Table 5.3 Sectoral output responses to a contractionary monetary policy shock…………………… 49
Table 5.4 Persistence of sectoral output responses to a contractionary monetary policy shock………50
Table 5.5 Spearman’s rank correlation coefficients…………………………………………………...60
FIGURES
Figure 3.1 Aggregate variables……………………………………………………………………….. 27
Figure 3.2 Sectoral variables…………………………………………………………………………. 28
Figure 4.1Impulse responses to a contractionary monetary policy shock…………………………….39
Figure 4.2 Cash rate impulse responses of the cash rate to shocks in aggregate variables…………….41
Figure 5.1 Sectoral impulse responses to a contractionary monetary policy shock…………………...46
Figure 5.2 Robustness tests - sample period…………………………………………………………...62
Figure 5.3 Robustness tests - lag length………………………………………………………………..64
1
CHAPTER 1: INTRODUCTION
1.1 MONETARY POLICY IN A TWO-SPEED ECONOMY
Over the past three years, the global resources boom has had a major influence on the Australian economy. Robust rates of economic growth in the global economy and in particular, the rapid industrialisation of the Chinese economy, have underpinned a surge in the price of non-rural commodities which represent the largest component of Australia’s export base. This has resulted in a rapid improvement in Australia’s terms of trade, which have risen by approximately 40 per cent over the past four years and in 2006 reached their highest level since records began in 1959. This dramatic rise in world commodity prices has affected the Australian economy via multiple channels, many of which are complex and still not well understood. While the strength of the global economy has provided a favourable economic environment for the Australian economy, the benefits of a record high terms of trade has not been evenly distributed across Australia, with the resources boom creating a sustained divergence in the performance of sectors and regional economies. This phenomenon is popularly known as the ‘two-speed economy’ (Garnaut, 2006).
While there are many dimensions to the two-speed economy, one notable characteristic has been the increasing divide between sectoral employment and output growth. Given that the mining sector is the most direct beneficiary of rising commodity prices, it is not surprising that it has experienced strong employment growth of 33 per cent over the past three years. In contrast, employment in manufacturing industries has been in decline, with regionally concentrated costs. In 2005-06 alone, the Western Australian economy, where the mining sector is more heavily concentrated, experienced 14 per cent growth in state final demand. This is in stark contrast to the sluggish 1.1 per cent growth in both the New South Wales and Victorian economies, which are more reliant on manufacturing and service-based industries (Bill and Mitchell, 2006).
This divergent growth performance has raised questions about the impact of monetary policy. In early 2005, the Reserve Bank of Australia (RBA) raised interest rates in response to growing risk of inflationary pressures. Some of these anticipated pressures were directly related to the commodity price boom, such as the concern over stronger wages growth in the mining sector where capacity constraints were developing. Others were more generally associated with the strength of global demand, such as the surge in oil prices (RBA, 2005a,b).[1] The combination of strong global conditions, tight capacity and solid demand growth prompted the RBA to increase interest rates another five times between 2005 and 2007. Although this tightening cycle was arguably consistent with maintaining the RBA’s inflation target of 2-3 per cent in the medium term, there was an ongoing debate amongst economists over whether higher interest rates would widen the division between the economic performances of both industry sectors and major economic regions, and if so, whether this was an appropriate action for the central bank to take.
The debate over Australia’s two-speed economy highlights an important area of research interest that has not been explicitly addressed in the literature: the sectoral effects of monetary policy. This is an important issue for several reasons. First, the impact of monetary policy on sectoral output presents a unique macroeconomic challenge for Australia given the uneven geographical distribution of sectors in the Australian economy. Second, if significant heterogeneity in interest rate sensitivity exists, monetary policy’s capacity to effectively and evenly stabilise an overheating or a slowing economy will depend on the relative size of interest rate sensitive sectors as a proportion of Gross Domestic Product (GDP) and their regional concentration. Third, examining the degree of dispersion in interest rate sensitivity across sectors is likely to shed light on the nature of the transmission mechanism, which is still something of a ‘black box’, despite the fact that monetary policy is at the forefront of macroeconomic management in most industrialised economies.
Despite the importance of this issue from a policy perspective, the sectoral impact of monetary policy has not been directly examined to date. This thesis presents new evidence on the monetary policy transmission mechanism by developing a small, open economy structural vector autoregression (SVAR) model of the Australian economy. This model is applied to nine sectors in order to examine the disaggregated effects of monetary policy. This allows the identification of the size, timing and persistence of the reactions to such a policy change. Section 1.2 outlines the theoretical background to the transmission mechanism and why the channels of monetary policy are likely to generate differing effects across sectors.
1.2 THE MONETARY POLICY TRANSMISSION MECHANISM
“The transmission mechanism is one of the most important, yet least well-understood, aspects of economic behaviour.”
King (1994, p.261)
Monetary policy is at the forefront of macroeconomic management in Australia. It is therefore understandable that the monetary policy transmission mechanism generates much interest. However, for the most part, monetary research has concentrated on the aggregate economy and has ignored important differences that can occur at the disaggregated level. Although the primary goal of monetary policymakers in Australia is to achieve an inflation rate of 2-3 per cent over the course of the medium term, a secondary yet nonetheless important goal is to keep output as close to its ‘natural’ level as possible. Although monetary neutrality implies that monetary variables have no impact upon real variables in the long run (Lewis and Mizen, 2000, p.18), it is widely accepted that changes to monetary variables can affect the real economy in the short term.[2] There is less agreement, however, about the precise channels through which monetary policy affects output. Conventional theoretical arguments suggest several key ways in which a change in the cash rate will induce output fluctuations. These include the interest rate channel, the exchange rate channel, cash flow effects, wealth effects and credit rationing effects (Bernanke and Gertler, 1995). Yet there is limited empirical evidence concerning the respective importance of these channels, especially in Australia. The fact that the monetary policy transmission mechanism remains a grey area in the literature is somewhat surprising and problematic given that monetary policy is currently the primary policy instrument used to influence macroeconomic outcomes in Australia.
A sectoral analysis of the impact of monetary policy may help clarify the aggregate transmission mechanism, as specific (and observable) industry characteristics will generate uneven output responses to a given change in monetary policy. The variation in the responsiveness of output across industries will be influenced by both demand and supply side factors. Notable factors that are suggested by economic theory include interest rate sensitivity of goods and services demand, capital intensity of production, the degree of leverage, the degree of trade openness and the exposure to financial markets via the extent of external financing, amongst others. Yet these differences in the responses to monetary policy, which have implications for policy effectiveness, are largely disguised at an aggregate level – making disaggregated sectoral data more informative than aggregate data for the purposes of analysing the transmission mechanism (Dedola and Lippi, 2005).
Grenville (1995) suggests five key transmission channels of monetary policy: the interest rate channel, the cash flow effect, the wealth effect, the credit rationing effect and the exchange rate channel. In isolation,these broad channels are not particularly indicative of how monetary policy will affect the economic activity of specific sectors. However, if these channels are considered in the context of industry characteristics, it is possible to draw inferences about which sectors are more interest rate sensitive. An understanding of sectoral interest rate sensitivity can therefore provide an important guide as to which industry characteristics, and therefore which channels, are more influential for the transmission of monetary policy.
The interest rate channel refers to the process through which changes in the stance of monetary policy alter the inter-temporal expenditure patterns of firms and individuals. The presence of nominal rigidities, particularly in prices, means that a change in nominal interest rates translates into a change in real interest rates. For consumers, real interest rates reflect the opportunity cost of consumption and so a monetary tightening may induce them to postpone expenditure in favour of saving. The prospect of lower consumer expenditure may also reduce the incentive for firms to invest. More directly, this channel will increase the cost of capital for firms, which is also likely to deter investment. The extent to which these effects occur is difficult to observe, largely because different investment projects have different time horizons, and a range of interest rates influence the inter-temporal savings-consumption decision.
The cash flow channel refers to the impact of interest rates on the liquidity of consumers and firms. If nominal interest rates rise then potential borrowers are less likely to take out loans as this will constrain their future liquidity. Current borrowers on variable loan contracts will face higher servicing costs, reducing their available liquidity for other expenditures. Higher interest rates can also have wealth effects. An increase in interest rates is typically associated with a fall in asset prices, which reduces the net worth of households and businesses. This may then reduce consumer confidence and subsequently dampen consumption and investment. The credit rationing channel of monetary policy has recently received growing attention in empirical monetary policy literature and relates to the impact of monetary policy on financial intermediation (Bernanke and Gertler, 1995; Hubbard, 1995). This is based on the idea that financial market frictions amplify the effects of the interest rate, cash and wealth channels as banks are likely to increase their risk premia, since the increase in interest rates depresses the value of debt-based asset portfolios and reduces the net worth and borrowing capacity of liquidity constrained agents. While this effect is once again more relevant at a firm (not industry) level, particular sectors may be on average less credit-worthy, which is likely to result in significant variation in the activity levels of sectors.
In a small open economy such as Australia, the exchange rate channel is a particularly influential transmitter of monetary policy. All other things being equal, an increase in the nominal differential between domestic and foreign interest rates causes an appreciation of the nominal exchange rate. If nominal rigidities exist, a change in the nominal exchange rate will result in a real exchange rate movement, altering the relative price between domestic and foreign goods. An appreciation will encourage expenditure switching away from domestic goods to foreign goods.
Combined, these channels of monetary policy mean that sectors will not react uniformly to a monetary policy shock. Several studies have highlighted that the interest rate channel is stronger in sectors that produce durable goods as demand for these goods is more interest elastic than demand for non-durable goods (Dedola and Lippi, 2005). Sectors that are highly capital intensive are also seen to be more susceptible to the interest rate channel, as higher interest rates will result in a significantly higher overall cost of capital. This provides a stronger incentive to alter investment and capacity decisions.[3] Although the cash flow channel is more likely to affect producers at a firm level rather than a sectoral level, as small firms are more likely to be liquidity constrained, sectors that experience relatively high average profit margins are likely to be less sensitive to this effect. Similarly, sectors that have low levels of financial leverage and low overall interest coverage ratios are likely to be less interest rate sensitive.
The exchange rate channel has important implications for sectors that are more export oriented (Gruen and Shuetrim, 1994), as a greater proportion of revenue is derived from overseas markets. It will also affect import competing industries and those that heavily rely on imported inputs. This does not imply that export oriented sectors will always be more responsive to interest rate changes. In fact, ceteris paribus, it is possible that open sectors are less interest rate sensitive, given that the traditional interest rate channel (which only dampens domestic demand) may be less important if domestic expenditure constitutes relatively small proportion of revenue.
This thesis pays particular attention to the mining sector and how it responds to a policy shock given it is the most export oriented sector in Australia. From this it will be possible to say something about the importance of the exchange rate channel. Another consideration relates to the induced or indirect sectoral effects of monetary policy. Changes in monetary policy may still have a large impact on sectors that are less directly interest rate sensitive if these industries are heavily influenced by the performance of other sectors that are highly interest rate sensitive. This is likely to be the case for sectors that provide key services or inputs into the production of downstream industries. Monetary policy is likely to have a strong, albeit lagged effect in this instance. Although this question is perhaps more subtle and difficult to isolate, it is still possible to identify whether impulse responses of sectors support inferences about these types of interactions.
The structure of this thesis is as follows. Chapter 2 provides an overview of the main conceptual issues in the literature, which are mostly related to SVAR modelling, its application the Australian economy and the incorporation of sectoral variables. Chapter 3 provides a discussion of the modelling approach that is adopted in this thesis. Chapter 4 develops a baseline SVAR model of the Australian economy and justifies its adequacy for the application to sectors. Chapter 5 examines the sectoral impacts of monetary policy and the relative influence of various channels of the transmission mechanism.