RDP 9607: Towards an Understanding of Australia's Co-Movement with Foreign Business Cycles 6. Conclusion

Previous studies have identified the extent of the correlation between Australian and foreign business cycles and at an aggregate level showed that foreign business cycles ‘cause’ the Australian business cycle. However, the transmission mechanisms which underpin the correlations have been more difficult to identify.

This paper has identified two large and significant transmission mechanisms. The first mechanism through exports is widely accepted even though it has been difficult to show empirically. By allowing for the effect of domestic activity on exports, we show in Section 3 that foreign activity has a large impact on exports as expected. Also shown was that after allowing for the feedback of domestic activity onto exports, Australia's exports are not only highly correlated with the cycle in foreign GDP but large enough to have a sizeable impact on Australian activity at times.

It was also argued that the effect on Australia's exports of the US and Japanese economic cycles is greater than indicated by their average shares of our export markets. This is because, as well as being Australia's two largest export markets, their output elasticities of demand for Australia's exports are relatively high. This explains why the export equations based on OECD or export-markets' GDP performed poorly relative to the US-based model. By implication, it may also explain why the US-based GDP model in Gruen and Shuetrim (1994) performs so well relative to the OECD and export markets based models.

The second transmission mechanism identified was through the impact of the US share market on the Australian share market. In Section 4 it was shown that the two countries' share markets are closely correlated and that the inclusion of share market variables substantially improves the explanatory power of the benchmark model of Australian GDP. This result does not necessarily imply that the cycles in the real economy will be correlated unless the within-country responses to share market movements in the US and Australia are similar. Section 5 provides some evidence that the responses of investment to the share market variables in the two countries are remarkably similar, while the responses of consumption are different. This implies that if the sharemarket is serving to correlate the US and Australian business cycles, it is likely to be through investment rather than consumption.