RDP 2002-01: Inflation Targeting and the Inflation Process: Some Lessons from an Open Economy Appendix A: A Small Macroeconomic Model of Australia

This model is similar in structure to that in Beechey et al (2000). The primary difference is that aggregate inflation is not modelled in an error-correction framework. The model is estimated over the period 1985:Q1–1999:Q4. All the inflation processes in the model are calibrated to deliver 2.5 per cent inflation in steady-state, which is the assumed value of the inflation target in the central bank's objective function.

Output gap

where y is the domestic output gap, measured as deviations from a linear trend of real non-farm output; yf is the foreign output gap, measured as deviations of US GDP from a linear trend; r is the real cash rate (the instrument of monetary policy less aggregate inflation); and rer is the real exchange rate.

Aggregate prices

where p is the level of the CPI, ulc is a measure of unit labour costs, and pm is import prices. The restriction that the coefficients on prices, unit labour costs and import prices sum to 1 was imposed.

Unit labour costs

The unit labour cost equation is a linear Phillips Curve incorporating adaptive expectations. The assumption of adaptive expectations has historically provided the best fit for Australian data. The equation was estimated with the restriction that the coefficients on lagged inflation sum to 1.

Import prices

where e is the nominal exchange rate and wp represents world export prices. We assume unitary pass-through of movements in the exchange rate and world prices.

Real exchange rate

where rer is the real exchange rate, measured using the real trade weighted index, tot is the terms of trade and rf is the G3 real interest rate.

Nominal exchange rate

where pf is the foreign price level, measured using G7 core inflation.

Foreign output gap

Terms of trade

World export prices

G7 core inflation

G3 real interest rate

The following reaction function was assumed:

where the equilibrium G3 real interest rate is 2 per cent and the equilibrium world inflation rate is 2.5 per cent.