RDP 9009: An Empirical Model of Australian Interest Rates, Exchange Rates and Monetary Policy 2. Some Stylized Facts
November 1990
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Figures 1a to 1d show bivariate relationships for five variables over the period January 1985 through January 1990. The data are monthly averages of the daily data that we use in the formal analysis in this paper.
Figure 1a shows the exchange rate and the unofficial cash rate. The exchange rate is defined as the number of Australian dollars per U.S. dollar, so an increase in the exchange rate is a depreciation of the Australian currency. The unofficial cash rate is the instrument of monetary policy. When monetary policy is being tightened, for example, the Reserve Bank sells a quantity of government securities in the money market sufficient to let rates on overnight cash reach their new, higher, desired level. These higher rates are soon transmitted to yields on financial instruments of longer maturities.[3]
Figure 1a indicates that up to about October 1987, a depreciation (appreciation) of the exchange rate was clearly associated with a tightening (easing) of monetary policy. This correlation might be reasonably interpreted as reflecting the reaction of monetary policy to developments in the foreign exchange market, possibly due to the inflationary implications of currency depreciation. After October 1987, however, this relationship becomes much more tenuous, indicating, perhaps, that monetary policy was not so tightly focused on the exchange rate.[4]
Figure 1b compares the cash rate with the principal instrument of monetary policy in the United States, the federal funds rate. The ability of each country to select its own inflation rate, via an appropriate monetary policy, has long been cited as one of the major advantages of a flexible exchange rate system. However, the conditions under which complete independence occurs (no international capital mobility) are inapplicable to modern economies. While it is clear that a flexible exchange rate affords more independence than a fixed rate, the extent of that independence is an empirical issue. Figure 1b shows that the cash rate and federal funds rate have demonstrated a general tendency to move together. The seems to be particularly the case since the end of October 1987. This does not mean, of course, that changes to the stance of monetary policy in Australia have been caused by corresponding changes in the United States; the coincidental changes in policy might simply reflect simultaneous responses to similar pressures.
At the other end of the yield curve, Figure 1c compares the Australian 10 year bond rate with the U.S. 10 year bond rate. We interpret these variables as proxies for the expected rate of inflation in each country; an increase in expected inflation is reflected in a higher bond rate. As figure 1c shows, the relationship between the two bond rates is ambiguous. At times they move together, possibly reflecting the transmission of inflationary expectations from the United States to Australia; at other times the relationship is weak, indicating that different factors are dominant in determining expectations of future inflation in Australia.
One such factor could be the stance of monetary policy. Figure 1d shows that depreciations in the exchange rate appear to be clearly associated with increases in the bond rate, and vice versa. Tighter monetary policy, for instance, might well decrease expected inflation and appreciate the exchange rate.
Figures 1a–1d suggest some interesting hypotheses, but such descriptive material has obvious limitations as an analytical tool. The remainder of the paper is devoted to a more rigorous statistical examination of the data and the hypotheses outlined in this Section.