Despite their simplicity, the equations explain a substantial part of the variation in Australian quarterly non-farm GDP growth, with adjusted R 2 s of 0. Both models explain the major features of the Australian business cycle since Figure 1 shows the results from the underlying CPI model.
We now return to the lags of monetary policy, and examine the impact on domestic output of a sustained one percentage point rise in the domestic short-term real interest rate.
Of course, in conducting this exercise, we should not lose sight of the fact that the domestic real rate is determined in the longer run by the world real rate rather than by domestic monetary policy. For both models, Figure 2 shows the effect of the rise in the domestic real interest rate on the level of non-farm output, while Figure 3 shows the effect on the year-ended growth of non-farm output. Both figures show point estimates and 90 per cent confidence intervals. Note: The figure shows point estimates and 90 per cent confidence intervals for the impact on the level of non-farm output of a one percentage point rise in the short-term real interest rate at the beginning of quarter 1.
Note: The figure shows point estimates and 90 per cent confidence intervals for the impact on four-quarter-ended growth of non-farm output of a one percentage point rise in the short-term real interest rate at the beginning of quarter 1.
The level of output in either model falls slightly for the first few quarters after a rise in the short-term real interest rate, but the fall is statistically insignificant. Over time, however, the contractionary effect on output gets stronger and becomes increasingly significant. Almost all the effect on the level of output occurs within three years.
It is also clear, however, that the confidence intervals are quite wide. The current real interest rate and its lags are quite strongly correlated, leading to unavoidable problems of multicollinearity in the regressions. In other words, it is hard to estimate accurately the length of the lags of monetary policy. Another way to highlight this problem is to compare results from the two models on the estimated effect on output growth in the first and second years after a rise in the real interest rate.
Assuming inflationary expectations respond to underlying inflation, the fall in output growth is smaller in the first year than in the second the point estimates are falls in growth of 0. Alternatively, assuming inflationary expectations respond to headline inflation, the fall in output growth in the two years is almost the same the point estimates are 0.
The point of this comparison is clear enough: subtle changes in assumptions about inflationary expectations can lead to somewhat different estimated results. As might be expected, while the point estimates from the two models are different, these differences are not statistically significant.
Although the underlying CPI model suggests that the contractionary impact is stronger in the second year, at conventional levels of significance we cannot reject the alternative hypothesis that the impact is in fact stronger in the first year.
An alternative way to summarise the length of the lags of monetary policy is to calculate the average lag length, defined by. For the reasons explained above, these numbers are again estimated imprecisely, with the 90 per cent confidence interval from 5.
We are faced with the common difficulty in econometrics that we require a timespan long enough to generate meaningful results but not so long that the underlying economic relationships change substantially during the estimation period. For both models, the general specification from which we begin includes contemporaneous and four lags of farm output growth and US GDP growth as well as lags one to four of the dependent variable.
A trend term is insignificant when added to either regression. We also generated estimates of the short-term real interest rate using a survey-based measure of consumers' inflation expectations from the Melbourne Institute survey. The estimation results were qualitatively similar, though the explanatory power of the regression was reduced.
Of the two measures of the past inflation used in our estimation, it is unclear which is a better measure of inflationary expectations in the economy. The headline measure is more widely reported but is directly affected by changes in the overnight cash rate via their effect on variable-rate housing mortgage interest rates ; by contrast, the underlying measure, which excludes this direct effect, is a better measure of core consumer price inflation.
As a check of robustness, we also estimated the regression using the yield gap the cash rate minus the year bond rate instead of the real cash rate to control for the influence of monetary policy. It uses these as vehicles to influence employment levels, manufacturing output and general price levels. Fiscal policy is a set of decisions enacted by the government. Essentially, the decisions involve the purchase of goods and services, as well as spending on transfer payments, such as Social Security and welfare, and the type and amount of taxes charged.
Monetary policy changes normally take a certain amount of time to have an effect on the economy. Fiscal policy and its effects on output have a shorter time lag. Additionally, if the government changes its fiscal policy and chooses to increase spending, for example, the fiscal stimulus may still take several months to have any effect on the economy. As an example of a time lag in action, the Fed may cut interest rates, but it will take time to see these cuts reflected in the economy for the following reasons.
During these two years, lower interest rates have not made any difference to the amount of disposable income for this group of individuals. Additionally, consumers and businesses may lack confidence in the economy, so even if interest rates become lower, they will look at the probability of future growth prospects before choosing to take advantage of the lower interest rates.
Because all economic action necessarily takes place over time, this chain of transactions may take a while. The process may be delayed if, at any step along this chain of transactions, the holders of the stimulus money hang on to it for a while as savings rather than spending it on.
Only once the new stimulus money has circulated throughout the economy can the full effect of the policy be felt and observed by policymakers.
The time interval between this point and the point of implementation the mailing of the checks is the response lag of the stimulus policy. In the popular imagination, central banks can control the economy at will by manipulating the money supply and interest rates.
In reality, it is difficult to determine how effective monetary policy has been, never mind knowing how tight monetary policy should be. This inability to fine-tune the economy, with the aim of evening out business cycles, is perhaps why many tightening cycles in the Fed's history have been followed by a recession or depression. There are many reasons for the response lag on interest rate cuts. Homeowners with fixed-rate mortgages cannot take advantage of interest rate cuts until their loans come up for refinancing, and banks often delay passing on bank rate cuts to consumers.
Businesses and consumers may also wait to see if a rate change is temporary or permanent before making new investments. And if lower interest rates weaken the currency, it can take months before new export orders are placed. The impact of tax cuts or changes in government spending is more immediate—although they also affect the long-run trend rate of economic growth.
But fiscal policies still take months to have any effect on the economy. Other policies encourage saving more to improve productivity.
A higher savings rate hits current consumption but leads to more investment and higher living standards in the long run—according to the Solow residual. Quantitative easing has been criticized because it does little to encourage real capital investment which would improve the productive capacity of the economy.
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