Business Cycle Properties and Macro Forecasting of the Australian Economy: An Empirical Research Report

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Business Cycle Properties and Macro Forecasting of the

Australian Economy:

An Empirical Research Report

Brittany Vande Wydeven, 312165048

The University of Sydney

ECOS2002: Sem. 2, 2012

Word Count: 2,000

Executive Summary

The purpouse of this paper is to obtain and analyze business cycle facts forAustralia from 1996 to 2011, in order to make macroeconomic forecasts ofAustralias future economic state. Through using quarterly, detrended, and

seasonally adjusted data, I was able to derive correlations, between the growthin output and in major indicators, to disocver both the cycical nature and

properites of these policy related statistical figures.


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IntroductionLahiri and Moore (1992) reveal that the leading indicator approach is based on the

idea that business cycles of indicator variables have repetitive expanding and contractingsequences which can aid in predicting a countrys future business cycle and economicactivity. This paper documents and analyzes the business cycle facts of Australias inflation

rate, nominal exchnage rate, private final consumption expenditure, gross fixed investment,unmeployment rate, labor productivity, short-term and long-term interest rate, money supply,and trade balance, in hopes that their correlation to GDP will help predict the futuremacroeconomic state of Australia. When combined with macroeconomic theory and policymodels, these derived business cycles will provide a benchmark for further inquiry onAustralias expectant macroeconomic happenings.

Part 1:Business Cycle Facts and Economic Explanations on the Movement of Indicators

Table 1 reports the quarterly Australian data series for the period 1996-2012.Statistical measures for the cyclical components of various Australian macroeconomicindicators are shown above. The natural growth rate was taken of all aggregate variables, thatwhen plotted against time had a consistent increase or decrease; I de-trended the series inorder to reveal actual fluctuations in the variables once population growth was held constant.Most rate variables, besides unemployment rate, did not have a trend and therefore statisticalmeasures were applied directly to the data found on ABS.


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Inflation Rate:

The cross-correlation between the growth rateof GDP and the inflation rate is largest in column

X(t+1), revealing the series lags the cycle by onequarter and is responding to changes inAustralias output during period t. This can beexplained by the Central Bank enforcing anexpansionary monetary policy in attempt toachieve economic growth. By the CB increasingthe price target, firms are getting more money fortheir goods and consequently will produce moreto increase profits. In the sort-run, the CB buysbonds to increase the money supply and decreasethe interest rate for each Y (a rightward shift in

LM). In the medium run, as seen through thequarter lag, the change in output will reflect agreater change in price and a higher inflation rate. AS will shift left to reflect a higher pricefor each Y, and output will shift back to the natural level of output. In the end, the price willrise even further then in the short-run.

The inflation rate has a counter-cyclical nature at -0.32. When the overall economy isslowing down, the inflation rate is rising; this negative value can be explained throughstructural shocks such as the GFC. During a recession, the Australian government may wantto run an expansionary fiscal policy and budget deficit in hopes that the increased interestrate and output will re-stabilize the economy. By increasing government spending, the IScurve shifts right, resulting in a rightward shift in the AD curve, and an increased price foreach Y.

Nominal Exchange Rate:

The nominal exchange rate is a coincidentindicator, because the cross-correlation is largest inperiod X(t). The series is contemporaneous with thecycle, in that a change in the nominal exchange rateoccurs at the same time as a change in output; this isbest understood through looking at the definition forGDP [Y= C+I+G+(X-M)]. Ceteris paribus, anincrease in the GDP can be reflected by an increase inthe amount of net exports in Australia. If Australiasexports are increasing, then there is an increase ininternational demand for local goods and thus anincrease in demand for Australian currency. Thehigher demand appreciates the $AU versus foreigncurrencies like the $US, meaning a stronger exchangerate.

The nominal exchange rate is of a counter-cyclical


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nature at -0.18. This seems counterintuitive, but may be explained if the trade balance strictlydetermines the business cycle behavior. During a recession the Australian government mayrun an expansionary fiscal policy, in hopes that increasing government spending will increaseaggregate demand. The resulting higher interest rate may attract foreign investment toAustralia, thus increasing the nominal exchange rate.

Private Final Consumption:

The correlation between private final consumptionand the growth rate of GDP was contemporaneous andpro-cyclical at 0.37. This is to be expected sinceconsumption is a component of GDP [Y=C+I+G+(X-M)]. Ceteris paribus, an increase in consumption isreflected by an equivalent increase in output, revealed bya rightward shift of the IS curve in the short-run. Thecorrelation is pro-cyclical because consumption is afactor of disposable income (Y-T), and output equals

income. When the economy is experiencing a growthperiod, peoples income is higher, so they will spendmore on goods.

Gross Fixed Investment:

Gross fixed investment is a coincidentindicator because it is one of the largest componentsof GDP (Y=C+I+G) in a simplified closed economy.The cross-correlation was pro-cyclical at 0.5, whichcan be revealed through the AD relation and the factthat investment is a factor of both the interest rate andoutput. A lowered interest rate makes investmentseem more attractive, and with an increase ininvestment comes an increase in output (interest rateeffect on investment). Similarly, an increase in outputincreases investment even further because outputequals income, and with more income comes moreinvestment (output effect on investment).


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Inventory Investment:Inventory investment is a minimal component of GDP

and a weak indicator of the current economic state.However, my results indicated inventory investment leadsthe cycle by 5 quarters, which is explained in the ASAD

model. Firms will cut production if they predict economicdownturn (a leftward shift in AS), resulting in higherprices and lowered output, which will drive the economyfurther into a recession. Inventory Investment has a pro-cyclical nature at 0.44, because during an economicdecline, production slows, consumer and capital spendingfalls, unemployment rises, and profits fall.

Unemployment Rate:

The cross-correlation is largest in columnX(t+1), revealing the series lags the cycle by one

quarter. The ASAD model describes howunemployment here decreases a full quarter afterGDP improves in period t. The aggregate supplycurve is derived from the Wage-setting/Price-setting relation, which determines theunemployment rate. The unemployment rate isdirectly related to output; when output increasesthere is a need for more workers to produceadditional goods so the unemployment rate willdrop [u=1-(Y/L)]. Okuns law supports thisrelation, in revealing that a 3% increase in outputis followed by a 1% decrease in unemployment(Freeman 2001, p. 511).

The cross-correlation statistical value iscounter-cyclical at -0.35. The counter-cyclicality of the correlation reveals that theunemployment rate tends to decrease during economic booms and increase during recessionperiods. When the economy is growing, more individuals are needed to produce goods,resulting in a lowered unemployment rate.

Labor Productivity:

The cross-correlation was 0.61 inperiod X(t), revealing a highly pro-cyclicaland contemporaneous series. Laborproductivity growth is dependent oninvestment in physical capital, newtechnologies, and human capital(http://www.investopedia.com/terms/l/labor-productivity.asp#axzz29BTFrCm9). TheSolow Model supports this pro-cyclicalcorrelation, by revealing economic growth is


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simultaneously dependent on these three factors. By definition (refer to Appendix A) laborproductivity is a coincident indicator; if hours worked is held constant and real GDP, thenumerator, increases then labor productivity would simultaneously increase.

Short Term Interest Rate:

The cross correlation was largest in period X(t+5),revealing the series lags the cycle by five quarters.The short-term interest rate therefore changes fivequarters after the economy changes, which can beexplained through the short-run ISLM model.Changes in the interest rates business cycle are dueto monetary and fiscal policy changes (shifts in the ISor LM curve); therefore, the series would lag afterthese policies are enforced on the economy. Thelagging nature of the short-term interest rate can alsobe attributed to the CB often altering i based on

changes in the inflation rate, which as seen in a) tendsto lag business cycle fluctuations.The cross-correlation is pro-cyclical at 0.24,

revealing that it is positively correlated with theoverall state of the economy. The short-run money-supply/money-demand graph reveals that an increasein income, or by definition output, leads to anincrease in money demand and consequently an

increase in the short-term interest rate, due to a fixed money supply.

Long Term Interest Rate:

The long-term interest rate series leads the cycle by fivequarters and is pro-cyclical at 0.24. Long-term interestrates are less variable then short-term interest rates, andless risky in terms of holding bonds. Therefore,individuals business decisions to invest, allocateresources, and consume are dependent on these rates.They are set by incorporating inflationary expectationsand thus are pro-cyclical; to prevent inflation at the endof an economic growth period, the CB will raise theinterest rate so that the opportunity cost of borrowingbecomes greater and less people will demand money toinvest. A yield spread, the difference between long andshort-term interest rates, is commonly used to predictfuture economic growth in output, consumption, andinvestment, supporting long-term interest rates leadingproperty.


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Money Supply:

The cross-correlation is largest in column X(t-4),revealing the series leads the cycle by four quarters. TheISLM relation reveals how output responds to changes in theMoney Supply. An increase in the money supply shifts the

LM curve right, therefore increasing output and decreasingthe interest rate.The statistical value is counter-cyclical at -0.18, yet

lacks significance because the magnitude is less than -0.2.The ISLM relation reveals that the money supply tends toincrease when the overall economy is slowing down. Duringa recession, the CB may implement an expansionarymonetary policy by increasing the money supply to spureconomic growth from a lowered interest rate and elevatedoutput (output and interest rate effects on investment).

Current Account Balance:

During boom periods, imports would increasemore than exports because people tend to spend moreboth domestically and internationally, revealing thecounter-cyclical nature of the series. Even though mystatistical representation was pro-cyclical at 0.24,graphically the trade balance is counter-cyclical in 1997,slightly in 2001, and majorly in 2008-2010. The growthof trade balance peaks around 2008 when the economy

was in a global financial crisis. The pro-cyclical yearsmay be periods when Australias growth was moreexport-led and dependent on oil prices, instead of basedon domestic demand. The trade balance also lags by onequarter instead of being contemporaneous as expected,potentially from people waiting to purchase more goodsfrom abroad after they see an increase in their income andafter the exchange rates are determined.


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Part 2:Forecasting Variables

(i) ABS gave a quarterly chain volume measure for Real GDP, revealing the productionvolume through holding prices constant. Regression of this data forecasted the Real GDP for

2012 Quarter IV at 349136.65 ($ millions) and at 357872.20 ($ millions) for 2013 Quarter I.In June 2012, the GDP was 345100.00. Consequently, GDP is forecasted to grow by 0.628%in 2012 and by 0.612% in 2013.

(ii) I measured Australias inflation rate as the growth rate in the Consumer Price Indexfound on ABS. From this data, I ran statistical regressions forecasting the inflation growthrates in the 2012 Quarter IV and 2013 Quarter I. December 2012 is expected to be at 0.62%and March 2013 at 0.623%.

(iii) The RBA sets monetary policy by changing the cash rate target, in order to maintainthe target rate of inflation. At the last board meeting on October 3, 2012 the cash rate was

lowered from 3.5% to 3.25%, and inflation rates were expected to remain consistent with thetarget over the next one to two years (http://www.rba.gov.au/media-releases/2012/mr-12-30.html). Consequently, I believe the RBA will not change the cash rate target from 3.25% atthe November 6th meeting. Although Australian GDP growth has slightly fallen due todecreasing residential investments, non-residential investments, and carbon prices affectingconsumer prices (http://www.rba.gov.au/media-releases/2012/mr-12-30.html), I believe theRBA will wait to see the recent monetary policy effect the economy before lowering the cashrate even further to spur economic growth.

(iv) The RBAs recent decision to lower the cash rate to 3.25% resulted in a weakenedexchange rate in early October 2012 at an average of 1.0259, because the fallen interest rate

impeded foreign investment (http://www.rba.gov.au/statistics/frequency/exchange-rates.html). Generally, as a countrys inflation rate is being consistently lowered, theirpurchasing power should increase and their dollar should appreciate(http://www.investopedia.com/articles/basics/04/050704.asp#axzz29BTFrCm9). FromSeptember Q3 2011- September 2012, the inflation rate has consistently lowered from 3.6 to1.2. Although this lowered inflation rate should reflect an appreciated AU currency, the factthat the interest rate is nearing the all time low of 3.0 is probably over-riding any possibleinflation rate effects. Furthermore, Australia has had a tirelessly large current account deficitbecause of its minimal exports, resulting in a low exchange rate. After running a statisticalregression from the quarter December 2000 onward, I expect to see the future exchange ratedecrease from 1.0259 to 1.01 during the Nov 2012-June 2013 period.

(v) IfoundAustralianhousepriceindicesbyrunningaregressionequationofthepriceindexofestablishedhouses:weightedaverageof8capitalcitiesfromMarch1996toDecember2012.Itookthegrowthrate,fromtheDec2011indexof269.98andtheDecember2012indexof278.58,tofindayear-over-yearpercentagechangeof3.19%.ABSrevealedtheyear-to-yearpercentagechangefromJune2011-June2012tobe-2.1%,thus revealing an overall increase in Australian house prices .


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a) I forecasted GDP to grow on an average of .62% between 2012 and 2013 andinflation rates to grow on an average of .6215% between 2012 and 2013. Ibelieved that the RBA would not alter its monetary policy and keep the interestrates at 3.25%, after their recent policy decision in October. Also, I expected theAustralian dollar to depreciate from $1 AU=$1.0259 US to $1 AU= $1.01 US.

The dollar can be depreciating due to the .62% growth in the inflation rates. Thesmall growth in GDP can be attributed to the recent expansionary monetary policyimposed on October 3rd, 2012. I believe that this interest rate will not decrease andwill remain at 3.25% for approximately three more years, in order to compensatefor the recent lag in economic growth.

ConclusionIn the end, many of the derived cross-correlations were supported by macroeconomic

theory and could be used to indicate future movements in the Australian business cycle.However, some statistical errors were made that may have altered the cyclical nature of thevariables, the magnitude of the correlation, or the indicating properties; the trade balance

business cycle was the least statistically and theoretically supported, and should be re-examined in future empirical research.

Assumptions were created during forecasting, predicting very minimal growth in bothGDP and the inflation rates. Similarly, I expected a weakened exchange rate and noalterations in the RBAs monetary policy. Overall, these combinations reveal Australiansfuture business cycle may trend slightly downward, yet lack any major spikes or falls.


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Appendix A:

Definitions of Indicator Variables

Real GDP

Definition: Inflation-adjustedmeasureofthevalueofallfinalgoodsandservices

producedinayear.Units:Chainvolumemeasure.($Millions).Source: AustralianNationalAccounts,ABSCatNo5206.0

Labor productivityDefinition: Real GDP divided by average hours worked. It reflects the growth in outputbased on factors of production other than hours worked.Units: SeasonallyadjustedquarterlyunemploymentrateindecimalsSource:AustralianNationalAccounts:NationalIncome,ExpenditureandProduct,ABSCatNo5206.0

Inflation RateDefinition: the rate at whichthegenerallevelofpricesofgoodsandservicesinaneconomyisrisingoveraperiodoftimeUnits: percentage change in CPI beyond all quartersSource:ConsumerPriceIndex,Australia,ABSCatNo6401.0.Short-terminterestrates:Definition:Australian90-daybankbillsUnits:SeasonallyadjustedquarterlygrowthrateofAustralian90-daybankbillsinpercentagesSource:AustralianEconomicIndicators,ABSCatNo1350.0.

Long-terminterestrates:Definition:Australian10-yearTreasurybondsUnits:SeasonallyadjustedquarterlygrowthrateofAustralian10-yearTreasurybondsinpercentagesSource:AustralianEconomicIndicators,ABSCatNo1350.0.

NominalExchangeRate:Definition:TherateatwhichtheAustraliandollarisbeingexchangedfortheUSdollar($1AU=?$US)Units:Seasonallyadjustedquarterlygrowthratesindecimals

Source:AustralianEconomicIndicators,ABS1350.0

PrivateFinalConsumption:Definitions:Sincefirm=investment,solelyexpenditurebyhouseholdsonindividualconsumptionofgoodsandservicesUnits:Seasonallyadjustedquarterlygrowthrateoftotalannualhouseholdfinalconsumptionexpenditureindecimalsbychainvolumemeasure($millions).Source:AustralianEconomicIndicators,ABSCatNo1350.0


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GrossFixedInvestment:Definitions:AmaincomponentofGDP[Y=C+I+G+(X-M)],measuringthevalueofneworexistingfixedassetsofthebusinesssector,households,andgovernmentsUnits:Seasonallyadjustedquarterlygrowthrateoftotalgrossfixedcapitalexpenditure

indecimalsSource:AustralianNationalAccounts:NationalIncome,Expenditure,andProduct,ABSCatNo5206.0

InventoryInvestment:

Definitions:MinimalcomponentofGDPthatsignifiestheamountofproducedgoodsleftoverfromfinalsalesinaneconomy.Units:Thegrowthrateinpercentofseasonallyadjustedquarterlychangesininventories($millions).Source:AustralianNationalAccounts:NationalIncome,Expenditure,andProduct,ABSCatNo5206.0

UnemploymentRate:Definitions:Numberofunemployedindividualsdividedbythelaborforce(employed+unemployedbutactivelyseekingwork)Units:SeasonallyadjustedquarterlyunemploymentratesinpercentagesSource:LabourForce,Australia,ABSCatNo6202.0MoneySupply:

Definitions:M3,totalmonetaryassetsavailableatagiventimeUnits:($millions).Source:AustralianEconomicIndicators,ABSCatNo1350.0

TradeBalance(CurrentAccountBalance):

Definitions:AcomponentofGDPinanopeneconomy.ExportsminusimportsoveraparticularperiodoftimeUnits:ThousandsSource:RBA,BalanceofPayments,CurrentAccount,Quarterly


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Business Cycle Properties and Macro Forecasting of the Australian Economy: An Empirical Research Report