External and Domestic Interactions: A Sensitivity Analysis (Further Results)

This paper discusses the effects of different exchange rate regimes with different assumptions about the speed of adjustment of capital flows and expectations about changes in the exchange rate. It does this using simulation and eigenvalue analysis of the RBA79 model of the Australian economy. Use of this model allows for a much wider range of interactions between the domestic economy and the balance of payments than has so far been attempted in theoretical work or in empirical analysis of single equations. Responses of key macro-economic variables are examined under a range of domestic and external shocks. It is shown that these responses can vary substantially depending on assumptions about: - the exchange rate regime; - the speed of adjustment of capital flows; and - the speed by which expectations about changes in the exchange rate adjust to information about relative prices. Specifically it is found that, in the RBA79 model, a flexible exchange rate produces instability if capital flows adjust sluggishly to changes in income, interest rates and expectations about the exchange rate. For this reason, a managed float may be desirable if capital flows are slow to adjust. If capital flows adjust rapidly, however, a much more flexible exchange rate is possible and contributes to the control of money and inflation in the model without additional detrimental effects on unemployment or output. The paper is intended mainly to illustrate the implication of assumptions and to stimulate further work rather than to make assertions either about the nature of reactions in the Australian economy or about exchange rate management in Australia.