On the Effects of Inflation Shocks in a Small Open Economy

On the Effects of Inflation Shocks in a Small Open Economy...

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The Australian Economic Review, vol. 40, no. 3, pp. 253–66 On the Effects of Inflation Shocks in a Small Open Economy Sushanta K. Mallick and Mohammed Mohsin School of Business and Management, Queen Mary, University of London Department of Economics, The University of Tennessee Abstract The effects of monetary policies remain always an important topic in macroeconomics. In the literature (closed and open economy), there is no theoretical as well as empirical consensus regarding the effects of monetary policies. In this paper we examine the real effects of infla- tion in an open economy. Australia is a clas- sic example of a small open economy and is known to exercise inflation targeting. Using quarterly data from Australia and employing vector autoregressive (VAR) analysis, we pro- vide evidence that inflation, both in the short and long run, negatively affects durable and non-durable consumption and investment, and has a positive effect on the current account. Further, we show that consumption of durable goods is more sensitive than the consumption of non-durables during the initial periods fol- lowing inflationary shocks. We thank two anonymous referees and the editor, Ian McDonald, for very helpful and detailed comments. The earlier version of the paper was presented in the Eastern Economic Association meetings, 2006, at Philadelphia. We thank the participants for their comments. The usual dis- claimer applies. 1. Introduction The long-run real effects of monetary policies on employment, capital accumulation, con- sumption and the current account have always been of interest to macroeconomists. 1 The ex- isting literature covering both theoretical and empirical studies provides no clear-cut conclu- sion. The present paper intends to contribute to the empirical side of the literature by work- ing out the effects of changes in inflation rates on the important macroeconomic variables in a small open economy. We consider Australia for the empirical study and investigate the ef- fects of inflation shocks on the major macro variables both in the short run and the long run. Using seasonally adjusted quarterly data from Australia and estimating simple correla- tions and impulse response functions, we find changes in inflation negatively influence con- sumption and investment, and have a positive impact on the current account balance. The correlation coefficient between Australian in- flation and real consumption of durable and non-durable goods is found to be 0.12 and 0.20 respectively. Similarly, real investment is negatively correlated with inflation with the estimated coefficient of 0.25. The real current account balance and inflation, on the contrary, are positively correlated with a coefficient of 0.29. Correlation coefficients with lags rang- ing from 0 to 10 are found to be good repre- sentations of short-run effects. The results are reported in Figure 1. To trace the effects of inflation on any individual variable over the longer time horizon, we estimate the general-
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This note was uploaded on 04/28/2010 for the course ECON ECON2001 taught by Professor Tonyblake during the Spring '10 term at University of St Andrews.

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On the Effects of Inflation Shocks in a Small Open Economy...

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