Research Discussion Paper – RDP 28 Reaction Functions and Stabilization Policy in Australia: An Objective Analysis

Introduction

A recent Brookings paper by Goldfeld and Blinder opened by asserting that

Just as everybody talks about the weather, every economist talks about endogenous stabilization policy, but nobody ever does anything about it.

Their paper went on to explore the problems for econometric model builders arising from the feedback from the state of the economy to policy decisions, and briefly surveyed the ‘existing empirical work‘ on the estimation of reaction functions, at least for America. This paper provides a set of Australian reaction functions. It concentrates on stabilization policy and develops equations for the major instruments of fiscal and monetary policy. This enables us to derive some objective knowledge about the (changing)view of the economic structure held by Australian policy makers.

The current paper bases its estimating equations on the standard Theil (1964) theory of policy used in previous reaction functions studies, but modifies the theory to introduce explicitly the political and other costs of adjusting the policy instruments. This follows the initial introduction of adjustment costs into the maximand in investment theory by Eisner and Strotz (1963) and Lucas (1967). More recently, Henderson and Turnovsky (1972) and Turnovsky (1973) similarly included the costs of adjusting the policy instrument in simple theoretical models of optimal stabilization, as do Parkin et al (1973) in their portfolio choice model. In all these fields, this approach puts the so called ‘partial adjustment’ model on a much sounder basis. The problem of aggregation of policy instruments is also handled in a new way, and as a spin off we find that while the tax rate equation and the interest rate equation are both unstable, a combined equation for tax and interest rate policy is stable. This emphasises the need to study fiscal and monetary policy as an interrelated set of instruments although most previous Australian studies have tended to take a more partial view. Most previous reaction function studies have also examined one instrument, or group of instruments, although Pissarides (1972) and Friedlander (1973) examined respectively a set of British and United States fiscal and monetary instruments.