RDP 2019-07: MARTIN Has Its Place: A Macroeconometric Model of the Australian Economy 3. A Stylised Description of the Model

3.1 Structure and Transmission Mechanisms

MARTIN is a large model, with over 30 behavioural equations. Variables that play a large role in the setting and transmission of monetary policy are modelled comprehensively. Examples include interest rates, the exchange rate, the expenditure components of real GDP, labour market variables and inflation. Some parts of the economy are modelled in a more disaggregated way than others, to account for key features of the Australian economy. For example, we model mining and non-mining investment separately, reflecting the importance of the resources sector in the Australian economy (Rayner and Bishop 2013). Similarly, we decompose exports into a number of different categories. On the other hand, overseas variables are aggregated, reflecting the domestic focus of the model.

Some variables are assumed to be exogenous. For example, because economic developments in Australia have little influence on the world economy, there is no feedback from domestic to overseas variables in MARTIN.^[9] We model other variables using simple statistical relationships because explaining their behaviour in detail would add considerably to the complexity of the model without providing much additional insight. Commodity prices are a good example of this given their volatility and unpredictable movements. We also treat some key domestic variables as exogenous, including population and productivity growth, the neutral interest rate and the non-accelerating inflation rate of unemployment (NAIRU).

The household and business sectors are at the core of MARTIN's structure (Figure 1). Domestically, these two sectors interact through labour and product markets (with the latter represented through domestic final demand). Households and firms also interact with the overseas sector through trade. Households' decisions to consume and invest in housing are affected by their income and balance sheet position. Business investment is largely demand-determined in the short run. Economic activity influences the demand for labour and thus the degree of spare capacity in the labour market.^[10] The state of the labour market – along with output prices and inflation expectations – determines wages. Wages and import prices (which are affected by the exchange rate) influence the input costs of firms. Input costs and capacity pressures flow into output prices and consumer price inflation. As such, wages and prices provide a link between the labour market and the nominal side of the economy.

The central bank sets the cash rate according to a monetary policy reaction function that responds to deviations of trimmed mean inflation from the inflation target, the unemployment gap and the change in the unemployment rate. Nonetheless, for some model simulations, we allow the cash rate to deviate from what the rule suggests. For example, it is often instructive to examine how a shock would propagate through the economy if the cash rate were held constant.

In MARTIN, the cash rate influences economic activity primarily through the exchange rate, dwelling investment, asset prices and the interest payments (and receipts) of households and businesses. Through these channels, a reduction in the cash rate provides a short-term boost to GDP growth because of increases in export volumes, dwelling investment, consumption and business investment and substitution in the composition of demand away from imported goods and services. Stronger GDP growth boosts household income, further increasing consumption and business investment. To expand capacity, firms must hire more workers, which increases employment and lowers the unemployment rate. Lower unemployment reduces the amount of spare capacity in the labour market and puts upward pressure on wage growth. Higher wages and import prices (because of exchange rate depreciation), in conjunction with increased capacity pressures, put upward pressure on inflation. Section 5.1 shows the effects of a change in interest rates on economic activity and quantifies the contribution of individual channels to the aggregate response.

3.2 Long-run Properties

To predict the behaviour of economic variables over a few months or quarters, it is often sufficient to extrapolate their recent trends into the future. However, one of MARTIN's core tasks is to provide a sense of how variables like inflation, GDP growth or the unemployment rate will evolve in scenarios or forecasts that span several years or even decades. Over these horizons, the model's projections will also reflect its long-run properties. If these long-run properties are implausible then the projections may lack credibility. For example, one might be sceptical about consumption forecasts from a model which predicted that, in the long run, nominal consumption expenditure grows faster than nominal GDP.

We impose a number of coefficient restrictions on MARTIN to ensure that its medium- and long-run projections are plausible. These restrictions ensure that the model converges to a stable balanced growth path, along which income and expenditure shares of GDP are stable, and variables like GDP growth, inflation and the unemployment rate converge to their target or potential values.

Four main assumptions ensure that MARTIN has a stable balanced growth path:

1. The inflation rates of all price indices are equal in the long run. This ensures that relative prices also stabilise, but places no restrictions on the particular values at which they stabilise.
2. Long-run income elasticities in the model's expenditure equations equal one. In conjunction with Assumption 1, this means that expenditure components of GDP, like consumption or services exports, grow at the same rate (in both real and nominal terms) in the long run, ensuring that the model's expenditure shares are constant.
3. Nominal wages grow at the sum of inflation and labour productivity growth in the long run. This ensures that the wage and capital shares of income are stable.
4. The central bank adjusts interest rates to ensure that consumer price inflation equals the inflation target and the unemployment rate equals the NAIRU.

While some of these assumptions are uncontroversial (for example, that the central bank adjusts interest rates to meet its inflation target) others (such as the assumption that long-run expenditure shares are constant) are open to debate. In cases where the coefficient restrictions are clearly at odds with the data, we allow for more flexible specifications, typically by including time-varying parameters or structural breaks in coefficients. But in most cases, we believe that our assumptions provide a better explanation for the long-run behaviour of Australian macroeconomic variables than alternatives that would allow factor and expenditure shares to expand and contract without bound.

The time it takes for MARTIN to converge to its long-run balanced growth path varies depending upon the current state of the economy or the scenario being considered. However, we typically find that most variables converge to their long-run paths within a decade.

Footnotes

This simplifying assumption is arguably less plausible for the pricing of some resource commodities where Australian producers exert a material influence on global supply. However, accounting for these effects would require detailed modelling of the structure of individual commodity markets, which is beyond the scope of a model like MARTIN. [9]

We do not model households' labour supply decisions explicitly in MARTIN. Instead, we model employment and the unemployment rate, which leaves labour force participation as a residual. This is an example of a modelling choice that we have made to be consistent with the single-equation framework used by staff at the RBA. Evans, Moore and Rees (2019) show that it is possible to use MARTIN to examine the consequences of changes in labour force participation. [10]