The Export share and Australia's real exchange rate : a dependent economy contribution

The thesis explores the role of the terms of trade and the export share in determining the Australian real exchange rate. The research is also motivated by Rogoff's (1996) purchasing power parity (PPP) puzzle; that is, a combination of high short-term volatility in the real exchange rate with a relatively slow rate ofreversion back to PPP. The thesis develops a neo-classical dependent economy model of the real exchange rate with two types of capital, namely, structures and equipment, and specific identification of the terms of trade and the export share. The real exchange rate is identified as the relative price of non-traded goods. The dependent economy model has a long history of application to Australia starting with the work of Salter (1959) and Swan (1960). The model developed in this thesis extends the neoclassical dependent economy model proposed by Bruno (1976) and solved by Brock and Tumovsky (1994). It also develops a log-linear framework to explore the relationship between the export share and the real exchange rate. The solution to the model developed in the thesis integrates long-term equilibrium with short-term disequilibria engendered by surprises to the terms of trade and the export share. By identifying an 'underlying' real exchange rate based on perfect forecasts in the long run, an adjustment path back to the steady state can be determined for the medium term. Perfect forecasts enable capital allocation to cancel demand-side impacts in the medium and long run. The introduction of a variable based on surprises to the export share as a determinant of the real exchange rate is novel. This variable represents a generalisation of demand-side influences as a single measurable factor, but closely aligns with the allocation of labour in the firm's problem. In this way the theorised model provides an explanation for elements of Rogoffs puzzle. The model is tested empirically on Australian data with positive results. The 'underlying' real exchange rate can be conceptualised as a cointegrating vector linking the real exchange rate, terms of trade and real interest rate, with a second vector identified as the steady state export share. Empirical evaluation is extended to Canadian, New Zealand, South African, Chilean, Norwegian, Swedish and Finnish time-series with mixed results. The fundamental predictions of the model are supported for several of the countries considered, such as Chile and South Africa, however the analysis also suggests some countries, such as Canada, should no longer be considered 'dependent economies'. Analysis of- the results indicates that sovereign wealth funds may have a role linking the export share with the terms of trade. This leads to a policy suggestion for Australia to establish a sovereign wealth fund. Overall, the theorised model appears to work well for Australia and less well for other countries, leading to a call for more research to determine whether Australia is unique in this regard.