Modelling the Australian Exchange Rate, Long Bond Yield and Inflationary Expectations

More than two decades have passed since the initial relaxation of domestic interest rate controls in Australia and just over one decade since the float of the Australian dollar. Interest rates and exchange rates now constitute two of the most important channels through which macroeconomic policy can affect the broader economy. It is widely recognized that expectations play a critical role in these mechanisms, affecting both the timing and speed with which interest and exchange rates transmit shocks through to real activity and prices. Over the longer run, the influence of these two asset prices extends to the efficient allocation of capital and resources. This paper builds on previous work undertaken at the Reserve Bank and the OECD to develop single-equation, behavioural models of these two variables. Consideration is paid to the role of inflation expectations in affecting their behaviour. In particular, a model of ex ante real bond yields is estimated using a measure of forward-looking inflationary expectations which has been constructed by recourse to a Markov switching technique.