This Selected Issues paper reviews how Australia’s economy has adapted to a flexible Australian Dollar. The paper provides a background on the float and the initial policy challenges. It discusses the main elements of the Future Fund proposal, and estimates how much Australia and other countries in the Asia-Pacific region would gain from greater financial integration. The results suggest that these welfare gains are large, giving an argument in favor of a progressive capital account liberalization across the region, once the needed supporting measures are in place.


This Selected Issues paper reviews how Australia’s economy has adapted to a flexible Australian Dollar. The paper provides a background on the float and the initial policy challenges. It discusses the main elements of the Future Fund proposal, and estimates how much Australia and other countries in the Asia-Pacific region would gain from greater financial integration. The results suggest that these welfare gains are large, giving an argument in favor of a progressive capital account liberalization across the region, once the needed supporting measures are in place.

I. Australia's Adaptation to a Floating Exchange Rate1

1. Floating the exchange rate in December 1983 has contributed to Australia’s improved economic performance. The Australian dollar (A$) has swung through wide ranges in the two decades since it was floated. Nonetheless, the flexible A$ has stabilized economic activity by allowing the Reserve Bank of Australia (RBA) to pursue an independent monetary policy, while market-led exchange rate adjustments have also tempered the impact of external shocks. Moreover, the float was a keystone for broader structural reforms, some of which may not have been feasible otherwise, or which would not have worked as well in the absence of exchange rate flexibility. The benefits of these reforms are evident in Australia’s sustained strong growth in the past 14 years. Australia’s experience may be of broader interest, and this chapter discusses how Australia’s economy has adapted to a flexible A$, and the economic results, after providing a background on the float and the initial policy challenges.


Real Effective Exchange Rate

(Percent Deviation from 20-Year Average)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Source: Reserve Bank of Australia

A. Floating the Australian Dollar—Taking An Upward Exit

2. Australia had a range of exchange rate regimes in the postwar period. The A$ was fixed to the U.K. pound sterling (to November 1971), the U.S. dollar (to September 1974), and then to the Reserve Bank of Australia’s (RBA) trade weighted index (TWI) of the exchange rate. A “crawling peg” to the TWI was used to set the A$ from November 1976 to December 1983. With the RBA required to clear the market in foreign currency at a set rate, its ability to manage domestic liquidity and hence to control interest rates was reduced.

3. Volatile capital flows increasingly exerted pressures on the economy. The postwar financial regulatory system relied on a range of restrictions on the activities of banks, leading to a growing role for nonbank financial institutions (NBFIs), such as merchant banks to service corporations and building societies to service households. Capital flows became increasingly volatile and sensitive to interest rates, partly because merchant banks could access funds from their overseas parents. In particular, heavy capital outflows were experienced during the March 1983 general elections, reducing reserves and lifting interest rates sharply. The newly elected Labour Government was forced to devalue the A$ by 10 percent within a few days.


90-day Bank Bill Rates in 1983


Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Source: Reserve Bank of Australia

4. Liberalization of the financial system, coupled with a float of the A$, had been recommended to overcome these problems. To allocate savings more efficiently and foster financial system development, the 1981 Campbell Committee of Inquiry recommended reforms including the removal of ceilings on bank deposit interest rates, the relaxation of capital controls, removal of restrictions on the entry of foreign banks, coupled with enhanced prudential regulation. The report also supported floating the A$ to allow an independent monetary policy. These recommendations were endorsed by a later review, and the Government progressively deregulated the financial system in the mid-1980s.

5. When capital flows turned around in late 1983, Australia took the opportunity for an upward exit. Capital inflows had put pressure on the exchange rate for many days, pushing interest rates to very low levels, and financial markets generally expected a revaluation of the peg. Instead, the government announced its decision to float the exchange rate on December 9, 1983, with effect from the next business day.2 On the day of the float, the Australian dollar appreciated from 90¼ U.S. cents to 91 cents, although it displayed significant intraday volatility, peaking at 92.6 cents. The exchange rate went on to peak at 96.7 cents in March 1984.

6. Domestic monetary control was greatly enhanced, as evident in the substantial decline in interest rate volatility after the float. An earlier contribution to improved monetary control was the introduction of tender systems for issuing Treasury notes in 1980 and Treasury bonds in 1982, which removed the RBA's responsibility for covering any shortfalls in government debt issuance.


Short-term Interest Rate 1/


Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Sources: Reserve Bank of Australia1/ Weighted average of overnight and call funds rate.

7. Opening debt markets to foreign investors helped the A$ market to soon become among the most liquid in the world. Establishing the Treasury securities market underpinned the development of money markets, which, together with a liberalization of foreign portfolio investment in 1980, laid the foundation for a well functioning foreign exchange market. Some initial exchange rate volatility was experienced, but the market soon matured (Fraser, 1992). By 1989 the A$ was the 6th most actively traded currency in the world, well ahead of Australia's ranking as the 12th largest economy at the time, partly reflecting the diversification opportunity the A$ offers to international investors (Battelino, 1999).

B. Overcoming Challenges in the Early Years of the Float

8. The Australian economy faced a series of challenges in the initial years of the float. Growth had been uneven in the decade prior to the float, unemployment had risen since the mid-1970s, and inflation had become entrenched at low double digit rates, where highly centralized wage setting was a key underlying problem. While the deregulation of the financial system and liberalization of the capital account brought increased competition and deeper financial markets, it was also associated with rapid credit growth, relatively large external current account deficits, and a weakening in financial and corporate sector balance sheets. This section outlines how these challenges were overcome, the role the exchange rate played, and draws some lessons from this experience.

9. Inadequate competitiveness was a key factor slowing growth and raising unemployment. A “real wage overhang” had developed when real wages increased in response to the terms of trade (TOT) boom in the early 1970s, but, owing to labor market rigidities, remained high even as the TOT fell. With the aim of improving competitiveness the authorities adopted an incomes policy in the form of the “Accord” with unions on wage moderation in exchange for changes in health, education, and tax policies.


Closing the “Real Wage Overhang”

(Four-quarter moving averages)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Sources: Australian Treasury, Unit Labor Costs, March 2005

10. A substantial exchange rate depreciation in 1985–86 improved competitiveness with the support of the Accord, kicking-off export-led growth. After remaining steady in the first year of the float, the exchange rate fell by almost 40 percent from the end of 1984 to August 1986. This drop was triggered by a 15 percent fall in the terms of trade, but was intensified by Treasurer Keating's public comment in May 1986 that Australia risked becoming a “banana republic,” which crystallized public concerns about the external position. Nonetheless, most of this adjustment proved to be structural, with the average real exchange rate in the next two decades being 29 percent below its average in 1984. By containing the development of a renewed wage-price spiral, the Accord played a crucial role in making these competitiveness gains lasting. Strong export growth followed, especially in manufacturing, which also benefited from export market development grants and greater access to financing due to financial deregulation.


Exports of Manufactures 1/

(Percent change in annual total)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Sources: Australian Bureau of Statistics1/ Excludes transport equpment.

11. However, the sharp A$ fall highlighted some weaknesses in private sector risk management, and it also delayed progress on lowering inflation. Unhedged borrowing in low yielding foreign currencies such as the Swiss franc became popular in the mid-1980s, especially among farmers and small businesses, with domestic financial institutions being the main lenders. These borrowers faced large losses when the exchange rate fell in 1985–86, and many went out of business, with loan defaults and court actions quickly deterring further foreign currency lending. In addition, after declining to 3 percent in 1984, inflation rose back to around 8–10 percent, largely due to higher prices for tradable goods, prompting the RBA to raise interest rates to limit the risk of second round inflation effects.

12. The financial sector responded vigorously to deregulation, with substantial side effects for macroeconomic developments. From 1983 to 1988 the amount of capital in the financial sector more than quadrupled as the number of banking groups rose from 15 to 34, and the number of merchant banks from 48 to 111. Credit expanded rapidly, growing almost 150 percent in this period, which was reflected in a rise in corporate gearing associated with a wave of leveraged corporate takeovers in 1984–87, and a property boom after 1987. Rising private investment was coupled with declining household savings, resulting in current account deficits (CAD) that were large by historical standards, at 5 percent of GDP on average in 1985–89, compared with 3¼ percent in the previous decade. Net foreign debt doubled in only two years to 31 percent of GDP by mid-1986, with valuation losses due to the A$ depreciation adding to the effects of higher CADs.


Balance of Savings and Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

13. In this environment, the floating exchange rate played a key role in disciplining economic policy and galvanizing the implementation of reforms. During the first five years after the float a correlation between the A$ exchange rate and consumer confidence emerged, and public debate on economic policies focused on the CAD and external debt. Political support for reforms could therefore be mobilized on the basis that they would enhance competitiveness or increase savings, and thereby strengthen the external position, with less emphasis placed on the benefits for living standards. This pattern is evident in the fiscal consolidation after the float, which over 5 years increased the underlying cash balance by 5¼ percentage points of GDP to a surplus of 1¾ percent of GDP in the 1988/89 fiscal year, serving to avoid a greater deterioration in the CAD. It is also seen in the broader liberalization of foreign investment in Australia that followed the sharp fall in the exchange rate in mid-1986, and in the adoption of mandatory private superannuation in 1993.

14. Financial deregulation was also followed by a decline in financial sector health, making the recession in the early 1990s more protracted. The RBA raised interest rates in the late 1980s, which, coupled with declining prices or shares and commercial property, made the underlying poor quality of credit more evident. The share of NPLs rose to about 6 percent on average, and although Australia avoided a full blown banking crisis, the deterioration in financial sector soundness was significant.3 The 1990–91 recession was initiated by external shocks, but the rebuilding of capital by financial institutions and by corporations slowed investment and credit growth, tending to delay the recovery. While the recession was of a similar magnitude as in the U.S., unemployment in Australia rose by 4½ percentage points 1990–91, much larger than the 1¾ percentage point rise in the U.S. This is consistent with anecdotal evidence that the recession in Australia was associated with substantial restructuring by firms, as efficiency gains made possible by structural reforms were realized.


Credit Growth

(Percent change, y/y)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001


Real GDP

(Percent change, y/y)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

15. Exchange rate flexibility aided the recovery. Utilizing its monetary independence fully, the RBA cut interest rates by 6 percentage points in 1990, and by a further 7¼ percentage points by mid-1993. Moreover, the A$ depreciated substantially, falling by over 20 percent in real effective terms in the two years after the third quarter of 1991. Nonetheless, it is notable that the decline in the A$ began some time after interest rate cuts began in early 1990, and also after the terms of trade began falling in late 1990.4 This may have been a period when the exchange rate was overshooting, indeed, the RBA intervened in both October 1990 and May 1991 to resist an appreciation of the A$, which it considered overly strong relative to fundamentals.

16. Some lessons can be drawn from Australia's initial experience with a floating exchange rate, most of which are common to other countries:

  • There are tradeoffs in the pace of financial deregulation and capital account liberalization, and careful sequencing may help contain transition costs. Floating the A$ made it possible to liberalize capital flows and the financial system, but, in hindsight, an earlier strengthening of supervision was needed (Australian Treasury, 2003). Perhaps more gradual liberalization of the capital account and the financial system could have eased the macroeconomic side effects, but the development of key financial markets, such as those in FX hedging instruments, would likely have slowed.

  • Labor market flexibility is needed to help a floating exchange rate cushion external shocks effectively. The Accord served to achieve flexibility in real wages at the outset of the float, such that a nominal exchange rate depreciation led to a lasting improvement in competitiveness. However, incomes policies can be difficult to sustain over time, suggesting that the underlying labor market rigidities would need to be addressed to help the economy cope with future external shocks.

  • Macroeconomic policies need to combine predictability with short-term flexibility. The float strengthened incentives to make policies more predictable, as there were periods when uncertainty about macroeconomic policy intentions added to A$ volatility. The benefits of putting macroeconomic policies on a medium-term footing were recognized in the 1980s, but taking this step was difficult given the macroeconomic effects of financial deregulation and pressures arising from the lack of microeconomic flexibility. Moreover, a simple policy rule would not be adequate, as substantial short-term flexibility was needed, with, for example, the fiscal balance declining by almost 6 percentage points of GDP by 1992/93 following the 1990–91 recession.

C. How Has the Economy Adapted Since the Float?

Economic reforms since the float have been wide ranging. Frameworks for macroeconomic policy have been adopted which use transparency to enhance policy predictability while retaining a high degree of flexibility in the short-run. Structural reforms have increased the efficiency of goods and labor markets, and a unification of financial supervision has reinforced incentives for sound private sector risk management. Together these reforms have strengthened the resilience of the economy, including to potential exchange rate swings.

17. Monetary policy evolved toward an inflation targeting (IT) framework. Owing to a breakdown in monetary relationships after financial deregulation, the monetary targets which had been in place since 1976 were abandoned in February 1985 (Grenville, 1997). Monetary policy initially played a supporting role for fiscal and incomes policies in seeking to improve competitiveness while containing inflation, and a “checklist” of indicators helped guide policy in 1985–86. In the context of the asset price boom of 1987–89, indicators of future inflation, such as demand and inflation expectations, gained increasing prominence. The RBA's 1989 Annual Report identified the reduction of inflation—then running at 7–8 percent—as the central priority for monetary policy. A reduction in underlying inflation to less than 3 percent was achieved by mid-1992, after the unexpectedly severe 1990–91 recession, and the RBA announced in 1993 that it would be targeting 2–3 percent inflation.

18. The design of the Australian IT framework includes an emphasis on preserving short-term flexibility. In particular, the inflation target is to be pursued on average over the economic cycle. This formulation recognized the risk that output and interest rates could be unnecessarily volatile if the central bank sought to achieve the inflation target in every period, and other countries with IT frameworks have tended to adopt a similar degree of flexibility once low inflation had gained credibility. To enhance predictability in policies, the RBA releases a detailed Statement on Monetary Policy on a quarterly basis, it explains any changes in the target cash rate, and senior staff often give speeches. The operational independence of the RBA was formally recognized by the Treasurer in the 1996 Statement on the Conduct of Monetary Policy, and the RBA Governor makes semi-annual appearances before a parliamentary committee to ensure accountability.

19. Monetary policy in Australia has seldom responded to A$ developments since the float, but the RBA has not pursued a policy of benign neglect to the exchange rate. The few instances when interest rates were adjusted in response to exchange rate moves occurred early in the float. In July 1986 and January 1987 policy was tightened in response to steep falls in exchange rate, while in October 1990 and May 1991 the RBA supported intervention against excessive strength in the exchange rate with interest rate cuts. Nonetheless, foreign exchange markets are not perfect, and the RBA considers intervention to be useful in circumstances where market imperfections are resulting in overshooting, and also to calm markets threatening to become disorderly. However, interventions tend to be infrequent, near the peaks and troughs of the exchange rate cycle, as the RBA does not treat the A$ as overshooting unless it has already moved a considerable way from its normal level, or at least a level that can be explained by what is happening in the economic and financial environment.5 Overall, intervention is not seen as a substitute for monetary policy, but it can play a useful role in limiting extreme movements in the exchange rate (Macfarlane, 1993).

20. Fiscal policy also adopted a medium-term focus and a high degree of transparency. As the economy recovered from the 1990–91 recession, the authorities steadily consolidated the fiscal position, returning the Commonwealth Government to surplus in 1997/98. The Charter of Budget Honesty Act 1998 lays out principles of sound fiscal management, and commits the government to set out its medium-term fiscal strategy in each budget, to aid the evaluation of whether fiscal policy is consistent with these principles.6 In 1998, within these principles, the Government adopted an explicit strategy to maintain budget balance, on average, over the course of the economic cycle. This clear objective, coupled with regular medium-term reports, enhances the predictability of fiscal policy. Consistent with the strong performance of the economy in the seven years since the adoption of the Charter, fiscal surpluses have been achieved with the exception of only 2001/02, when the deficit was small, and the government's net worth has improved by 9 percentage points of GDP, with net debt estimated at only 2 percent of GDP in mid-2005.

21. Industrial relations reforms boosted labor market flexibility, especially in themid-1990s. Wages and conditions of work had been determined by a complex set of high prescriptive and centrally-determined “awards” since early in the 20th century in Australia, with the objective of promoting equity and justice. As a consequence of this centralization, wage pressures in one sector or region would quickly spillover to other parts of the economy, reducing relative wage flexibility and increasing the inflationary impact of shocks. This process was aided by limited competition in goods markets. There was a progressive decentralization of bargaining beginning from the 1980s, with significant reforms achieved with the Workplace Relations Act 1996, which redefined the role of awards to be more of safety net of minimum standards for collective or individual agreements negotiated directly with enterprises.7 By 2002 the share of employees relying on awards for pay rises had fallen to 20 percent from 67 percent in 1990. The change in labor market dynamics has been evident in recent years, as demand for workers in construction and mining has been very strong, but spillovers into generalized wage pressures has not been observed.

22. Broader microeconomic reforms also increased the competitiveness and flexibility of the economy. A steady reduction in tariff protection from the mid-1980s opened the economy to external competition. In the late 1980s, recognizing that the efficiency of the nontraded goods sector—which often provides key inputs to the traded goods sector—was central to Australia's competitiveness, a broad program of microeconomic reforms was pursued, with the commercialization and privatization of government business enterprises, along with reforms of the communications, energy, and transportation sectors. Under the umbrella of the National Competition Policy, agreed to by the Commonwealth and State governments in 1995, barriers to competition were reduced, by, for example, enhancing third-party access to infrastructure. The overall impacts on economic efficiency have been substantial (Productivity Commission, 2005). By containing the adjustment costs associated with reforms, the floating exchange rate may have facilitated structural reforms (Banks, 2005).8

23. Placing financial supervision under a unified framework has encournaged improved private sector risk management. Financial deregulation was associated with an initial deterioration in financial sector health as risk management practices took time to adapt to the new environment, calling for an updated supervisory system. In particular, financial supervision had been based mainly on the institutional forms of service providers; as financial innovations increasingly blurred the boundaries between different industries, this framework sometimes left regulatory gaps. Following the report of the Wallis Committee, a single regulator, the Australian Prudential Regulation Authority, was established in 1997 with responsibility for the entire financial sector. The new framework emphasized greater reliance on disclosure and market-based signals rather than industry-specific regulations, helping promote sound private sector risk management practices by providing additional market discipline and ensuring early detection of financial difficulties.

24. Foreign exchange hedging is now extensive, reducing vulnerability to exchange rate fluctuations. Private sector experience with the floating A$, such as the losses by farmers borrowing in Swiss francs in 1985–86, reinforced by corporate disclosure requirements and prudential regulations, increased demand for instruments to manage FX risk. Markets in these instruments have become deep, with turnover in forwards, swaps, and derivatives being 2½ times that in the spot market (BIS, 2005). Even though net external debt is 50 percent of GDP, a 2001 survey by the Australian Bureau of Statistics showed that, taking into account derivative positions, Australian entities had a net long foreign currency position of 22 percent of GDP (RBA, 2002). Indeed, due to hedging practices, the country's international investment position is now little affected by exchange rate movements.


International Position and Exchange Rate

(Correlation of quarterly changes, rolling 20 quarters)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

D. Why Does the Australian Dollar Exchange Rate Fluctuate?

25. Australia's real exchange rate has fluctuated significantly since the float, although it was also volatile prior to the float. As noted above, the real TWI fell sharply in 1985–86, an adjustment which has proven to be lasting. Since then, the real TWI has fluctuated around an apparently stable trend, with peaks and troughs about 15 percent above and below its average level. Interestingly, the standard deviation of monthly changes in the real TWI is only slightly higher in the post float era than that during 1970–83, reflecting the frequent devaluations and revaluations, and volatile inflation owing to large swings in international commodity prices.


Real Exchange Rate and the Terms of Trade

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

26. Most major swings in the A$ during the float have been linked to TOT developments. Since the 1985–86 adjustment, the major swings have included:

  • 1988–89: Large appreciation (22 percent in year to 1989Q1) associated with a 15 percent rise in the TOT and higher interest rates.

  • 1991–93: Large depreciation (21 percent in two years ended 1993Q3) following a large fall in interest rates and a fall in the terms of trade.

  • 1998: Depreciation (8 percent in year ended 1998Q4) as the Asian crisis led to a decline in the Australia's export prices and the terms of trade.

  • 1999–2000: Further depreciation (13 percent in the 18 months to 2000Q4), despite an improving terms of trade and a rise in interest differentials as Australia cut interest rates by less than other countries more affected by the global IT slow-down.

  • 2003-03: Large appreciation (27 percent in two years to 2003Q4), apparently correcting the low level of the A$ in 2000-01 and responding to the continued increase in the terms of trade, while interest rates rose only modestly.

27. More formal analysis confirms the importance of the TOT for A$ movements. Along with interest rates, shifts in the terms of trade were identified as the key factor in driving the A$ by Blundell-Wignall and Gregory (1990) and Blundell-Wignall et al (1993). Rises in terms of trade reflect an increased demand for Australian commodities, and thus shift the equilibrium real exchange rate required to maintain balance of payments equilibrium.9 Nonetheless, as would be expected given the general difficulty of predicting floating exchange rates, there have been periods when this pattern does not appear to hold, including the somewhat delayed depreciation of the A$ in the early 1990s (Section B), and the unusually weak A$ earlier in this decade. Most recently, the A$ has appreciated less than might be expected given the rising TOT, possibly because part of these gains are expected to be temporary.

E. What are the Economic Results Since the Float?

28. Floating the A$ preceded a turning point in Australia's overall economicperformance. Australia has enjoyed a strong and sustained economic expansion in the 14 years since the 1990–91 recession, with growth averaging 3.8 percent. As a result, unemployment has fallen by 6 percentage points from its peak in 1993 to reach 5 percent in mid-2005, and per capita incomes (PPP basis) have risen from the OECD average in 1991 to almost 10 percent above average by 2003. The floating A$ contributed to this strong economic performance in a number of ways. First, it induced the sharp initial adjustment in competitiveness in 1985–86. Second, the floating exchange rate helped to galvanize political consensus on the implementation of structural reforms as discussed earlier. Finally, it also facilitated structural reforms by enhancing macroeconomic stability, which is the focus of the remainder of this section.

29. Exports remained robust through the 1990s even as the exchange rate fluctuated. International research is largely inconclusive on whether exchange rate volatility impedes trade and investment (Clark et al, 2004). In the case of Australia, exports performed well through the 1990s, with manufacturing and services exports—which are likely more sensitive to the exchange rate than mining or agricultural commodities—growing at average annual rate of 12 percent from 1985 to 2000. This strong performance may reflect foreign exchange hedging, the benefits of structural reforms, and the increased integration with Asian markets. The sunk costs of entering foreign markets (market research, establishing distribution networks, etc.), may also help explain the resilience of exports to exchange rate volatility (Menzies and Heenan, 1993). Manufacturing export growth has slowed in recent years, reflecting more intense global competition, as well as the appreciation of the A$ (Kennedy et al, 2005).


Exports of goods and services

(Constant price, A$ billions)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Source: Australian Bureau of Statistics

30. The amplitude of Australia's economic cycles has declined over time, partly owing to structural reforms. In the 14 years since 1992, the standard deviation of output gap estimates have declined to 3¾ percent, compared with 1% percent in the 10 years prior to the float, and 1⅔ percent in the 1984–92 period.10 Similar declines in output volatility have been observed in some other advanced economies (Cotis and Coppel, 2005), and recent research finds that these declines partly reflect the liberalization of product, labor, and financial markets tending to reduce both the scale and impact of shocks (Kent et al, 2005).


Output Gap

(Percent of GDP)

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Source: Australian Bureau of Statistics and staff estimates.

31. Running monetary policy within an IT framework, as permitted by the float of the A$, has promoted economic stability. As would be expected, in seeking to maintain inflation around the target rate on average, the RBA has adjusted interest rates to lean against the business cycle trends, thereby tending to moderate the peaks and troughs in the cycle. Research also finds that Australia's relatively low propensity to adjust monetary policy in response to changes in the exchange rate has further enhanced economic stability (Clinton, 2001). This approach to monetary policy is facilitated by the medium-term focus of the inflation target, along with the decline in the pass-through of exchange rate changes into inflation as the credibility of low inflation has risen, and as competition in goods markets has increased due to reforms (Ouliaris, 2005).


Output gap, Percent, LHS

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Source: RBA, ABS, and staff estimates1/ Target cash rate-trimmed mean CPI inflation.

32. Exchange rate flexibility has also contributed to economic stability by helping insulate the economy from external shocks. In the early 1970s, a sharp rise in Australia's terms of trade boosted demand and raised inflation to double-digit levels. Since the float, however, as the A$ responds to TOT shocks, their macroeconomic impact has diminished. For example, the recent rise in the terms of trade has been associated with a stronger A$, which has eased inflation pressures by reducing tradable goods prices and channeling part of the increase in domestic demand into imports. Indeed, Clinton (2001) finds that the typical reaction of the A$ to commodity price shocks is broadly of the magnitude needed to stabilize GDP growth.


Inflation Performance Under Different ER Regimes

Citation: IMF Staff Country Reports 2005, 330; 10.5089/9781451802078.002.A001

Source: Australian Bureau of Statistics

33. Australia's economic resilience during the Asian crisis was a clear example off lexibility in the A$ helping to sustain growth. Australia's terms of trade fell by 7 percent y/y by 1998Q4 as commodity prices fell owing to the 1997–98 Asian crisis. The 8 percent decline in the real TWI over the same period contributed to a slowing in import growth, from 10½ percent y/y in 1997 to 6 percent in 1998, even as final domestic demand growth remained at 5 percent. With inflation remaining broadly stable despite the decline in the A$, interest rates were not changed until a 25 basis point reduction in the target cash rate in late 1998. Overall, Australia's real GDP growth remained at 4 to 5 percent in 1998 and 1999 at a time when key trading partners were facing severe economic contractions.


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Prepared by Craig Beaumont (Ext. 37411) and Li Cui (Ext. 36539).


In a preparatory step, restrictions on trading in the forward market in foreign exchange were eased in October 1983, which helped to deepen trading in advance of the float.


Two of the largest banks faced substantial losses, some banks owned by the States were recapitalized or taken over, and a number of NBFIs were closed.


One interpretation of this apparent slow adjustment is that “fundamentalist” traders only enter the market when there are substantial deviations from fundamentals from which they can profit through speculation, while in normal times the market is dominated by “chartists,” see Djoudad et al (2000).


Under this approach to intervention, the RBA has made a profit of $A 5.2 billion on its intervention, suggesting that these operations tended to stabilize the exchange rate (Becker and Sinclair, 2004).


The principles include: managing fiscal risks prudently, having regard to economic circumstances, including by maintaining general government debt at prudent levels; ensuring that fiscal policy contributes to national saving and moderating cyclical fluctuations in economic activity; spending and tax policies that are reasonably stable and predictable; ensuring that policy decisions have regard to their financial effects on future generations.


A detailed discussion of labor market reforms is provided in OECD (2001).


For example, if trade liberalization impacts negatively on the trade balance, the exchange rate would tend to depreciate, tempering the initial decline in output and employment.


The high correlation of the real TWI and the TOT has puzzled some researchers, as the TOT appears to have a significant cyclical component, and the deviations should have been perceived as largely transitory (Gregory, 1993). Gruen and Kortian (1996) suggested these might reflect a lack of market efficiency and the short-sightedness of investors. An alternative explanation is that the TOT are forward-looking and may not be as predictable as argued (Douglas, et al 1997).


Staff estimates of the output gap use a Hodrick-Prescott filter on GDP excluding agriculture and mining—fluctuations in the output of these two sectors are treated as supply shocks.

Australia: Selected Issues
Author: International Monetary Fund