Executive summary - Download full version (pdf)

Supervisors: Professor Warwick McKibbin, Dr Renee Fry and Professor Farshid Vahid

Broadly speaking, macroeconomic stabilization policy entails the design and implementation of fiscal and/or monetary instruments in such a way as to ensure macroeconomic outcomes converge to their targeted levels within some reasonable time period. Whether this can be achieved depends on many factors, including the structure of the economy, the nature of underlying disturbances, the set of objectives, the effectiveness in policy implementation and the appropriateness of the instruments. Keynes' (1936) General Theory explained how fiscal and monetary policy can be used to end depressions. Over time, many have viewed this as an argument for stabilization policy itself -- Keynesian economics. While the literature has largely focused on the closed economy setting, this thesis aims to provide a deeper understanding of the role of monetary policy as a stabilization tool in a small open economy.

This thesis includes four case studies. The first study looks at the importance of time-inconsistent policy for New Zealand and how this notion has led to a number of interesting insights regarding the central bank's behavior and institutional design. The results indicate that the size of the stabilization bias is nearly twice as large for a small open economy (SOE) relative to that usually found for closed economies. The results also indicate that the size of the stabilization bias is increasing with the policymaker's preference for stabilizing exchange rate fluctuations.

The second case study tries to uncover the underlying macroeconomic stabilization objectives for Australia, Canada and New Zealand, and to see how this can be used to enhance the transparency and accountability in the implementation of monetary policy. The estimated policy preference parameters suggest the three central banks are very similar in their overall objective. None show a concern for stabilizing the real exchange rate and all three share a concern for minimizing the volatility in the change in the nominal interest rate.

The third case study examines the sources of business cycle fluctuations, in particular, the role of international shocks for Australia. In contrast to previous VAR studies, international factors are found to contribute to over half of the output forecast errors whereas demand shocks have relatively modest effects.

The fourth case study examines possible changes to the international transmission mechanism in the case of U.K over the period 1975 to 2005. In the period before 1990 the response of the domestic economy resembles a classic beggar-thy neighbor scenario, with increases in foreign money supply resulting in a fall in U.K. real activity. Whereas, for the period after 1990, the results suggest a foreign monetary policy easing has substantially different effects on the U.K. In this later period, the response is positive but insignificant.