Macroeconomic Shocks, Depreciation and Inflation: an Australian Perspective

The general equilibrium approach demonstrates that macroeconomic shocks link the exchange rate and the inflation rate through diverse transmission channels. Therefore, the one-track focus of the partial equilibrium 'pass-through' approach that predicts that exchange rate depreciation causes inflation is flawed does not explain the exchange rate inflation dynamics of post-float australia. In this paper based on a mundell-fleming stochastic rational expectations model the theoretical priors that link exogenous shocks and macro-variables such variables real exchange rate, relative prices and relative output have been identified. Thereafter, the structural var (svar) methodology has been deployed to the identify the exogenous shocks by appealing to the long-run classical neutrality postulates. The dynamic interactions between shocks and macro-variables have been empirically reviewed using innovation accounting.