Some time ago I posted about a Taylor rule for Australia, which related the setting of interest rates to expected output and inflation. But another interesting question is what were the actual economic outcomes for Australia? More specifically, if you were to combine actual output and inflation figures into a single figure (an 'Economic Health Indicator' if you will), how has Australia's economic performance been tracking over time?
For now, just to see how such an indicator might work I've just looked at economic outcomes from 2001 to 2010. To construct the indiactor I used the following equation:
"EHI" for year x = a * "Normalised" output gap + b * "Normalised" absolute deviation of inflation from target inflation
So what's all this then?
Essentially, for any given year, the higher the output gap and the lower the absolute deviation of inflation from target inflation the higher is the "EHI".
By "normalise" I just mean that I've adjusted the outcomes for each year by subtracting the average for that outcome from 2001 to 2010, and dividing by the variation (i.e. standard deviation).
The output gap means how much actual output is above the economy's "potential output". (Some might argue that a higher output gap is not necessarily better, but I've assumed it is here.) For the output gap I have taken the figures from the International Monetary Fund website. (Some might
argue that these are a load of garbage, but I've assumed they are not.)
I have assumed target inflation is 2.5 per cent per annum, though that is not technically the Reserve Bank's target. By taking the absolute deviation I have assumed that it's a "bad" outcome if inflation is much higher than this figure or much lower than this figure (think Japan).
For "a" and "b" I tried a few different figures. First, I made them both 0.5, which gives both components equal weight. Then, I tried a=0.8, which gives more weight to the output gap component. Then, I tried a=0.2, which gives more weight to the inflation component.
Got it? Alright, let's see some results.
Whichever weighting system I used the year 2007 stands out as the Australian economy's highlight of the decade. It had the highest output gap of any of the years, and inflation was quite close to 2.5 per cent.
The worst year of the decade depends on the weighting scheme used. With an even weight it is 2006, which had the lowest output gap and high inflation. But if a high emphasis is put on inflation then 2001, which had the highest inflation figure, comes out worse. (Though there were "extenuating circumstances" in this case - it being the first year the GST had been in effect for the whole year.)