Understanding a Small Open Economy Business Conditions Index

Abstract

We estimate an unobservable domestic business conditions index for Australia using a variety of observable macroeconomic and financial variables, relating it to an unobservable external index involving external variables relevant to Australia. Our small open economy, dynamic factor model uses stock and flow variables arriving at mixed frequencies. We find important links between the domestic and external indices, consistent with the small open economy assumption. A business confidence measure and the terms of trade play significant roles for the indices, making them leading indicators. Financial variables matter only in severe macroeconomic episodes.

Keywords: Business conditions, Kalman filter, State-space model, Australia, Dynamic factor model, Mixed frequency

JEL Classification: E2,E3