The role of portfolio shocks in a structural vector autoregressive model of the Australian economy

Domestic and foreign equity shocks on the Australian economy are analysed within a five-variate structural vector autoregressive model, with identification achieved through long-run restrictions based on the natural rate hypothesis, monetary neutrality, long-run portfolio balance and purchasing power parity. The results show that real equity values were undervalued by 19 per cent by June 2005, with the gap narrowing thereafter. Foreign crises are important factors explaining this deterioration. The real wealth effects of equity market shocks impact significantly upon financial and goods market prices, whereas output tends to be immune. The model is also able to address puzzles that exist in the vector autoregression literature.