The Effects of Foreign Price Uncertainty on Australian Production and Trade

This paper provides a framework for the empirical analysis of the role of uncertain international prices for the Australian economy’s production sector and its international trade. We model the movement of traded goods prices via a bivariate GARCH model and embed this within an expected utility maximizing model of the production sector. We find that the empirical results are consistent with expected utility maximization and that the hypothesis of risk neutrality is soundly rejected. Estimates of the effects of changes in expected prices and volatility of traded goods prices upon production decisions and the return to capital are presented and discussed, as are the impacts of changes in output growth of Australia’s major trading partners. The overall conclusion is that price uncertainty matters for the Australian production sector.