The Major Macroeconomic Policy Instruments in Australia - Essay Example

Macroeconomic Problems and Analysis In recent years, "inflation targeting" is one of the major macroeconomic policy instruments in Australia. Under this regime, it has been argued that "Phillips Hypothesis" is no longer appropriate to achieve a trade-off between inflation and unemployment. Investigate this argument with the Australian inflation and unemployment data in between 1994 to 2004. Overview The Phillips curve, named after A.W. Phillips, shows how inflation and unemployment are said to be inversely related. His hypothesis is primarily based on his observation with regard to the prevailing economic conditions in Great Britain from the onset of the 1900s until 1958. According to his published article, Phillips posited that when unemployment rate fell, inflation tended to rise and vice-versa, thus, the apparent link between these economic factors. (Cobham, 1998) However, with the recent economic trends, economists of various countries noted that low inflation can, in fact, coexist with low unemployment rate (Oliver, 1999). Such observed trend is deemed to be contrary to the hypothesis of Phillips. This paper discusses the inflation and unemployment rate trend in Australia from 1994 to 2004. The paper aims to provide an explanation as to why the "Phillips Hypothesis" is regarded as an insufficient or inapplicable too to be used in analysing the relationship between the two economic factors. Critics of the Phillips Curve - A Background For over 40 years, the link between inflation and unemployment has been intensely debated upon by economists all over the world (Oliver, 1999). They hypothesis postulated by Phillips has been subjected to myriad criticisms regarding its ability to explain the inflation-unemployment relation. For instance, in the 1970s, the Phillips curve fell short of elucidating why many countries experienced stagflation - an economic condition characterised by high level of unemployment coupled with high level of inflation ("Wikipedia," 2005). With this, new theories emerged to better illustrate the observed link between inflation and unemployment levels. One of the most notable is the theory on non-accelerating inflation rate of unemployment (NAIRU) or the natural rate of unemployment. Based on this theory, the short term Phillips curve is negatively sloping showing the inverse relationship between unemployment (on the x-axis) and inflation (on the y-axis). (Samuelson & Nordhaus, 2001) On the other hand, the long run Phillips curve is vertical, wherein only the natural rate of unemployment was consistent with stable inflation rate as expectations of market players change. In this regard, no trade-off is seen between inflation and unemployment in the long run. However, this theory is critiqued due to the difficulty in determining the natural unemployment rate. (Levacic & Rebmann, 1982) Another theory, which is influential in explaining the inflation-unemployment linkage, is the one postulated by Milton Friedman. He argued that the Phillips curve is formed due to "money illusion" such that the price inflation "fooled" businesses into perceiving that there is demand surge. As such, they hire more people, thus, decreasing the unemployment rate. Friedman's theory asserted that inflation tends to precede drops in unemployment rather than follow it. (Oliver, 1999) Other economists believe that, contrary to Friedman's theory, low unemployment raises bargaining power of workers. Given this, they tend to push for higher nominal wages resulting in cost-push inflation. Employers then would raise prices to remain within targeted profit level. ("Wikipedia," 2005) Inflation-Unemployment Relation - The Case of Australia The theories discussed only addressed scenarios in which stagflation occurs and when inflation and unemployment behave inversely. In the case of Australia and in other OECD countries as well, particularly in the 1990s to early 2000s, the robust output growth and prevailing low unemployment rate are coupled with low inflation. The growing Australian economy even requires additional labour but manages to pose no substantial acceleration in inflation. (Argy, 2005) According to the report of the Australian Bureau of Statistics (2004), though inflationary pressures persisted in the 1980's, partly attributed to oil price shock, it began to slow down in the early 1990s and has remained at relatively low levels in 2000s. In the aspect of labour, the unemployment rate declined steadily to about 8% from 1995 to 1997. From then on, it has been falling gradually. Given the data in Annex A (see attached Australia-Inflation and Unemployment Rate), it is apparent that decreasing unemployment is accompanied by declining inflation, specifically from 2001 to 2004. Some economists believe that such trend in the inflation-unemployment trade off, which runs contrary to the "Phillips Hypothesis," is brought about by the deregulation of financial markets and freezing up of external trade in 1980's. In this regard, excess aggregate demand is said to more likely affect current account deficit rather than inflation. As such, the link between inflation and unemployment is not as striking as it used to be. (Argy, 2005) Nevertheless, this economic improvement is a ramification of optimistic policy developments such as Australia's monetary stance (Argy, 2005) and the introduction of structural labour market reforms in the 1990s ("Australian Chamber of Commerce," n.d.). Monetarists deem inflation as mainly a monetary phenomenon which occurs when the central bank allows the money supply to grow too fast (Bowden & Carlin, 1977). This has emphasized the vital role of a country's central bank in controlling inflation. In terms of the monetary policies implemented by the Reserve Bank of Australia (RBA), the framework introduced allows for the expression of inflation target as a range, thus, allowing flexibility. Furthermore, the inflation target, which does not take into account extraordinary factors like one-time increase in oil and other commodity prices, is expressed as an average over a certain period. In this regard, the monetary framework utilised by the RBA provides an anchor for inflationary expectations of industry players. Moreover, such model enables financial institutions to react based on medium-term prospects (Argy, 2005). These factors accompanied by either contractionary or expansionary monetary policies to control the growth of money supply have facilitated the maintaining of inflation at stable levels. To address unemployment, the government has introduced economic and regulatory reforms, specifically in the labour market ("Australian Chamber of Commerce," n.d.). The government has undertaken significant reforms to employment service such that the efficiency of job search and matching is substantially enhanced. It has also invested considerably on post school education, training and re-skilling so that the local labour force matches industry skill requirements. (Argy, 2005) Furthermore, the government's highly interventionist approach has significantly reduced trade-union bargaining power and increased competition in the product market. Relating this to inflation, potential cost-push pressure in price increases is eased and greater movements of relative wages are permitted. These factors have also inculcated better wage and price disciplines among employers. (Argy, 2005) Conclusion Given the Australian case, it can be concluded that a well-managed policy mix is crucial to attain sustainable growth with moderate inflation. Monetary policies and fiscal reforms play an important role in honing the economy based on indicated targets. As mentioned, this economic condition renders the so-called "Phillips Hypothesis" inapplicable since there is no perceived trade-off between the said factors as previously believed. In this case, Australia's monetary perspective and economic regulations have positively affected its output growth as well as uphold low levels of unemployment and inflation. As part of the incomes policies to control these economic factors, the Australian government has implemented market strategies which strengthen market forces and impose discipline on price and wage levels. The low unemployment and stable inflation regime bode well for both investors and workers since they are better equipped to make wiser consumption, saving and investment decisions. Annex A Australia - Inflation and Unemployment Rate Year-End Inflation Unemployment Rate 1994 2.5% 8.8% 1995 5.1% 7.9% 1996 1.5% 8.4% 1997 -0.2% 7.9% 1998 1.6% 7.3% 1999 1.8% 6.7% 2000 5.8% 6.3% 2001 3.1% 6.8% 2002 3.0% 6.3% 2003 2.4% 5.8% 2004 2.6% 5.1% Source: Reserve Bank of Australia References Argy, F. (2005). An Analysis of Joblessness in Australia. Economics Society of Australia, March 2005. Australian Bureau of Statistics. (2004) Retrieved October 14, 2005 from: http://www.abs.gov.au Australian Chamber of Commerce and Industry. Structural Labour Market Reforms: The Key to Sustaining Lower Unemployment. Retrieved October 14, 2005 from: http://www.acci.asn.au Bowden, E.V. & Carlin, T.W. (1977). Economics. Alexander Hamilton Institute. Cobham, D. (1998). Macroeconomic Analysis. Pearson Education Levacic, R. & Rebmann, A. (1982). Introduction to Keynesian-Neoclassical Controversies. Palgrave Macmillan. Oliver, C. (1999). Who's Afraid of A Red-Hot Economy-Investor's Business Daily. Ludvig von Mises Institute. Retrieved October 14, 2005 from: http://www.mises.org/story/149 Reserve Bank of Australia. (2005) Retrieved October 14, 2005 from: http://www.rba.gov.au Samuelson, P.A. & Nordhaus, W.D. (2001). Economics. McGraw-Hill (17th ed). Wikipedia. Phillips curve. Retrieved October 14, 2005 from: http://en.wikipedia.org Read More