Research Discussion Paper – RDP 33 Inflation: Prices and Earnings in Australia

Introduction

Several recent studies have been concerned with inflation, not only with a view to locating its causes and cures but also with a view to identifying some of the more important characteristics of Australian inflation. This latter aspect has raised issues of immediate political interest such as the existence of short and long-run trade-offs between inflation and unemployment, or, in their absence, the likely range and acceptability of the ‘natural’ rate of unemployment. This paper attempts to fill several deficiencies which exist in the field of short-run inflation analysis at present, most particularly in the consistency of the theoretical specification of the basic inflation model and in the construction of data to test hypotheses about the causes of inflation.

In this work, an attempt is made to provide an explanation of inflation consistent with the micro-foundations of market theory and individual behaviour. The short-run partial equilibrium model so constructed is used to develop equations for prices and earnings, in which tax, world price and exchange rate variables are introduced and constrained in accordance with the theoretical structure. The price equation is estimated for both the consumer price index and the implicit deflator for gross domestic product, either of which, together with the equation for average weekly earnings, could be used as the basis of a wage-price sector in a larger macro-economic model.

In addition to the theoretical modifications, a more accurate and consistent measurement of each of the variables is attempted. These measures incorporate the farm sector and provide consistent use of male units in constructing all labour market variables.

The theoretical models for both earnings and prices are developed in Section II. In Section III the empirical constructions and results for earnings are presented. Section IV summarises the price equations estimated for the alternative price series and Section V draws together the various conclusions and implications of the study. The mathematical derivation of the model is presented in Appendix A.