RDP 7702: Inflation and Economic Stability in a Small Open Economy: A Systems Approach 5. Concluding Comments

The simulation analysis presented in this paper has illustrated how several related impulses contributed to a rise in the monetary growth rate and a build-up of inflation and the associated economic instability in Australia. The results emerge from a highly aggregated structural model which contains the usual channels for the influence of policy and foreign variables. The discussion of the various simulation experiments indicate how these standard channels operated in Australia in recent years. Two somewhat unusual channels also contribute significantly to the results: the first is the effect of monetary disequilibrium on consumption expenditure and on the adjustment of wages and prices; the second is the important role of the arbitration commissions, which the model implies have provided substantial exogenous wage push in recent Australian experience. The wage push was underwritten and reinforced by budgetary and monetary expansion.

Section 4 discusses interdependencies among the various impulses, and how the rise in world inflation and the resulting balance of payments surpluses contributed to high wage increases and somewhat contradictory monetary and budgetary policy responses. When the propensity of a new labor government to expand the government sector was reinforced by the rising unemployment rate, high international reserves, and rapidly increasing tax receipts, further instability was added to the system. While there was an autonomous element to each of the impulses whose effects are examined above, it is also necessary to recognize the complex interdependences among the various impulses during the inflationary take-off. It can reasonably be argued that the build-up of inflation was, while not inevitable, highly likely in view of the world instability, the distributional and other objectives of successive governments and the attitudes and institutions inherited from the earlier period of relatively low inflation, fixed exchange rates and an entrenched belief in the efficacy of discretionary macroeconomic policy making.

At the most general level, it could be argued that considerable responsibility for increased inflation and economic instability be attributed to the failure of Australia's economic policy to sufficiently emphasise monetary growth rates as crucial indicators of the stance of policy. Greater emphasis on the need for monetary stability would have involved a setting of policy instruments – including wages policy – conducive to a more stable outcome for money and economic activity. A conclusion suggesting a link between monetary and economic stability for Australia would be based in part on the correlation between lower inflation, steadier growth of real product, and more stable money in the simulations presented above, but, as in the analysis of Friedman and Schwartz (1963), this would have to be supported by a judgement that the monetary instability was triggered by factors exogenous to the normal working of the economy. As section 4 attempts to indicate, such a case could be put for the recent Australian experience; but it is not proven in any formal sense, and further work on the determinants of economic policy reactions is required.