RDP 7702: Inflation and Economic Stability in a Small Open Economy: A Systems Approach 4. Interdependencies Among the Impulses: Towards a General Interpretation
June 1977
There are two general reasons for interdependencies among the impulses: the technical factors such as the existence of the government budget constraint, the bank lending function, and other endogenous responses which transmit and may amplify the effect of each impulse throughout the system; and the broader factors relating to the stabilisation policy rules followed and the policy objectives chosen by successive governments. It is necessary to consider these factors in any general evaluation of the reasons for the inflationary take-off in Australia, even though the second set involve consideration of relationships which are to some extent outside the formal framework of the model.
4.1 Technical factors
The most basic technical factor is that the existence of the government budget constraint combined with the traditional policy of setting important prices such as the exchange rate and the yields on government securities, rather than financial quantities, means that each of the impulses acted to raise the monetary growth rate. Thus the build-up of international reserves, the increase in government outlays and the rise in award wages all contributed at various times to the excessive increase in money. The reductions in cash ratios of the banks, and their traditional tendency to expand lending in response to demand,[37] meant that the monetary effects were multiplied, and contributed to excessive demand in the commodity market (via the effects on consumption) and to price and wage rises, through expectational effects.
The dependence of wages on prices, and of prices on wages, helped maintain the wage-price spiral, especially with a largely accommodating monetary policy, and then the adoption of wage indexation. There were, of course, some negative or dampening feedbacks, such as the rise in tax receipts due to the interaction of highly progressive income tax schedules and the rise in nominal incomes, the rise in interest rates and the increase in inflation. These dampening feedbacks operated partly by reducing real product and it is worth noting that the specification of the price expectations effect in the model as a disequilibrium real balance effect has an important implication for the “trade-off” debate. If increased inflation and economic instability reduces real output and raises interest rates, it is likely to reduce the demand for money,[38] which, given supply, increases the excess supply of money. This will, in turn, produce a higher price level for any given money stock and during the adjustment to a higher price level the inflation rate will be greater, in parallel with lower activity and employment.
4.2 Policy rules and policy objectives
A complete analysis of the influence of policy rules and policy objectives in Australia's recent experience would require a major study, and this section can do no more than point to some of the important factors in this area which need to be considered in understanding the inflationary take-off.
As discussed above, economic policy was conducted in the 1960's with a fixed exchange rate, and by setting a range of nominal interest rates and bank liquidity ratios. These policy instruments, and the rate of growth of government outlays and statutory tax rates, had tended to respond systematically to the conventional targets of stabilization policy. Reinforced by progressive personal income tax schedules, the policy responses were probably stabilizing in the face of domestically generated inflation. They were far less appropriate to maintain economic stability with the increase in world inflation. Indeed as suggested by Porter's (1974) analysis of capital movements, the tightening of budgetary policy in the early 1970's helped to generate the enormous build up of international reserves and self-fulfilling expectations of exchange rate revaluation.[39] The larger than usual increase in award wages in 1970/71 can be related in part to the exceptionally strong balance of payments at the time, and contributed to a rise in the unemployment rate above that which had in the past triggered expansionary policy responses. In 1972 tax rates were cut and social service payments increased more quickly than usual, although in common with the experience of many other countries, the unemployment rate remained somewhat higher than usual.
One of the first economic policy changes of the Labor Government elected late in 1972 was a revaluation of the exchange rate and the tightening of capital controls. Revaluation was repeated twice in 1973, with an across-the-board tariff cut in the middle of the year providing a further external policy initiative. Budgetary policy eventually became extremely inflationary, and an adviser to the Labor Government, in an article entitled “What Went Wrong?” [Gruen (1976)], gives considerable weight to both the tendency to use the labor market as the major indicator of domestic demand pressure and to the unusually high levels of unemployment, especially after the onset of recession in the middle of 1974.[40] While labor governments might in any case be expected to increase government outlays more rapidly than more conservative parties, it can be argued that in recent Australian experience a further factor was that the high level of international reserves inherited from previous years meant that a traditional constraint upon expansionary social policies was missing; the strongly rising tax revenues also provided a permissive background for the Labor Government's policy making. From having a combination of tight budgetary policy with an undervalued exchange rate, the economy moved to a situation with a higher and more flexible exchange rate, but much more rapid domestic credit expansion.
The general air of permissiveness extended to the wage fixing authorities, who were in fact urged to grant large wage increases by government, submissions to the 1973 and 1974 national wage cases.[41] A further impetus to wage rises was provided by the phasing in of equal pay for females over the three years following the 1972 national wage case and by various other innovations such as a 17.5% loading for holiday pay; then the adoption of wage indexation tended to put a floor under before tax real wages. After a sharp monetary contraction in the middle of 1974, the thrust of macroeconomic policy was quickly reversed and the exchange rate devalued in an attempt to boost demand; the rapid turn around in policy is likely to have had effects on consumer and business confidence, which, while difficult to quantify, may be quite important. As noted elsewhere, the relationship between increased policy variance and a worsening trade-off between inflation and unemployment is one area where further analysis is indicated.[42]
Footnotes
With demand for credit reinforced by lending rates below market rates. [37]
Although increased uncertainty associated with increased instability may partly or in some conditions wholly offset this negative effect on the demand for money. See Brunner & Heltzer (1971) for a discussion of this issue. [38]
The failure to revalue in 1971 stemmed partly from distributional factors. The country party members of the government coalition were reported to have threatened to leave the government if the rate was revalued. [39]
Gruen also discusses the effects of errors in forecasting, a certain degree of mutual suspicion between the government and the Treasury and the inflationary situation inherited by the Labor administration. [40]
The Labor Government's concern to raise the share of wages provides another example of the weight of distributional objectives being raised relative to that of stabilization objectives for some time. [41]
See Lucas (1973) for a theoretical analysis and a cross-country comparison, and Jonson (1977) for a discussion in the context of recent British experience. The comments in section 4.1 are also relevant. [42]