RDP 7702: Inflation and Economic Stability in a Small Open Economy: A Systems Approach 1. Introduction

In the past six years, Australia has experienced its third major inflation of the twentieth century. It has shared this inflationary episode with the rest of the world, but in several ways its experience has differed from that in earlier times and in other countries. Indeed, the recent Australian experience offers evidence of the effects of several impulses: the worldwide inflation impinging on an economy which initially maintained a relatively fixed exchange rate and then first revalued and later devalued its currency; strong expansion of the government sector, with government outlays, tax receipts, and the budget deficit increasing rapidly; a wage explosion generated to a considerable extent by large increases in centrally determined wages; and rapid increases in credit which, with the monetary effects of the other impulses, raised the monetary growth rate from an average annual rate of 8% in the 1960's to a maximum of 26% in 1972/73, and around 15% for about the last four years. The net effect of these impulses has been an entrenched inflation, a marked cycle in real product and an unemployment rate which is approximately three times the average for the 1960's.

It is difficult to disentangle the effects of the various interrelated impulses. Nevertheless, analysis of a structural model of the Australian economy yields some tentative judgements about the proximate role of the various factors listed above. Before presenting this analysis it is put into perspective in section 2 by an overview of recent economic experience. Then in section 3 simulation analysis of this experience is presented, using an aggregate macroeconometric model, with the usual stock and flow adjustment mechanisms, some innovatory monetary feedbacks and allowance for the centralized wage fixing institutions in Australia. Section 4 discusses the interdependencies among the impulses examined in section 3 and section 5 draws some conclusions.