RDP 9105: Inflation in Australia: Causes, Inertia and Policy 4. Short-Run Determinants of Inflation

The above results suggest a possibly significant role for nominal wage growth in the determination of price inflation. The variance decompositions of inflation, reported in Table 2, confirm that this is indeed the case. For Australia, well over half the forecast variance of inflation is explicable by shocks to the growth rate of wages, even after five years. In contrast, shocks to money growth explain only a relatively small proportion of this variance. The contributions of shocks to productivity growth to the forecast variance of Australian inflation are negligible, while the effects of world inflation shocks are only modest. Only initially does inflation itself contribute a large proportion of its forecast variance, indicating (not surprisingly) that the inflation rate responds endogenously to other macroeconomic variables. (On the other hand, Fahrer and Shori (1990) find that inflationary expectations in Australia appear to be largely exogenous.)

The variance decompositions for the other four countries indicate that wages consistently dominate money as explanators of inflation. Some interesting cross-country differences do however arise. New Zealand stands out in that world inflation appears to be a important determinant of its domestic inflation, where it accounts for about 50 per cent of the forecast variance after two years. Productivity growth plays a significant role in Japan and the United Kingdom, but not elsewhere.