RDP 1999-01: The Phillips Curve in Australia 5. Conclusion

In this paper, we have examined the history of the Phillips curve in Australia in the forty years since Phillips first estimated one using Australian data. We focused on the changing perspectives of researchers trying to estimate Australian Phillips curves, as well as on the fluctuating fortunes of the Phillips curve in the intellectual framework used to analyse inflation in Australia within the Reserve Bank.

Several themes stand out from this history. First, from Phillips (1959) onwards, researchers estimating Australian Phillips curves have had to deal with the unique institutional features of the Australian labour market, particularly in the era when the Arbitration Court set both award and minimum wages. As a consequence of the Court's role in that era, it has been particularly difficult to model the evolution of wages in Australia without taking explicit account of arbitrated movements in award wages.

A second important theme is the crucial role of inflation expectations in the Phillips curve framework. Here the Australian experience mirrors that of other countries. In the 1960s, there was a widespread assumption, implicit or explicit, that in response to a change in the trend rate of inflation, inflationary expectations either did not adjust, or adjusted only incompletely. As a consequence, there was a presumed trade-off between inflation and unemployment, even in the long run.

With the deterioration of the inflationary performance in the early 1970s, however, this presumption was challenged, by Austin Holmes in an internal Reserve Bank paper written in 1971, and by Michael Parkin in an academic paper written while he was visiting the Reserve Bank in 1973. In the aftermath of these papers (which drew their inspiration from the 1968 papers of Friedman and Phelps) the idea of a long-run trade-off between inflation and unemployment was soon discredited.

A third recurring theme in the history of the Australian Phillips curve concerns the difficulties posed by the changing level of the non-accelerating inflation rate of unemployment (NAIRU). While it is now clear that the NAIRU was rising rapidly in the early 1970s, this was far from obvious at the time – with Parkin even arguing that it may have fallen since the early 1960s, to be in the range 1½–2 per cent by late 1973. It was not until a few years after 1973 that analysts became confident that the NAIRU had indeed risen significantly.

One response to this problem by researchers estimating Phillips curves had been to simply impose a structural break in the level of the NAIRU, on the basis of an examination of the history of the unemployment rate. An alternative response, introduced into the Australian literature by Debelle and Vickery (1997) and also adopted in this paper, was to estimate the Phillips curve in conjunction with an equation that allows the NAIRU to evolve through time.

Using this approach, we estimated Phillips curves for both prices and unit labour costs in Australia over the past three decades. These Phillips curves suggest a role for both the level of unemployment and its rate of change (‘speed-limit’ effects) in the determination of inflation outcomes. Our results imply that the NAIRU in Australia rose from around 2 per cent in the late 1960s to around 6 per cent in the mid 1970s. Since then, the NAIRU was estimated to have dipped slightly in the mid 1980s, before rising slightly to be around 5½–7 per cent at the end of our sample in 1997.

The difficulty of assessing the actual level of the NAIRU in the early 1970s also played a part in a final theme in the history of the Phillips curve in Australia: its changing influence in the intellectual framework used to analyse inflation within the Reserve Bank.

An expectations-augmented version of the Phillips curve had formed the centrepiece of the analysis presented by Austin Holmes in his 1971 internal paper, ‘Inflation’. This centrepiece was not of much use, however, if one had very little idea about the actual level of the NAIRU, which left the way open for other explanations of the inflationary process to gain prominence. In particular, those based on excess money growth were becoming influential around the developed world. As in other countries, this confluence of events led to a downplaying of the importance of the Phillips curve in the framework used to analyse inflation in the Reserve Bank, and an increase in the focus on money growth.

From the mid 1970s to the mid 1980s, money growth remained at centre-stage, both as an intermediate target for monetary policy, and in the modelling of the inflationary process in the Reserve Bank. With the end of money-growth targeting, a transition period followed, in which the framework for monetary policy gradually evolved.

By the 1990s, however, the intellectual framework for analysing inflation had come full circle. The framework of the 1990s had much in common with the one enunciated in the 1971 ‘Inflation’ paper. The intervening years had led to some refinement of the analysis, but the expectations-augmented Phillips curve had returned and once again was at centre-stage.