The Economic Situation

Throughout the first nine months of 1976 the Australian economy has remained virtually stagnant, with output and employment increasing only marginally and unemployment rising also. With the government following a severely contractionary policy in an attempt to break inflation the economy seems poised for a further modest downturn in the next nine months so that a self-sustaining recovery from the current recession does not seem to be in prospect before the second half of 1977. On the basis of existing policies our forecasts indicate a rate of growth of real GDP of only about 1.0 per cent in 1976–77, implying a further significant rise in unemployment during the financial year. There have been some hopeful signs in recent months of a reduction in inflation — the consumer price index increases in the first three quarters of 1976 were modest and wage rate increases remain closely in line with the wage indexation guidelines — but three factors have emerged to cast doubt on whether this improving trend will continue. The first is the effect of the recent drought on prices of foodstuffs, particularly meat, and the second is the expected 1.5 to 2.0 per cent increase in the consumer price index as a result of the changes in the method of financing hospital and medical services. These two factors mean that the December quarter increase in the consumer price index may be more than 5 per cent, threatening a further stimulus to inflation in 1977. Thirdly, present government policies could easily lead to a breakdown of the wage indexation system and a return to some form of collective bargaining over wage rates. Assuming nevertheless, a de facto continuation of partial indexation in 1977, we expect increases in male award wages and male average earnings of about 13 per cent during 1977, these increases being similar to those during 1975 and 1976 but much below the increases of 36 per cent and 28 per cent respectively recorded during 1974. Our forecasts also indicate increases in the consumer price index of 14 per cent during 1976 and 11 per cent during 1977, following increases of 16.3 per cent and 14.0 per cent during 1974 and 1975 respectively. These forecasts indicate that the government's fiscal, monetary, exchange rate and wage policies are likely to come under heavy challenge early in 1977, and decisions taken at that time are likely to be major determinants of economic developments in Australia in the next few years. The Institute would again urge a shift to a co-operative package including full wage indexation, with cuts in indirect taxes and public sector charges to wind down inflation and expand the economy. On current indications, labour productivity will be no higher in 1976–77 than in 1973–74, because of the weakness of total output, so that the whole burden of wage increases in that three year period has fallen on unit costs of production. It is our belief that the twin problems of inflation and unemployment will only be defeated in Australia when both cuts in indirect or direct taxes and increases in productivity are applied to reducing inflation in the context of an orderly system of wage and price determination.     

The Australian Economy after Devaluation

Before taking account of the measures announced by the government on and after 28 November 1976, the latest statistical information suggests that the economy was broadly on the course outlined in detail in Review 3'76. Both business investment and consumer demand appear to have fallen in real terms, seasonally adjusted, in the last few months. With public sector demand also weak the economy was moving Into a new period of modest decline in overall activity, so that real non-farm GDP was expected to grow by 1 to 2 per cent in 1976–77 and by only 1 per cent in calendar 1977. The rate of inflation has moderated in the first three quarters of 1976 and, in spite of the large increase in the consumer price index expected in the December quarter and the granting of full percentage wage indexation for the September quarter, the rate of inflation seemed likely to be lower in 1977 than in 1976.     

An Analysis of the Effects of Recent Changes in the Exchange Rate and the Terms of Trade on the Level and Composition of Economic Activity

Over the eighteen-month period ending June 1986, the Australian economy experienced two major shocks: a nominal devaluation of the $A of some 28 per cent and a terms of trade decline of some 16 per cent. The effects of these influences are examined using the ORANI model of the Australian economy. The effects of the devaluation on selected macroeconomic variables and key sectoral variables are presented for various degrees of wage indexation. Effects on quota rents are calculated and compared with actual outcomes. The terms of trade decline has an adverse impact on the balance of trade and in order to offset this impact while maintaining aggregate employment demand the model calculates that both real wages and real absorption would need to be around 4 per cent less than the values they would otherwise take.     

Union objectives and indexation externalities in a monopolistically competitive economy

This paper extends the literature on indexation externalities by analyzing equilibrium and efficient indexation in a unionized economy characterized by a monopolistically competitive goods market. The assumption that union objectives relate to both employment and the real wage implies that union indexation decisions are associated with a negative externality and, as a consequence, the equilibrium degree of indexation is inefficiently high. This feature is characteristic of both passive and activist policy environments.     

Wage Indexation, Employment and Inflation

Price versus productivity-indexing is considered in a model of monetary policy with incomplete information and wage bargaining. In a perfectly price-indexed economy, the inflationary bias due to lack of credibility is eliminated. However, productivity-indexing is more appropriate to dampen macroeconomic fluctuations that are caused by real disturbances. We show that productivity-indexing alone guarantees both price and employment stability, provided the government's reputation is good enough and the union's bargaining power is not too strong. This reduces the degree of price indexation as the union becomes weaker and the government's reputation improves. Productivity-indexing is desirable with volatile productivity processes and weak unions.
JEL classification : E 24; E 52     

The Macroeconomic Outlook

This quarterly two-year forecast from the Access Economics Murphy (AEM) model updates that presented in the corresponding article in the 4th quarter 1991 issue of the Australian Economic Review.
As predicted in the previous forecast, the economy entered a slow recovery in the December quarter of 1991. Steady growth averaging close to 1 per cent per quarter is likely during 1992–93 and 1993–94.
Unemployment may peak at around 10 3/4 per cent in mid-1992, before slowly falling to a year-average level of around 9 per cent in 1993–94.
Under the influence of the recent recession, CPI inflation is likely to be around 2 per cent per annum on a year-on-year basis for both 1991–92 and 1992–93. With economic recovery, it is forecast to rise to 4.5 per cent per annum in 1993–94.
While the recession has helped bring the current account deficit down from near 6 per cent of GDP in 1989–90 to around 3 per cent for 1991–92, it will rise with economic recovery, and is forecast to exceed 5 per cent of GDP by 1993–94, compared with a sustainable level of 3 to 3 1/2 per cent.
The economic recovery is not proving to be as strong as forecast in One Nation.
However, there is a recovery clearly underway, and any further easing of monetary and fiscal policy risks prejudicing a substantial part of the recent impressive gains on inflation and creates a major medium-term problem for public finances.     

Implications of Economic Interdependence for Endogenous Wage Indexation Decisions

This paper shows how economic interdependence affects the indexation decisions of atomistic wage setters in an environment in which monetary authorities do not observe stochastic disturbances before making their policy choices. If stochastic disturbances are common across countries, interdependence has no effect on equilibrium indexation choices in identical countries. However, if disturbances are country specific, numerical simulations show that interdependence is likely to reduce equilibrium indexation choices relative to a small open economy. We also show that indexation choices may be either strategic complements or strategic substitutes, but that strategic complementarity becomes more likely as the degree of interdependence rises.     

The International Economy — A Survey

In most of the major world economies the hesitancy evident toward the end of last year has dissipated and the cyclical upswing in economic activity was well advanced by the middle of 1976, with the recovery showing particular strength in the first half of 1976 inthe United States and in West Germany. Even so industrial production had not yet returned, by the end of June 1976, to the previous cyclical peak in any of the major economies. With the OECD countries in aggregate sure to achieve a real growth rate of 4 per cent in 1976, and quite possibly an appreciably higher rate, the attention of many national and international policy makers is turning to ways of moderating the recovery so that inflationary pressures can be minimised. For in spite of the depth of the 1974/75 world recession the outlook for inflation remains threatening, much more so than at the corresponding stage of the previous cycle in 1972. In the twelve months to May 1976 consumer prices rose by 9.0 per cent in all OECD countries and this figure is disturbingly high for the trough of a serious recession. World commodity prices have risen about 35 per cent in dollar terms in the past year; as in the 1973–74 boom the major economies are now moving into an upswing simultaneously, thus compounding possible demand effects on inflation; business investment has fallen sharply in all countries during the recession, and only in the United States is a strong recovery in investment currently in evidence. The rate of growth of wages has however moderated in most countries, reflecting weak labour market conditions, lower consumer price increases and in countries such as United Kingdom and Canada the successful implementation of incomes policies. With output increasing, the rate of growth of unit wage costs has in most cases dropped sharply.     

Real wage rigidities and optimal monetary policy in a small open economy

The main objective of the study is to provide a theoretical analysis of optimal monetary policy in a small open economy where households set real wage in a staggered fashion. The introduction of real wage rigidities plays a important role to resolve main shortcomings of the standard new Keynesian small open economy model. The main findings regarding the issue of monetary policy design can be summarized as three fold. First, the optimal policy is to seek to minimize variance of domestic price inflation, real wage inflation, and the output gap if both domestic price and real wage are sticky. Second, controlling CPI inflation directly or indirectly induces relatively large volatility in output gap and other inflations. Therefore, both CPI inflation-based Taylor rule and nominal wage-inflation based Taylor rule are suboptimal. Last, a policy that responds to a real wage inflation is most desirable.     

The effects of indexation of wage contracts on macro-economic stability

The paper develops a simple analytical framework in which the shortrun affects of wage indexation on the dynamic stability of inflation can be analyzed. It consists of a unlonized labor market faced by a competitive demand. Without indexation, the wage contract is based upon the union's prediction of the price level during the period of the contract. With indexation, the same objective is achieved by contracting only once at some initial period, subject to the stipulation that the nominal wage is linked to the price level. The main result is that when the demand for money is sensitive to changes in the expected rate of inflation, nominal variables like prices and wages are more likely to yield an unstable dynamic response with wage indexation, thus endangering the monetary system.     

Intergenerational consequences of gradual pension reforms

Balancing the government budget in an aging economy may require adjusting gradually pension benefits. Such policy change can take two forms: adjusting the accrual rate (the rate at which individuals built-up pension entitlements while working) or the indexation rate (the rate a which accrued entitlements are linked to nominal wage growth). We compare the consequences of such gradual policies across cohorts. We identify a fundamental generational trade-off between democracy and equality. In particular, we show that for Belgium, 80% of the population alive at the time of the reform prefers the accrual to the indexation reform, with the implication that the youngest half of the population would bear 85% of the total adjustment cost. The indexation reform provides more generational equality because the phasing in over time has larger base and thus benefit cut can be smaller per capita. We then consider other reforms improving the generational equality, showing that all those reforms fail to gain majority support. Finally, considering labor incentives, we show that the indexation reform is also more efficient than the accrual reform. Efficiency meets generational equality.     

Macroeconomic Policy and the Current Account in an Open Economy with Partial Wage Indexation*

In Australia the practice of partially indexing wages has become an art form. While open economy macroeconomics has been extended by various authors to the indexed wage case, none highlights the distinctive effects of partial indexation. This paper examines short-and long-run consequences of partial indexation. The standard conclusions that partial indexation is conducive to growth and that fiscal policy with partial indexation is expansionary are seriously questioned     

The importance of composition of fiscal policy: evidence from different exchange rate regimes

We study the macroeconomic effects of fiscal policies in an open economy. We emphasize two transmission mechanisms: the cost channel, by which wage government spending and labor taxes raise the real wage firms must pay, and the exchange rate channel, by which the nominal exchange rate shifts induced by fiscal policy have real effects if (some) prices and wages are sticky. The latter channel implies that changes in wage government spending or in labor taxation should have different effects under flexible than under fixed exchange rates. In a 1964–93 panel of OECD countries we find significant evidence for both channels. Moreover, we find that the real product wage and profitability are more responsive than quantities (employment and output) to fiscal policy innovations.     

The Macroeconomic Outlook

A slow recovery is expected from the current recession. Since reaching a trough in the September quarter of 1990, real gross domestic product (GDP) has followed a flat path which is likely to continue through to the September quarter of 1991. A slow recovery may then commence in the December quarter of 1991. This is consistent with real GDP growth of -0.9 per cent in 1990-91 followed by 2.4 per cent in 1991-92 and around 3 per cent per annum to the mid- 1990s compared with 'normal' growth of 2.5 per cent per annum.
This recovery is likely to see the unemployment rate at over 10 per cent for most of 1991-92, before moving to around 8 per cent by the mid-1990s.
Inflation may fall sharply from a peak of 8.0 per cent in 1989-90 to a trough of 3 to 4 per cent in 199 1–92, due to the recession and movements in oil prices. With a slow recovery, inflation may increase to 4 to 5 per cent per annum in the medium term.
The current account deficit has fallen from 5.9 per cent of GDP in 1989-90 to a likely level of 4.1 per cent in 1990-91, but part of this gain is cyclical rather than structural. Thus the deficit is expected to increase to around 5 per cent during recovery and remain flat to the mid- 1990s, implying steady increases in the ratio of foreign debt to GDP.
Looser monetary policy would erode part of the forecast sustained reduction in inflation. Looser fiscal policy would lead to a higher current account deficit.     

The Output-inflation Tradeoff and Central Bank Reform: Evidence From New Zealand

The 1989 Reserve Bank of New Zealand Act provides a natural experiment in which the effects of institutional change on economic relationships can be studied. The Act set price stability as the single objective of monetary policy and gave the Bank great independence. Reforms of this nature may lead to a greater short-run output-inflation tradeoff by altering optimal stabilisation policy and wage indexation. Allowing for environments where 'learning' about the new regime is assumed to be rapid as well as slow, we find that a large rise in the New Zealand tradeoff has occurre d since implementation of the Act     

WELFARE COSTS OF SHIFTING TREND INFLATION: STAGGERED WAGE AND PRICE CONTRACTS

We develop a New Keynesian model featuring staggered price and wage contracts to study welfare costs of exogenous variations in trend inflation. The analyses show that the consequences of constant positive trend inflation and shifting trend inflation are severe, especially when trend inflation is high. Among two channels, staggered wage contracts play a vital role in transmitting adverse impacts of constant and shifting trend inflation into the economy. Without the staggered wage channel, these costs are modest. We also conduct exercises to examine the sensitivity of welfare costs to a wide range of plausible parameters. The results show that if the price and wage friction are sufficiently large, the price and wage indexation level are sufficiently small, or there is upward biased trend inflation process, the welfare costs become larger.     

A dynamic macroeconomic model with monopolistic behavior in the labor market

Is the monopolistic behavior of a wage setting labor union compatible, in the long and in the short run, with price stability and full employment? What is the effect, if any, of economic policies? The answers are strongly affected by the prevailing technology and by the union's objective function. With limited short run production possibilities, a short run trade-off may exist between full employment and maximum expected real wage revenues. In the long run, however, when expectations are fully adjusted, this trade-off disappears. Therefore, a labor union consistently pursuing maximum short run expected real wage revenues may not maximize long run effective real wage revenues. Price stability is granted in the long run, provided inflation is not induced by public policy. The only instrument a pure consuming government has to fight long unemployment is to reduce its share of aggregate demand.     

Cyclical implications of indexing the minimum wage

Macroeconomic implications of proposals to index the minimum wage are examined in a two-sector labor-market model with random aggregate demand disturbances. Traditional policy, which sets the nominal minimum wage for several periods before reestablishing its real value, increases both the amplitude and persistence of cyclical movements in employment. Full indexation, by reducing the amplitude of cyclical fluctuations in employment, will improve the allocative performance of low wage market empirical analysis indicates that modest but statistically significant fluctuations in employment result from the process of periodically setting the minimum wage. These effects are most pronounced for youths. Overall, the empirical results suggest that indexation can result in a small increase in efficiency.     

Chapter 3. Domestic Demand — Household, Business and Public

Real public sector demand rose by 1.9 per cent in 1976–77 and we have forecast a similar rise in 1977–78. However, when real public demand is adjusted to exclude expenditure by Qantas for the deliveries of planes real growth is only about 1 per cent. This picture is slightly more optimistic than the one presented in Review 2'77 when we forecast a decline of 1.5 per cent in real public sector demand. For the second half of 1978 we have assumed an annual rate increase in real total public sector demand of about 4 per cent.     

Macroeconomic effects of fiscal policy changes: A case of South Africa

This study develops comprehensive full-sector macro-econometric models for the South African economy with the aim of explaining and providing the macroeconomic effects of fiscal policy changes in the country. The models are applied to test the effectiveness of fiscal policy actions in an economic environment with existing structural supply constraints versus demand-side constraints and also to detect which components of the fiscal would be more effective in stabilising the economy. Based on the structure of the South African economy and the framework presented, the study concludes that the South African economy can be characterised as one which is embedded with structural supply constraints. Thus, a model which is suitable for policy analyses of the South African economy needs to capture the long-run supply-side characteristics of the economy. A price block is incorporated to specify the price adjustment between the supply-side sector and real aggregate demand sector. The models are estimated with time-series data from 1970 to 2011, capturing both the long-run and short-run dynamic properties of the economy. The results from the series of fiscal policy scenarios suggest that fiscal policy actions are more effective in an economic environment with limited or no supply constraints. Fiscal expansion or consolidation that comes more from government spending changes will be more effective in an economic environment where structural supply constraints are absent while tax revenue changes will be more effective in an economic environment where there exist major structural supply constraints.