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Methodology

In order to understand the test it is necessary to briefly explain the concept of the Natural Rate and the SRPC. Originally coined by Friedman (1968) the natural rate concept states that there is a unique rate of equilibrium unemployment where inflation is stable. This is determined by structural supply-side factors in the economy, primarily the intersection of the labour supply and labour demand curves. Even though this concept is derived under a perfectly competitive general equilibrium framework, the labour market does not clear as a result of imperfections. These include job mismatching, the level of benefits, the effect of tax on earnings, the power of wage bargainers, efficiency wages, and the elasticity of product demand for firms.

Since the economy has a positive equilibrium rate of unemployment, the theory postulates that if unemployment falls below this level then inflation will accelerate as long as unemployment is below the natural rate. Conversely if unemployment is above the NAIRU then inflation will decelerate as long as it is above this level. As a result, the relation should be similar to that of Figure II.1, which is the relationship that will be tested for in Section III.A. This is represented by equation 2.1.

Figure II.1

(Equation 2.1) π = α + β(U) + ε

π = Inflation (2 year average)

U = Unemployment level

In accordance with the theory, the value of β should be negative, which will be tested using an OLS regression and the use of t-statistics.

Despite the advancements of information processing and financial markets over the last few decades the consensus[1] still agree with Friedman’s (1972) evidence that because of rigidities in the economy it takes around two years for the full effects to inflation to be felt, with the peak effect taking place after one year. Consequently, in this study the inflation values will be an average of the inflation at the time, the inflation one year after, and the inflation two years after (t, t+1, t+2), in order to accommodate the lag. An average was chosen rather than using separate variables for each year because it was difficult to find significant results when each year was analysed separately.

Although this analysis can be seen as being overly simple, including other factors that contribute to inflationary pressures such as commodity prices and financial indicators (which include exchange rates, interest rate differentials and monetary aggregates) were insignificant the majority of the time, and thus not included in order to increase the already small number degrees of freedom and provide a consistent method for the test. It was surprising to find little relationship between oil prices and inflation, considering the marked correlation of the 1970’s. This can be seen in Figure II.2 which demonstrates how the relationship deteriorates from the mid 1980’s[2].

Figure II.2

For Section III.B the premise is to study in greater detail the unemployment-inflation trade-off, by taking into account the movements of the NAIRU from 1990-2003. Hence the equation regressed will be:

(2.2) π = α + β(U-U_n) + ε

By allowing for the changes in U_n in accordance with the estimate, it is hoped that the unemployment related inflation changes can be tracked with better precision and that a stronger SRPC relation can be extracted from the data. How much this improves the accuracy is difficult to estimate, especially considering the tendency of the natural rate estimates to follow the actual unemployment rate. Palley (1998) carries out a regression of OECD unemployment rates which shows that every 1% increase of the actual rate raises the NAIRU estimate by 0.915%.

This relationship will also be tested by OLS regression, and whether β is significantly negative will be analysed with t-statistics. The inflation values are taken as the average of 8 quarters inflation (t,t+1….t+8)