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Section III.C

Causality Issues

When discussing the differences of coefficients between the periods the main concern is the effect that inflation targeting has had in reducing inflation in these countries. As Table III.4 shows, many of these countries introduced inflation targeting in the 1990’s, and were able to reduce inflation with little change of unemployment simply as a result of the increased credibility. Thus there may be many values which report a fall of inflation even without a change of unemployment which will bias the result. These fortunate results will only occur during the first few years of inflation targeting; as a result it is necessary for more years to pass before it can be confidently said that the Phillips curve relationship has been severely dampened. As an extension it would be useful to introduce some form of dummy or structural break to account for the introduction of targeting in these countries

Table III.4

Additionally, it may be possible that there is an element of reverse-causality, whereby inflation is affecting unemployment. Although contended, this is mentioned by Akerlof, Dickens and Perry (2000) who posit that there is an optimum level of inflation.

Finally, there is the likely omitted variable bias as a result of the other factors that contribute to inflationary pressures which were mentioned earlier.

Policy Implications

As can be seen the significant differences between the two periods suggest that there has been a flattening of the SRPC relationship. Although it is too early to consider this a lasting relationship, it is useful to postulate what this may mean for policy makers if it continues.

Firstly, as a result of the reduced sacrifice ratio it is now increasingly in the policy maker’s interest to experiment with lowering the unemployment rate, since testing the water can be now be achieved with little cost.

Second, because much of this change can be attributed to the introduction of inflation targeting and central bank independence, is there a need for a different approach to unemployment policy? It may be possible that the unemployed are being denied jobs because policy makers are clinging to old models which have not yet accumulated a record of failure, when a better model or policy may be available. With inflation under control in many of these countries, there is little need for contractionary policy except to keep expectations anchored, and thus policy makers should be able to focus primarily on reducing unemployment, either via eliminating structural factors or facilitating wage decisions and job matching. Furthermore, because this relationship is starting to hold over the medium term there may be implications for fiscal policy, which takes longer to take effect.

Third, given that the U-NAIRU test of Section III.B was outperformed by the unemployment level test, as well as the fact that the NAIRU estimate has a large standard error, it is necessary to question the use of the NAIRU as a signal for monetary policy. Successive over-estimation, as was seen in some countries in the 1990’s, may lead to expansion opportunities not being exploited if the firms in the economy believe that monetary policy will be conducted based on the over-estimated NAIRU value.

Fourth, there may be other factors at play that are keeping inflation low. For example, the increase of global competition and trade has put a ceiling on the wage demands of some low skill labourers, since their employer may outsource or move production abroad. In addition, cheap production abroad has lowered import prices, and puts a ceiling on tradeable items in the domestic economy[1]. Further, the rise of the digital economy has raised productivity, improved the facilitation of commerce and job-matching and introduced new employment opportunities, which may lower the level of structural unemployment.

Whether these favourable conditions will hold is important, a return to protectionism for example may see the Phillips curve relationship strengthening again.