Traditional macroeconometric models of the Australian economy estimate the behaviour of wage and price inflation separately, thereby ignoring the possibility that there is a contemporaneous relationship between these two variables. This thesis follows a recent trend emerging in other small open economies, such as the UK and Norway, which is to estimate the behaviour of wage and price inflation in a simultaneous-equations model. In order to capture the behaviour of the major variables which drive wages and prices, a complete model is constructed which embeds these important transmission channels.
The model is developed in three stages. First, underpinned by a theoretical framework of a unionized economy with imperfect competition, the core wage- price system is developed whereby consumer prices and average weekly earnings are jointly estimated in a simultaneous-equations framework. Particular atten- tion is given to estimating two identified cointegrating relationships for wages and prices. These equations are interpreted as the long-run targets of workers and firms respectively and are embedded in a parsimonious system of short-run dynamics which drive wages and prices towards their long-run levels.
Second, llie behaviour of llie main feedback variables driving llie wage-price system is modelled, with particular attention given to the unemployment rate. While several of the most recent models of unemployment show that the aggregate unemployment rate in Australia does indeed behave differently during periods of low and high unemployment, none can explain what drives the unemployment rate to increase at such a rapid rate and what contributes to its much slower decrease. Another central issue of this thesis, therefore, is to propose a rationale for this as yet unexplained phenomenon. The remaining behavioural variables in the model, including aggregate labour productivity, domestic output and the real exchange rate, are all estimated in a single-equation framework.
Third, these equations are then combined with a number of important identi- ties and an interest-rate reaction function to close the model. Then, the impacts of several simulated economic scenarios on Australia's economic landscape are considered. Special emphasis is given to analysing the impact of a large nomi- nal wage shock. The outcomes from these simulated scenarios are pertinent to understanding the inflation process and have important implications for a small open economy like Australia with an explicit inflation target.
Overall, the major result to emerge from this thesis is that there is significant statistical support for the hypothesis that wage and price inflation in Australia are jointly determined. This phenomenon has not yet been fully exploited in current macroeconometric models of the Australian economy. The modelling exercise also reveals that the Australian unemployment rate is linear in demand and labour productivity shocks, with nonlinear behaviour caused by real wage rigidity and generous unemployment benefits. Importantly, this simple model is able to simulate the behaviour of the Australian economy extremely well. The outcome from the policy scenarios is clear: both demand-side and supply-side shocks have real and nominal effects on the economy in the short- to medium- run, ceteris paribus. Moreover, a large nominal wage shock to the economy, which results in a real wage rise, will have no sustained effect on the level of domestic activity in the economy, the inflation rate or the real exchange rate. Unemployment is, however, pushed slightly above equilibrium in the short- to medium-run due to a sustained higher real wage level.
