Inflation in Australia

This is an earlier report on the quantitative model of  price inflation in Australia. We use our general approach well described in this blog.

To create an inflation model for Australia we use our concept linking inflation solely to the change in labor force. As for other developed countries we use data obtained from various sources. Because of definitional and measuring problems data compatibility over time is not routinely provided by statistical agencies and one has to check for artificial breaks in data series. The OECD reports the following:

Series breaks: A new questionnaire was introduced in 2001 and employment and unemployment series were re-estimated from 1986. From April 1986, employment data include unpaid family workers having worked less than 15 hours in a family business or on a farm. Previously, such persons who worked 1 to 14 hours or who had such a job but were not at work, were defined as either unemployed or not in the labor force, depending on whether they were actively looking for work.
Many central banks shifted their monetary policy to inflation targeting around 1995. This can also introduce a break in underlying time series and the generalized dependence between three economic variables under study. This is the case for France.

The data
Here we introduce the estimates of all variables used in the study. There are two time series for inflation, unemployment and the level of labor force. Figures 1 and 2 introduce the overall behavior of all time series.

Figure 1. Upper panel: Comparison of CPI inflation and GDP deflator in Australia. Lower panel: Comparison of two estimates of unemployment according to US and OECD definitions.

Figure 2. Comparison of two estimates of the change rate of labor force level – according to the OECD and US definition (BLS).

The Phillips curve
Here we plot the rate of unemployment in Australia against reduced CPI inflation. The period between 1974 and 1994 shows a relatively good agreement, but then the curves diverge. This might be related to the new central bank monetary policy, as observed in France. All in all, the Phillips curve does not exist in Australia for the entire period between 1978 and 2009, i.e. for the period of accurate measurements presented by the Australian Bureau of Statistics.

Figure 3. Upper panel: Comparison of the measured unemployment (US definition) and that predicted from the CPI inflation according to the relationship obtained in the lower panel. The curves are close between 1974 and 1994. The following deviation might result from changes in monetary policy after 1994 and also be associated with revisions to corresponding definitions and measuring procedures. Lower panel: Scatter plot and linear regression of the CPI inflation and unemployment between 1974 and 1994.

Inflation as a linear function of the change in labor force
According to the change in definition of labor force in 1986, as described above, we have slit the period after 1978 (the start of reliable measurements (as reported by the Australian Bureaus of Statistics) into two segments and obtained the following models for inflation (GDP deflator) :

DGDP(t) = 4.2dLF(t)/LF(t) – 0.042; t>1985
DGDP(t) = 7.8dLF(t)/LF(t) – 0.024; t<1986 (1)

Figures 4 and 5 display the observed DGDP curve and that predicted according to (1).

Figure 4. Modeling of unemployment using the change rate of labor force level. Coefficients in the linear relationship are presented in the text and obtained by the trial-and-error method to fit the cumulative curves in Figure 5 between 1978 and 2009.

Figure 5. Modeling the cumulative GDP deflator as a function of the change rate of labor force level. The break in 1985 is explained by the changes in definition the labor force definition and corresponding measurement procedure.

Figure 6. Absolute and relative modeling error for the cumulative inflation in Figure 5. The curves converge in relative terms and one can replace the price deflator with the growth in labor force with the accuracy incrasing with time.

Generalized model for the link between labor force, inflation and unemployment
Because of breaks in the definition of labor force and unemployment/inflation relationship in 1995 (as shown in Figure 3) we spit the entire period of modeling into three segments:

CPI(t) = 3.9dLF(t)/LF(t) +0.88UE(t) - 0.1; t>1995
CPI(t) = 3.9dLF(t)/LF(t) +0.97UE(t) - 0.1; 1985
CPI(t) = 8.3dLF(t)/LF(t) +0.97UE(t) - 0.1; t<1986 (2)

Figure 7 presents the model.

Figure 7. Upper panel: Illustration of the generalized relation between inflation, unemployment and the change rate of labor force leveling Australia. The CPI inflation is modeled using the change rate of labor force level and unemployment. Lower panel: Cumulative curves use to estimate all coefficients in defining relationships (2).

Price inflation in Australia is a one-off function of the change in labor force. This conclusion validates earlier models for many developed countries: the US, Japan, Germany, France, Italy, Canada, the Netherlands, Sweden, Austria, and Switzerland.

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