Economic philosophy under question

In 1958, Bill Phillips identified a direct link between wage movements and unemployment. In 1960, two eminent American economists, Paul Samuelson and Robert Solow, argued that when US unemployment was high, inflation was low and vice versa[ii]. Their research had identified that in the USA, when unemployment was at 5%-6% inflation would be zero. Further, if unemployment was 3%, then inflation would be within the range of 4%-5%. Consequently, the Phillips Curve evidence suggested that by manipulating policy, governments could choose the relationship between inflation and unemployment. Pragmatic monetarism followed.

Over the 1970's, the established interpretation of the Phillips Curve broke down across advanced western economies[iii]. The breakdown of the Phillips Curve encouraged Friedman and others to assert the superiority of micro level theoretical competitive equilibrium theory over established macroeconomics. They argued that the breakdown of the Phillips Curve discredited Keynesian economics and the belief that governments could manipulate tax rates and spending to control the level of employment.

Free market economist argued further that governments could no longer manipulate policy to ensure full employment. As the Phillips Curve relationship had broken down, attempts to vary output through expenditure and tax rates would result in inflation. The free-market school offered a different interpretation of theory. Free market economics combined the Philips Curve with rational expectations to re-establish economic orthodox theory, and the micro foundations of macroeconomics

The rational expectations Phillips Curve argues that there is a unique level of unemployment at which unemployment and inflation will neither accelerate nor decelerate. This level of unemployment is known as the Non-Accelerating Inflationary Rate of Unemployment or NIARU. This theory passed quickly from theory to the world of politics.[iv]

As NAIRU is a supply side phenomenon, it cannot be affected by government policies designed to alter the level of demand in the economy. Consequently, reform of supply side phenomenon in the economy becomes the focus of economic policy. The concept has become very influential across academic circles, financial journalists, and policy makers. However, it is the underlying assumption of rational expectations that holds the key to its relevance in the real world.

Rational expectations asserts that when economic agents make decisions, they learn from past experiences. Whilst some mistakes will be made, correct expectations of the future will dominate decision making.

The importance of the underlying rational expectations assumption cannot be overstated. It is the dominant assumption used in business cycle and finance theory. Moreover, it is the cornerstone of the efficient market hypothesis.

IV Monetary policy in Australia

On election to Government in 1983, the Labor Government renounced monetarism in its pragmatic form; and it was finally abandoned in 1985. Labor saw a wages and incomes policy as the principle means of achieving price stability. Consequently, some mix of a wages policy and monetary policy seemed the way forward. Targeting M₃ was seen as an intermediate target rather than the prime instrument of monetary policy. Neither did the RBA see monetary targets as a realistic operational target. Price expectations were left to the Accord.

Over the late 1980's, monetary policy underwent structural reform. Monetarist principles were incorporated into a new neoclassical synthesis which replaced the old neoclassical synthesis from the 1930's. By 1988, the Australian money supply was redefined from an exogenous variable to an endogenous variable. Monetary policy changed from demand management to supply management. By the early 1990's the RBA moved to employ the cash rate as the supply side policy instrument. Unofficial independence emerged for the RBA to pursue both external and internal balance.

The RBA adopted Inflation targeting in 1993. As rational expectations underwrote the inflation augmented Phillips Curve, NAIRU became the policy objective. The RBA decided that this level of unemployment should lie between 2% and 3% inflation. In other words, Marx's nineteenth century reserve army of unemployed returned to the economic agenda of the late 20^th century.

In 1996, the RBA was granted official independence. Consequently, through monetary and exchange rate policy arms, both internal and external balance became the responsibility of an independent central bank. This effectively removed administration of internal and external balance from voter assessment at election time.

Chart 3 depicts graphically, applied monetary policy from 1993 to 2024