Download The relative effectiveness of fiscal and monetary

University of Wollongong
Research Online
Faculty of Business - Economics Working Papers
Faculty of Business
1993
The relative effectiveness of fiscal and monetary
policy on inflation and unemployment: the
Australian experience
Kui Yin Cheung
University of Wollongong
Lillian Cheung
University of Wollongong
Recommended Citation
Cheung, Kui Yin and Cheung, Lillian, The relative effectiveness of fiscal and monetary policy on inflation and unemployment: the
Australian experience, Department of Economics, University of Wollongong, Working Paper 93-1, 1993, 11.
http://ro.uow.edu.au/commwkpapers/282
Research Online is the open access institutional repository for the University of Wollongong. For further information contact the UOW Library:
[email protected]
the
u n iv e r s it y
OF W O L L O N G O N G
DEPARTMENT
OF E C O N O M I C S
T h e R el a t iv e E f f e c t iv e n e s s
F is c a l and M o n e t a r y P o lic y
on I n f l a t io n an d U n e m p l o y m e n t :
t h e A u st r a lia n E x p e r ie n c e
of
Kui Yin Cheung
Lillian Cheung
IS S N 1035 4581
WP 93-1
IS B N 0 86418 248 1
THE RELATIVE EFFECTIVENESS
OF FISCAL AND MONETARY POLICY
ON INFLATION AND UNEMPLOYMENT:
THE AUSTRALIAN EXPERIENCE
Kui Yin Cheung
Lillian Cheung
Department of Economics
The University of Wollongong
Northfields Avenue
Wollongong NSW Australia
Coordinated by Dr C. Harvie & Associate Professor M.M. Metwally
Working Paper Production & Administration: Robert Hood
Department of Economics, University of Wollongong
Northfields Avenue, Wollongong NSW 2522 Australia
Department of Economics
University of Wollongong
Working Paper Series WP 93-1
ISSN 1035 4581
ISBN 0 86418 248 1
In this study, we apply the J-test to a
simple IS-LM model to test the relative
effectiveness of fiscal and monetary
policy on inflation and unemployment
for the Australian economy over the
period 1961-1990. Empirical ecvidence
shows that there exists no significant
relationship between the supply of (or
demand for) money with inflation and
unemployment. It is fiscal policy which
is effective in managing both inflation
and unemployment.
I
Introduction
Since the early 1970s, Australia has experienced high rates of
inflation, relatively weak economic growth and rising
unemployment.1 The purpose of this paper is to compare the
relative effectiveness of the fiscal and monetary policies in
controlling inflation and unemployment. Hence, we have two
hypotheses: the Keynesian model and the monetarist model
for inflation and unemployment respectively. When the
emphasis is on the supply of (or demand for) money as the
sole contributing factor of inflation and unemployment, we
have what is known as the monetarist approach. On the other
hand, when the emphasis is only on taxes and government
expenditures as the main determinants of inflation and
unemployment, we come to what has been called the
Keynesian approach.2 The validity of these models is being
tested here by employing the J-test proposed by Davidson and
MacKinnon (1981) on the time series data of Australia for the
period 1961 to 1990. However, the 1983 Accord might have led
to a structural change in the economy and affect the
relationship between fiscal and monetary policies on inflation
and unemployment. Therefore, before applying the J-Test, a
test for structural change would be carried out by using the
dummy variables devices. The structure of the paper is as
follows: the 1983 Accord is described in next section. Section III
discusses the model and the properties of the J-test, while
Section IV gives the empirical results. Conclusion is given in
Section V.
1
2
OECD Economic Surveys (Australia) 1983-84, June 1984, p. 7.
See Dombusch and Fischer (1982), and Perkins (1982).
n.
The Accord
In February 1983, a Statement of Accord by the Australian
Labor Party and the Australian Council of Trade Unions
regarding economic policy was ratified by a special conference
of unions. The main elements of the Accord include support
for a centralised system of wage determination and the
establishment of a Price Surveillance Authority. Agreement
was also reached that the maintenance of real wages should be
a key objective, although this should be an objective over time
in a. period of economic crisis.^
The policy adopted by the Government elected in March
1983 differed substantially from those in earlier years in that
inflation and unemployment were dealt simultaneously with
consultation and consensus. The Government pursued a
degree of fiscal stimulus in the 1983-84 Budget, combined with
broadly neutral monetary policy to avoid the potentially
inflationary effect of fiscal stimulus. The Accord argued for a
return to centralised wage fixation, and with government's
support for full cost of living adjustments. Unions, however,
agreed to consult government when formulating claims.4 To
aid the prices and incomes agreement, a Price Surveillance
Authority has been established to monitor prices nationally in
areas where competition were limited. In short, the approach
consists of an expansionary fiscal policy, a non-inflationary
monetary policy and an accord on prices and incomes with the
trade union. As a result, it provides a brake on inflation and
avoids upward pressure on interest rates.5
3
ibid., p. 59.
4
Maxwell, P., p. 236.
5
op. cit., OECD Economic Surveys (Australia) 1983-84, p. 26.
HL The J-Test
Consider the following two linear non-nested regression
models: the Keynesian and monetarist models of inflation and
unemployment respectively. The possible determinants of the
monetarist inflation model include money supply, which can
be specified simply as
Ho: P = ctg + OjM + ^
On the other hand, the determinants of the Keynesian
inflation model consists of tax receipts and government
expenditure. This can be written as
H j: P = Pq + p^T + P2G + ^2
In order to apply the J-test, we specify a maintained
hypothesis Ho and the alternative H i. Since H i is not nested
within Ho and that Ho is not nested within H i, therefore, the
truth of Ho implies the falsity of Hi and vice versa.£ In other
words, this suggests that there is information in Hi that can
significantly improve the explanatory power of Ho. We are,
therefore, led to ask whether Ho is adequate. For instance, the
equation for testing between money supply (or Ho) and taxes
(or H i) as the possible cause of inflation can be presented as
P = (l - AXoq + ctjM) + xf* + v
where X is a mixing parameter, and
(the rate of inflation) under H i:
6
P is the OLS predictor of P
op. cit., Davidson, R. and J.G. M acKinnon, 1981, p. 782.
P=lWiT
where T is independent of v by assumption, and Pi is also
asymptotically independent of v, since the influence of any
particular error terms on the estimates tend to zero as the
sample size tends to infinity. Hence, J3 will be independent of v
and thereby the significance of \ can be tested by using the
conventional asymptotic t-test.7 If Ho is true, the true value of A,
-Is zero. The t-statistics of A, are conditional on the truth of Ho
rather than H i. Therefore, a t-statistic which is valid for testing
the truth of Ho will not be valid for testing the truth of H i. In
order to test H i, the roles of Ho and Hi can be reversed, and the
test is to be carried out again.8
In this paper, we specify six hypotheses and their six
alternatives for testing the cause of inflation and
unemployment respectively, which can be written as follows:
Monetary policy as maintained hypothesis:
1. Ho: Monetary policy
H i: Tax (T)
2
H i: Government expenditure (G)
Ho: Monetary policy
3. H o; Monetary policy
H i: fiscal policy (T and G)
Fiscal policy as maintained hypothesis:
4
7
8
Ho: Tax (T)
H i: Monetary policy
5. H o: Government expenditure (G)
H i: Monetary policy
6. Hq : Fiscal policy (T and G)
H i: Monetary policy
ibid.
ibid., p. 783.
IV.
Empirical Findings
The 1983 Accord might have caused possible changes in the
structure of the economy. It would be expected that response of
inflation and unemployment to fiscal and monetary policies
would be different in the pre- and post-Accord 1983 periods. A
test for this structural change is being carried out here by using
dummy variables. Consider the simple IS-LM model of a
policy mix of inflation,
P t= ao + aiTt + o^Gt + (X3Mt + eit
where
Pt = the rate of change in the inflation rate
Tt = the rate of change in total government tax
receipts
Gt = the rate of change in total government
expenditure
Mt = the rate of growth in money supply, M2.
The unrestricted equation becomes
Pt = Po + P lD + P2T t+ P3DT t+P4G t+ P 5 D Q + = P6Mt + PzDM t + eit
where
0 for the pre-1983 period
1 otherwise
Similarly, the unrestricted equation for unemployment is,
UMt = TO + Yi D + Y^Tt + Y 3 DT t + Y4Gt + 75DGt + TfcMt + TtfDMt + *2t
where
UMt = the rate of change in unemployment rate, and
0 for the pre-1983 period
D=
1 otherwise
The estimated results using annual Australian data are
given as follows:
For the period 1961-1990
P = 0.04 + 0.69D + 4.19T - 7.9DT + 0.17G + 0.37DG - 3.24 M + 1.43DM
(0.10) (0.46)
IT2 = 0.09
(1.75) (-0.75)
(0.08)
RSS = 10.11
(0.07)
(-0.90)
D.W. = 1.18
(0.19)
d.f. = 22
For the period 1965-1990
UM = 0.13 + 0.14D - 1.38T + 0.29DT + 3.61G - 3.78DG - 0.93M - 0.08DM
(0.37) (0.16) (-0.76)
(0.05)
(2.71)
(-122)
T P = 0.22
RSS = 2.63
D.W. = 2.60
(t values are in parentheses.)
(-0.41)
(0.02)
d.f. = 18
The results for both the inflation and unemployment
equations indicated that all the t-values of ps' (1, 3, 5, 7) and ys'
(1, 3, 5, 7) are insignificantly different from zero, and this
implies that there is no evidence of any structural change in
both the relationship of fiscal and monetary policies with
inflation and unemployment. We are also interested in the
overall effect of the Accord on both equations (that is, in
testing if ps' (1, 3, 5, 7) and ys' (1, 3, 5, 7) as a group are all equal
to zero.) The calculated F[4,18] and F [4,14] statistics for both the
inflation and unemployment model are 0.16 and 0.98
respectively, which are obviously less than the corresponding
F values (2.93 and 3.11) at 5 per cent significance level. Thus we
cannot reject the null hypothesis and conclude that the
dummy variables as a group are not significantly different
from zero. This implies that there is no structural change in
the post-Accord 1983 period. The estimated results of the J-Test
for the whole period (1961-1990) are given in Table 1 and 2
with the variables marked m as the maintained hypotheses.
The values below the variables denote the estimated t-statistics
of the parameter \ of the particular variable. Durbin-Watson's
d-statistics and -2 log likelihood of each model are also given
in the table.
It is shown that, with monetary policy (via the use of M2) as
a maintained hypothesis, both tax (T) and combined tax and
government expenditure (TG) have significant t-statistics.
Based on the Aka ike Information Criterion (AIC) (Akaike,
1973)9, the model with tax as policy appears to be the better
model. Government expenditure, however, appears to have
no significant impact on inflation. This confirms the relative
effectiveness of tax as an instrument in controlling inflation.
Also from Table 1, it appears that, when the maintained
hypothesis is either tax (T), government expenditure (G), or a
combination of both (TG), controlling the supply of (or
demand for) money does not have a significant effect on
inflation. Thus, fiscal policy tended to have a greater impact
than monetary policy on inflation.
With regard to unemployment, fiscal policy again indicated
greater effect on unemployment than did monetary policy for
9
AIC = {-2 In maximised likelihood + 2 (number of independent
parameters estimated)}.
the 1965-1990 period (see Table 2). With monetary policy as a
maintained hypothesis, it is the government expenditure (G)
alone and the combined tax and government expenditure (TG)
which have the significant t-statistics. Tax receipts (T) alone did
not show any significant impact on unemployment. Again,
based on the Akaike's Information Criterion, government
expenditure alone as policy appears to be the better model in
solving unemployment. In this case, it appears that controlling
the supply of (or demand for) money does not have a
significant effect on unemployment either.
V.
Conclusion
In this study, we apply the J-Test to a simple IS-LM model to
test the relative effectiveness of fiscal and monetary policy on
inflation and unemployment for the Australian economy
during the period 1961-1990. In both the inflation and
unemployment models, it appears that monetary policy did
not work well over the study period. There exists no
significant effect on inflation and unemployment by
controlling the supply of (or the demand for) money, M2. It is
fiscal policy which is effective in managing both inflation and
unemployment. With monetary policy (via the use of M2) as a
maintained hypothesis, tax (T) alone appears to be the most
effective policy in controlling inflation; while government
expenditure (G) alone appears to be the most effective tool in
solving unemployment. In sum, it is the superiority of fiscal
over monetary policy which was most effective in controlling
inflation and unemployment in Australia over the study
period.
Table 1
Modelling Inflation (1961-1990)
Policy
Model 1
Model 2
Model 3
Model 4
M odel5
Model 6
M
T
m
m
m
1.55
1.46
1.52
2.20*
G
TG
1.05
2.19*
m
m
m
DW
Log-Lik
1.25
1.51
1.24
1.25
1.51
1.25
-26.69
-28.56
-26.70
-26.69
-28.56
-26.68
Note: * denotes significant at 5% level.
Table 2
Modelling Unemployment (1965-1990)
Polio/
Model 1
Model 2
Model 3
Model 4
Model5
Model 6
M
T
m
m
m
0.20
-0.29
-0.30
1.39
G
TG
3.25*
3.26*
m
m
Note: * denote significant at 5% level.
m
DW
Log-Lik
2.38
2.36
2.37
2.38
2.36
2.37
-13.56
-9.68
-9.66
-13.57
-9.68
-9.66
APPENDIX: DATA
Data used in this article consist of M (log differences of M2
money stock multiplied by 100), P (log differences of the CPI
multiplied by 100), T (log difference of total government tax
receipts multiplied by 100), UM (log difference of
unemployment rate multiplied by 100), and G (log Differences
of total government expenditure.) The M2 money stock is
from the International Financial Statistics, IMF, various issues;
the CPI series, the unemployment rate series, the total
government tax receipts series, and the total government
expenditure series are from the Australian Economic Statistics,
Reserve Bank of Australia, 1949-50 to 1989-90.
REFERENCES
Davidson, R. and J.G. MacKinnon (1981), 'Several Tests for Model
Specification in the Presence of Alternative Hypothesis',
Econometrica 49, 781-793.
Dombusch, R. and S. Fischer (1982), Macroeconomics, McGraw-Hill,
Sydney.
Maxwell, P. (1987), Macroeconomics:
Contemporary Australian
Readings, Harper & Row, Sydney.
Perkins,
J.O.N.
(1982),
Unemployment,
Inflation
and
New
Macroeconomic Policy, Macmillan, London.
Pesaran, M.H. (1982), 'Comparison of Local Power of Alternative Tests
of Nonnested Regression Models', Econometrica 50,1287-1306.
OECD Economic Surveys (Australia) 1983-84, OECD, June 1984.
Tran, V. H. (1986), 'Effects of Monetary and Fiscal Policy on Inflation',
Economic Letters 22,187-190.
r, i!v
.
’
PAPERS IN THE SERIES
90-1
C-H. Hanf and D.J. Thampapillai, Optimal Taxation Policies for a
Nonretiewable but Quasi-infinite Energy Resource: a Two-period
Framework.
90-2
C. Nyland, Sexual Difference and Industrial Relations Research.
90-3
J. Halevi, Employment, Investment and Structural Maturity.
90-4
A. Levy, Repudiation, Retaliation, and the Secondary Market Price of
90-5
A. Chaturvedi, V.H. Tran and G. Shukla, Performance o f the Stein-
Sovereign Debts.
rule
Estimators
when
the
Disturbances are
M isspecified
as
H om oscedastic.
90-6
C. Nyland, John Locke and the Social Position of Women.
90-7
E.J. Wilson, Exchange Rate Variability. A Case of Non-Linear
Rational Expectations.
90-8
E. Pol, Ray Scale Economies and Multiproduct Cost Functions.
90-9
V.H. Tran and A. Chaturvedi, Further Results on the Two-stage
Hierarchical Information (2 SHI) Estimators in the Linear Regression
M odels.
90-10
A. Levy and T. Romm, Need Satisfaction Motivated Behaviour: Static
and Dynamic Aspects.
90-11
A.H. Vanags, A Marshallian Model o f Share Tenancy
90-12
A. Levy, An Analysis o f the Potential Externalities Affecting the
Borrowing Behaviour of Developing Countries.
90-13
Tran Van Hoa, System Estimation o f Generalized Working Models: A
Semiparametric Approach.
90-14
A. Chatuverdi, Tran Van Hoa and R. Lai, Improved Estimation o f the
Linear Regression Model with Autocorrelated Errors.
91-1
C. Nyland, Adam Smith, Stage Theory and the Status of Women.
91-2
A. Levy and T. Romm, Optimal Timing o f M igration: Expected
Returns Risk Aversion and Assimilation Costs.
D.P. Chan and K.Y. Cheung, Covered Interest Arbitrage Under the
Linked Exchange Rate: Does it Exist? An Evidence from the Hong
Kong Foreign Exchange Market.
914
M. M. Metwally, Role o f Advertising in Oligopolistic Markets: Theory
& Evidence.
91-5
A. Levy and T. Romm, The Consequences o f Mutually Secured
Debts: The Case of Israeli Moshavim.
91-6
Tran Van Hoa, Fundamentals of a new Macro-Modelling. Approach:
With Application to Explaining and Forecasting Growth.
91-7
Boon-Chye Lee, A Sequential Bargaining Model of International
Debt Renegotiation.
91-8
A. Levy, K. Chowdhury, and E. Wilson, Are the External Debts of
Developing Countries A
Symptom
or
a
Cause
o f Economic
Slowdown?
91-9
Amnon Levy, A Pareto Optimal Condition for Bankruptcy and the
Role o f Variations in Aggregate Variables.
91-10
K. Y. Cheung, On Testing the Joint Hypothesis of Short Term Interest
Rate: A Single Extraction Approach.
91-11
Tran Van Hoa, How to Forecast Wage and Price Inflation with More
Accuracy: The Australian Experience: 1945/50 to 1988/89.
91-12
Amnon Levy, Unemployment
and
Feedback
Approach
to
the
Management o f Immigration by the Host Country.
92-1
Ann Hodgkinson, An Industry Policy Debate for the 1990s— What
Lessons from the USA?
92-2
Lino Briguglio, Tourism Policies, Environmental Preservation and
Sustainable Development on Small Islands: the Case of Malta.
92-3
Amnon Levy and Khorshed Chowdhury, An Integrative Analysis of
External Debt, Capital Accumulation and Production
in Latin
America, Asia-Pacific and Sub-Saharan Africa.
92-4
Tran Van Hoa, Effects o f Oil on M acroeconomic Activity in
Developing Countries: A Cointegration Analysis.
Amnon Levy, The Role of Repudiation and Trade and Credit
Sanctions in the Accumulation of Sovereign Debt, Production Capital
and Reputation.
92-6
Kui Yin Cheung, On Testing the Hypothesis that Premium in US$/$A
Forward Exchange Rate is Constant: A Signal Extraction Approach
92-7
Khorshed Chowdhury, On Trade and Economic Growth: Further
E vidence
92-8
Charlie Harvie, Chris Nyland and Stuart Svensen, The Effects of
Protective Legislation on Occupational Segregation in the United
States and Australia.
92-9
Amnon Levy, Efficiency and Equity Considerations in Allocating
Renum erations
Under
U ncertainty:
The
Case
of
A ustralian
Universities.
92-10
Amnon Levy, D.P. Chaudhri and Khorshed Chowdhury, The Effects
of Yield Variations, Price Expectations, Risk Aversion and Money
Illusion on Farm-land Allocation in Punjab.
93-1
Kui Yin Cheung and Lillian Cheung, The Relative Effectiveness of
Fiscal and Monetary Policy on Inflation and Unemployment: the
Australian Experience.
93-2
Daniel Po-ming Chan and Kui Yin Cheung, One-Way Arbitrage with
Transaction Costs: an Evidence from
the Hong Kong Foreign
Exchange Market.
93-3
Amnon Levy, Rescheduling a Sovereign Debt: a Theoretical Analysis.
WORKING PAPER 93-1
Coordinated by Dr C. H arvie and Dr M.M. Metwally
W orking Paper Production and Administration: Robert Hood
University of W ollongong
Northfields Avenue, W ollongong, NSW 2522 AUSTRALIA
Phone: (042) 213 666
Fax: (042) 213 725