Is There a Macroeconomic World of One Simple Model?

BARRY HUGHES The Hinders University of South Australia

Bedford Park, SA 5042

I Introduction As part of their extremely useful survey of

comparative macroeconomic performance, Norton and McDonald (1981) consider the policy options raised by their data. They conclude ’that there seems usually to have been a choice open for policy between more production with higher inflation, or lower inflation with less production’. One simple central choice seems capable of illuminating the OECD world’s recent painful arpaimces. No other factors than output growth differences (and earlier consideration of related matters like differences in growth of money supply and total nominal spending) are adduced as explanations of varying international inflation experience. The clear implication is that neglected factors, such as individual conduct of wagoprice setting and other matters specific to the institutions of particular countries, are unimportant (at least relatively so) to the inflation outcome.

The Norton-McDonald (NM) result, of course, goes to the heart of the current macroeconomic policy debate. Were it to be sustained (and its leverage adjudged to be sufficiently powerful), an important empirical basis would be provided for the restrictionist stance of policy around the world. Accordingly, this short note subjects the evidence presented to scrutiny.

I1 Is There Evidence of a Trade-off? NM offer two pieces of ‘evidence in favour of

their proposition. The first (their Figures 12 and 13) is a series of scatter diagrams depicting the course of inflation and output growth in ten OECD countries (including Australia) between 1%8 and 1977. In each country the experience is broken and down into four two-year periods, with inflation

lagging output by two years. There are thus 40 separate observations. NM conclude (p.314) that ’the outcomes for (these) shorter periods suggest that there has normally been a choice between more production and less inflation’. In fact only 24 of 40 paired movements in inflation and output growth feature the suggested positive relationship. The other 16 observations feature movements in inflation opposite in direction to those of output growth.’ Only in the US did inflation (suitably lagged) invariably move in the same direction as output growth. In Germany and Australia three out of four links were in the wrong direction.

This is scarcely compelling evidence of the relationship NM seek to establish. One way of illustrating this is to note that the probability of obtaining 24 or more successes if there had been no underlying relationship between output growth and inflation (i.e., if the probabilities of negative and positive links both equalled one half) is 0.134.

The second piece of evidence put forward by NM consists of a comparison of decade averages over the 1960s and 1970s of inflation and output growth for the same ten OECD countries. While the basic data are presented (in NM’s Table 10). they do not follow their earlier practice of computing correlation coefficients (both Pearson and Spearman) and displaying a scatter diagram. Instead, comparisons are made of a particular form of extreme behaviour in the sample (NM’s Table 11). The average change in inflation in the three countries with the biggest reductions in output

’This count is based upon NM’s unpublished data appendix. Figure 12 in the published article includes an additional positive link, that of the UK between periods 0 and I , which appears to have resulted from faulty plotting.

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growth rate between the 1%os and the 1970s is shown to have risen less than that on average in the three countries with the smallest reductions in growth. Similarly. the three countries with the smallest increases in inflation between the decades had on average larger reductions in output growth than the three with the biggest rises in inflation.

The scatter of NM's data is displayed in Figure 1. It is no surprise, given the visual impression, that the Pearson correlation coefficient (r) is the only 0.37 and the Spearman rank coefficient (rho) 0.45.' While neither of these results is encouraging to NM's hypothesis, it is an accepted belief that sometimes relationships reveal themselves only at extremes. Here, however, we would look for strong

lJapan's productivity growth rate dipped sharply in the 1970s. reflecting in part, no doubt, her inability to maintain the phenomenal 9.7 per cent annual average increase during the 1960s. The effect of this would have been to have displaced the Japanese observation substantially downward vertically from where it otherwise might have been. But this does not account for the result. The r coefficient over the remaining nine countries is an even lower .34.

consistency of the data with the hypothesis. That is not the case with the NM data. Thus, of the three countries with the largest increases in inflation, two (Italy an Australia) experienced bigger-than-median (1.9 per cent) falls in output growth. Only the UK remains consistent with the hypothesis. In the other three comparisons employed by NM, the hypothesis fits in each instance in two out of three cases. Inconsistent examples are Germany (with the second-lowest rise in inflation but a below-median fall in output growth), US (with the third-lowest fall in output growth but a below-median rise in inflation) and Italy (with the third biggest fall in output growth but an above-median rise in inflation).

How might we assess the degree of correspondence of these results obtained from the extremes of the scatter with NM's hypothesis? Two tests, one weak and one strong, are proposed. The weak test suggests that a position on the extreme tail of one distribution ought to be accompanied by the country being above or below the median (in accordance with the NM hypothesis) on the other. A null hypothesis is formed on the basis of

188 ECONOMIC RECORD JUNE

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Change in Inflation and Real GDP 59/60-72/3 to 74/81

no relationship between the variables, i.e., an extreme value on one variable has probability of one half of being associated with an above-median value on the other. Eight countries occupy extreme positions in one respect or another. Four of them (Japan, Switzerland, UK and Canada) had performances on the other variable in the opposite half of the distribution to the extreme concerned. These countries are the ones that meet our weak test of the NM hypothesis. But the other four (Germany. Australia, Italy and the US) do not.

Given the null hypothesis, the probability of at least four successes out of eight attempts is 0.64. The null hypothesis cannot be rejected.

A stronger test along the same lines would require conformity with the NM hypothesis to lie in an extreme value of one variable being assoCiated with an appropriate extreme on the other. Only three (Japan, Switzerland and the UK) of the eight countries meet this criterion. It is clear that no claims of association between the variables based upon the extremes can be entertained on the

1984 MACROECONOMIC WORLD 189

evidence presented by NM. Their case for a relationship between output growth and inflation has thus not been made.

A final objection to NM’s empiria is that their sample of ten OECD countries is only a partial s u b set of those available. Some spectacular examples of the miscarriage of the NM hypothesis occur amongst those ommitted from Figure 1. Thus Spain and Greece have both suffered sharply reduced output growth in the 1970s compared with the 1960s but have experienced relatively substantial accelerations in inflation, On the other hand, Norway has had a relatively small reduction in its output growth rate which has not been accompanied on average by a particularly sharp acceleration in inflation. Figure 2 presents a scatter of similar observations to those of NM for 20 OECD countries on a slightly different timing basis.’ Only Iceland, Luxembourg, Turkey and Portugal are excluded from the possible list. The correlation coefficient (r) is a mere 0.14. The NM hypothesis is equally doubtful at the extremes. The dotted vertical and horizontal lines represent median inflation acceleration and output growth reduction for the sample as a whole. The countries with the biggest inflation acceleration (Greece and Italy) had much-bigger-than-median reductions in output growth, as did Spain, the joint third place getter in this particular stakes. Turning the comparison around, it is hard to pick the difference in the inflation performance between the three countries with the lowest reductions in output growth and those with the highest. The latter group (Japan, Spain and Greece) has an average increase in inflation rate between the two periods of 8.9 per

’The timing differs since the scatter was originally consmcted for a different paper, Hughes (1982). Statistics are from OECD Economic Outlook, June 1976. and June 1982 issues. I t is perhaps appropriate to note here that Norway’s productivity was boosted by North Sea developments. It is an opposite case to that of Japan noted earlier, in that macroeconomically exogenous developments have displaced its position vertically upwards.

cent. Those with the least restriction in output (Norway, Ireland and New Zealand) had increased inflation on average of 8.5 per cent. Here the NM relationship is rejected even on their own criterion.‘

There is no conclusion possible other than that NM have failed to provide acceptable evidence of the relationship between output growth and inflation that they seek to establish. This is no great surprise. Since the instability of the Phillips relationship over the period under review is notorious, and since there is no particular reason to expect such a simple trade-off in any of the standard models of inflation in comparisons involving averages as long as a decade, the lack of a f m result is of little consequence to the inflation policy debate. About all the empirics presented here establish are some problems for the rational expectations school. Both the substantial diversity of inflation acceleration experience and the implied suggestion (Figure 1) that during the 1970s the UK had the least and Japan and Switzerland the greatest decrease in the underlying non-inflationary growth rate of output represent damaging evidence against this school of thought.

REFERENCES Hughes, Barry (1982). ‘Incomes Policy: The International

Experience’, in Pat Walsh (ed.), Proceedings of a National Seminar on Incomes Policy, Victoria University of Wellington.

Norton, W.E. and McDonald, Robin (1981). ‘Implications for Australia of Cross-country Comparisons of Economic Performance’, Economic Record, 57. 301-18.

‘Amongst this disarray, it should be noted that of the four lowest increases in inflation, three have above- median output growth reduction. This is the most comfort NM can derive from Figure 2.

There is little association even on the basis of correspondence of the observations wih the respective medians. If the NM hypothesis held, above-median inflation acceleration ought to be associated with below- median output growth reduction and vice versa. All the observations ought to be in the second and fourth quadrants and none in the first and third. In fact only ten are in the right quadrants, seven are clearly in the wrong place and the remaining three are on the output growth median line (two being clearly distant from the inflation median line).