The relationship between inflation and unemployment

Abstract

The nature of the relationship between inflation and unemployment has implications for the appropriate conduct of monetary policy. However, the question as to whether the traditional Phillips curve relationship holds true remains debatable despite advances in both theoretical and empirical evidence. This study revisits this debate for South Africa by examining data on unemployment, the repo interest rate and core CPI for the period from 1994Q1 to 2015Q4. This was in the light of recent developments in both theoretical and empirical Phillips curve literature. The research employed a hybrid version of the NKPC and various econometric techniques. The Augmented Dickey-Fuller test was used to examine the unit root properties of the data series. The Johansen cointegration technique was applied to test for cointegration among the variables. The research derived and estimated an error correction model for inflation. The model results demonstrated that the repo interest rate is statistically significant in explaining inflation. The VECM was derived and estimated to examine both short-run and long-run relationships among the variables. The results confirmed the existence of a positive but insignificant long-run relationship between unemployment and inflation. The study used the Granger causality test to ascertain the nature of causality among the variables. The research established the presence of unidirectional Granger causality running from core CPI to unemployment. Forecast error variance decomposition shows that large percentages of variations in each variable are attributable to each variable respectively. The empirical findings are helpful to the understanding of the Phillips curve relationship in South Africa and emerging economies in general.