 2001 Monetary Authority of Macau

The Phillips Curve in Macau and

Its Implications for Macroeconomic Policy

Thomas Vong

Abstract

Relatively high rates of unemployment have been recorded in recent years when
inflation rates were decreasing after the Asian financial crisis erupted in 1997, which
sent most Asian-Pacific countries into recession. This paper attempts to find out
whether there exists a tradeoff between unemployment and inflation, as widely known
as the Phillips curve, in Macau. A literature review of the traditional Phillips curve
and its recent modifications will be discussed. Different models will then be
constructed based on Macau’s available data for the best approach to this problem.
Discussions about recent economic measures utilized by the SAR government to fight
unemployment will follow to access the possible consequences on both
unemployment and inflation in Macau.

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1. Introduction

The employment situation remained stable in Macau in the first half of the 1990s
when the economy grew at an annual average rate of 6%. Unemployment was not on
the government’s top economic agenda as the jobless rate was only 2.7% during this
period, though the inflation rate, measured by the consumer price index, rose faster at
an annual average rate of 7.8%. The Portuguese Macau government even relaxed the
labour importation policy, allowing the employment of more foreign workers to ease
the labour shortage in some specific economic sectors such as manufacturing and
hotel. Thus, the number of imported workers rose gradually before the establishment
of the Macau SAR from 21,088 in 1993 to 32,183 at the end of 1999 with a peak of
35,286 in 1996.

However, the employment picture has been changing sharply after 1997 when two
forces exerted higher pressure on both the quantity and quality of labour demand.
First, the eruption of Asian financial crisis in October 1997, which sent most Asian
Pacific countries into recession, hit hard on Macau’s economy. One of the major
economic engines, export of services which is predominated by tourism receipts, lost
steam rapidly; and the investment sentiment deteriorated, as indicated by a two-digit
drop in gross fixed capital formation. As a result, the output of Macau plunged by
4.6% and 3% in 1998 and 1999 respectively. The adverse shift in output demand
lowered the labour demand and hence the unemployment rate. Second, the ongoing
economic restructuring requires an “upgrade” on the skills of human resource to
accommodate the applications of fast-changing technology with the ultimate aim of
increasing the productivity of Macau’s economy. These two driving forces caused the
unemployment rate to rise gradually from 2.7% in the last quarter of 1997 to a peak of
7.1% in second quarter last year.

The deterioration in employment has greatly concerned the Macau SAR government.
Various measures have been introduced to fight unemployment: firstly, cutting the
quota on labour importation in an attempt to increase the number of jobs available to
unemployed persons, and secondly, providing more career training courses to

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residents, who are lack of the skills needed in the economic restructuring. The
number of foreign workers thus fell sharply by a year-on-year rate of 15.4% last year
to 27,221, and the employment situation has recently witnessed some improvement.

At the same time when the employment situation was eroding, it was noted that
inflation rate dropped rapidly from a positive 3.5% in 1997 to a negative 3.2% in
1999. This situation is coincided with a well-known macroeconomic hypothesis
known as the Phillips curve, which states a tradeoff between unemployment and
inflation.

This paper attempts to find out the relationship between unemployment and inflation
in Macau and discusses the implications of recent economic measures adopted by the
SAR government for future movements of these two macroeconomic variables. Next
section begins with a brief review of the traditional inflation model pioneered by
Alban William Housego Phillips which depicts a simple relationship between
unemployment and inflation, and the subsequent modifications made by Edmund
Phelps and Milton Friedman known as expectations-augmented Phillips curve. The
concepts of non-accelerating inflation rate of unemployment (NAIRU) and natural
unemployment rate will come into the picture when long-term Phillips curve is
discussed. A review of research by Robert J. Gordon who proposes to add supply
shocks will come next. Section 3 then focuses on model development based on
Macau data on unemployment and inflation. It is found that the short-term model
incorporated inflation expectations, NAIRU and supply shocks yields the best
predictive power on movements of unemployment and inflation. Section 4 discusses
recent anti-unemployment measures taken by the government, and finally Section 5
concludes.

2. Empirical Studies of the Phillips Curve

In an article published in Economica in 1958, A.W. Phillips, a professor at the

London School of Economics, studied comprehensively wage behaviour in the United

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Kingdom from 1861 to 1957, and concluded that there was a tradeoff between wage
inflation and unemployment - the higher the rate of unemployment, the lower the rate
of increase of money wages. Following Phillips’ pioneer work, economists in the
Untied States, Canada and most other countries found that there also existed such a
trade-off in their countries. The trade-off is now widely known as the Phillips curve
(Figure 1).

Figure 1: A Phillips Curve

Inflation rate

Unemployment rate

The Phillips curve can also be expressed by the following equation if we assume that
the relationship between unemployment and inflation holds constant:

π = α + βu (1)
where π denotes inflation rate and;
u is unemployment rate

The Phillips curve was then adopted widely in macroeconomic policy analysis as it
suggested that policymakers could choose different combinations of unemployment
and inflation rates along the Phillips curve. However, the coexistence of high
inflation and unemployment rate in the United States during the 1970s highlighted
that there were some other important factors, which could dominate the Phillips curve.
One of those important factors is inflation expectation.

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 Friedman (1969) and Phelps (1972) argued that the traditional Phillips curve could
only be a “short-term” tradeoff sustainable only over a certain period. The convex
Phillips curve only exists in the short run under which Friedman and Phelps argued
that the rate of change in unemployment did not only reflect the regular actual
inflation but also the expected inflation. If people asked for future wage rises based
on their expected inflation rate, there was no tradeoff between unemployment and
inflation in the long run. An economy will move to the natural rate of
unemployment at any rate of change of prices so long as the inflation rate is well-
expected. In other words, a long-term Phillips curve is a vertical line at unemployment
rate equal to the natural unemployment rate. The expectational Phillips curve is shown
in Figure 2 and the long run Phillips curve in Figure 3.

Figure 2: An Expectational Phillips Curve Figure 3: A Long Run Phillips Curve

π-πe π

u
u* u

In Figure 2, inflation rate is replaced by unexpected inflation rate π-πe, and in Figure
3, u* refers to the natural rate of unemployment.1 The expectational Phillips curve
can be expressed in Equation (2):2

1
The natural rate of unemployment is also known as the full-employment level of unemployment or
the structural unemployment rate. It is the unemployment rate at which flows in and out of
unemployment just balance each other (i.e. the unemployment rate is constant). This is possible
because there are people leaving their jobs and seeking new ones at the same time. This natural rate is
usually calculated by averaging the prevailing unemployment rate in the economy.
2
There is no constant term in this model as imposed by economic theory.

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 π t = ϕ ( L)π t −1 − φ ( L)(ut − utn ) (2)

where π is inflation rate;

u is unemployment rate; and
un is the natural unemployment rate or NAIRU;3 and
ϕ(L) and φ(L) are polynomials in the lag operator

The expectational model states that it is not the actual inflation per se which causes
unemployment to occur, but the expected rate of inflation. If a government wants to
reduce unemployment, the only way is to generate more inflation than expected. The
first term in Equation (2) implies that inflation is inertial. This inertia arises because
historical inflation affects expectations of future inflation, which, in turn, influences
wages and prices people set. The second term represents that inflation also depends
on cyclical unemployment. Deviations of unemployment from the NAIRU will exert
pressure on prices to move either upward or downward. A long term Phillips curve
can also be derived from Equation (2). It is known that in the long term when an
economy is in equilibrium, actual inflation rate will be equal to expected inflation rate
(i.e. πt=πt-1), then the unemployment rate will be equal to the natural unemployment
rate (U=Un) and results in a vertical Phillips curve.

The expectational Phillips curve primarily utilizes endogenous variables. As the

world has been moving towards free trade, economists have also looked for new ways
to incorporate exogenous variables, which could also be important factors in
determining price movements. Gordon (1997), for example, argued that supply
shocks like import prices had a significant effect on core inflation. Thus, Equation (2)
can be rewritten to include supply shocks as follows:

3
The “Non-accelerating Inflation Rate of Unemployment” (NAIRU) is a theory implicit in researches
done by Friedman (1968) and Lucas and Rapping (1969). They argued that unexpected inflation, which
spur prices up, was not sustainable in the long term. Unemployment would start escalating to eliminate
unexpected inflation to a level until the actual inflation equal to anticipated one and this level is
technically known as NAIRU. Although NAIRU is a similar concept to Friedman’s natural rate of
unemployment, there is a difference between them. NAIRU sets out the rate of unemployment above
which inflationary pressure is building and under which prices will start to fall. By means of a
mathematical proof, Debelle and Laxton (1996) stated that in a stochastic steady-state equilibrium, the
natural rate of unemployment must be greater than NAIRU by a constant amount χ.

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 π t = ϕ ( L)π t −1 − φ ( L)(ut − utn ) + η ( L)ε t −1 (3)

where ε represents supply shocks.

Inclusion of supply shocks in Equation (3) simply accommodates the adverse or

beneficial effect of this variable on inflation. Adverse supply shock implies a positive
value of ε and pushes inflation up, while favourable supply shock refers to a negative
value of ε and brings inflation down.

3. The Phillips Curve in Macau

The relationship between unemployment and inflation between 1992 and 2000 is
depicted in Figure 4. A possible nonlinear Phillips curve is plotted alongside with the
actual one to postulate the trade off between π and u. By means of least square error
regression method on Equation (1), a simple linear relationship between these two
variables is derived and is given in the following equation.

π = 12.234 - 2.162u (4)

(0.0003) (0.002)

R2 = 0.77

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 The dot line in Figure 4 shows predicted linear Phillips curve.

Figure 4: Unemployment and Inflation, 1992-2000

10

1995

8
1992

1993
6
1994

1996
Possible Philips Curve
4
1997
Inflation

1998
0
0 1 2 3 4 5 6 7 8

2000
-2

1999

-4
Unemployment

Next, we will estimate the expectations-augmented Phillips curve, which is usually a

short run curve. Data used to build up this model are quarterly statistics from
1996:Q1 to 2001:Q2. A simplification is made on Equation (2) in which we only use
the inflation rate in immediate previous period and assume the natural rate of
unemployment remains constant at 3%, the average inflation rate in the first seven
years of the 1990s. The equation can be re-written as:

π t = ψπ t −1 + δ (ut − u n )

and the estimated equation is shown below:

π = 0.861π −1 − 0.112(u − u n ) (5)

(0.0) (0.1056)
R2 = 0.94

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Although this model has a higher predictive power over the previous one, the Phillips
curve constructed here is not a stable one because the coefficient, ψ, should be unity
when inflation is stable. Figure 5 shows the results of this model.

Figure 5: Relationship between unemployment and inflation, 1996:Q1 to 2001:Q2

(Short-term augumented expectation Phillips Curve without supply shock)
8
Actual Predicted

1996 Q1
6

Q2
1997 Q1 Q4
4 Q3 Q3
Q2

Q4
2
1998 Q1
Inflation

Q2

0
2 3 4 5 Q3 6 Q4 7 8
Q3
Q4 Q2
-2 2001 Q1 Q2

2000 Q1
1999 Q1 Q4
Q2
-4 Q3

-6
Unemployment

We now add the final supply shocks variable (i.e. the change in import prices) into our
model, and obtain an equation like the following one:

π = 0.797π −1 + 0.141(u − u n ) + 0.088ε −1 (6)

(0.0000) (0.0035) (0.0173)
R2 = 0.96

This model has the highest predictive power among all three models we have
discussed so far because its coefficient of determination is at the highest level of 0.96,
saying that 96% of the variation in price can be explained by the three regressors. The
estimated relationship between inflation and unemployment using this final model is
drawn in Figure 6.

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 Figure 6: Relationship between unemployment and inflation, 1996:Q1 to 2001:Q2
(Short-term augumented expectation Phillips Curve with supply shock)
8
Actual Predicted

1996 Q1
6

Q2
1997 Q1
Q4
4 Q3
Q2 Q3

Q4 1998 Q1
2
Inflation

Q2

0
2 3 4 5 6 7 8
Q3
Q3
Q4 Q2 Q4 Q2
-2 2001 Q1

Q4 2000 Q1
1999 Q1
Q2
-4 Q3

-6
Unemployment

Equation (6) shows that the Phillips curve relation exists in Macau with three
distinguished properties. First, current inflation is highly depended on previous
inflation, saying that wage rate rises or falls are determined by the prevailing inflation
in Macau’s economy as they form their inflation expectations on previous experience
and demand necessary wage changes accordingly. Second, the curve is negatively
sloped, implying that lower unemployment rates cause inflation to rise and vice versa
but the influence from the unemployment gap (measured as the difference between
actual and natural unemployment) on inflation is a gradual one through an inertial
process. Third, the change of prices of imports is positively correlated as it is
straightforward to see that increase in import prices would exert pressure on inflation.
These three properties are very important in macroeconomic policy as they set out a
framework in which policy makers can determine the effects on inflation if they
choose to lower unemployment to a certain level.

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4. Implications for Macroeconomic Issues in Macau

The prevailingly high unemployment rate in Macau since the Asian financial crisis in
October 1997 has caused major social concerns. The government of Macau SAR has
devised several measures to alleviate this situation. These include cutting the number
of foreign workers in Macau, initiating a number of infrastructure projects, developing
a closer economic and business link with neighbouring regions, providing more
training programmes for the unemployed and creating a brand new technology
incubator. In the absence of full monetary policy capability under a linked exchange
rate regime, the power of manipulating money supply to create a bold impact on
output is not strong as local interest rates have to move in line with foreign interest
rates. Thus, the measures taken by the government are highly practical ones, which
aim at boosting the domestic demand and thus improving the employment situation.

However, our model predicts that as the unemployment rate subsides, inflation will
start rising. In order to avoid rapid build-up of inflation, there is a need to improve
the productivity in the long term so that the productivity gains can offset the pressure
on inflation. Gordon (1999) argued that the prolonged growth in the United States in
the 1990s, when the unemployment rate dropped below 5% but inflation pressure did
not mount, was made possible by the arrival of “New Economy”: a fast growth of
high-tech products had rendered previous capacity constraints associated with the
Phillips curve. A typical production function Y = f ( L, K ,...) implies that continuous
improvement in productivity will keep prices low as higher output of labour lower
business costs, offsetting the effect of wages rises when unemployment rates are near
the natural level. The training courses offered by the SAR government (which aims at
equipping the unemployed with the necessary skills) and the technology incubator
will enhance the productivity of Macau’s economy as a whole by increasing the
efficiency of both capital (K) and labour (L).

However, the unemployment situation is facing another upcoming challenge as the

final stage of trade liberalization in Macau will be finished in 2005. There is a need to
design a practical and feasible economic restructuring programme, which can draw on

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the competitive advantage of Macau and then develop bold measures to increase
productivity in the chosen industries.

5. Conclusion

The objective of this paper is to explain the relationship between unemployment and
inflation in Macau. We have argued that the relationship between excess demand – as
measured by the gap between the unemployment rate and the natural rate of
unemployment – and inflation (adjusted for expectations and modified by import
prices) exists in Macau. Capitalizing this idea and the vivid example of non-
inflationary growth in the United States in the 1990s when both unemployment and
inflation remained low, we move on to discuss the recent unemployment problem in
Macau and the measures being implemented by the government. It is believed that
the current policies will gradually reduce the unemployment rate without triggering
significant acceleration of inflation.

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References

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Appendix 1

Selective Unemployment-Related Statistics in Macau, 1992-2000

Unemployment Real GDP Inflation Number

Rate Growth Rate of Foreign
Workers

1992 2.2 13.3 7.7 n.a.

1993 2.1 5.2 6.7 21,088
1994 2.5 4.3 6.3 25,324
1995 3.6 3.3 8.6 30,604
1996 4.3 -0.4 4.8 35,286
1997 3.2 -0.3 3.5 29,723
1998 4.6 -4.6 0.2 32,013
1999 6.4 -3.0 -3.2 32,183
2000 6.8 4.6 -1.6 27,221

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