Academic journal article Economic Inquiry

Why Is Inflation Low When Productivity Growth Is High?

Academic journal article Economic Inquiry

Why Is Inflation Low When Productivity Growth Is High?

Article excerpt

I. INTRODUCTION

In the United States since World War II, inflation has been low when productivity growth has been high. For example, the 1950s and 1960s were a period of low inflation and high productivity growth, whereas the 1970s and 1980s were a period of high inflation and low productivity growth. The negative correlation between inflation and productivity growth over the years 1949-2000 is much stronger than the correlation between inflation and unemployment (i.e., Phillips curve-type correlations) or the correlation between inflation and growth in monetary aggregates (i.e., quantity theory correlations). Little research has explored the comovement between inflation and productivity growth. The evidence developed herein suggests that the negative correlation reflects the behavior of the Federal Reserve.

Over the postwar period, the Federal Reserve has not adjusted nominal income growth (through changes in the growth of the money supply) to changes in "trend" productivity growth, as will be documented. Such a policy induces a negative correlation between trend productivity growth and inflation, as an acceleration in trend productivity growth in the face of constant nominal income growth leads to a deceleration in inflation. This focus on monetary policy as the key factor behind medium- to long-run correlations between inflation and productivity seems more plausible than a focus on peculiarities of Phillips-curve reduced-form relationships, because such relationships are plausibly more appropriate guides to the short-run dynamics of inflation. As a case in point, consider the recent shift to inflation-targeting monetary policy strategies in the United Kingdom and Sweden--which emphasize the key role that monetary policy plays in the inflation outlook over several years.

The role of monetary policy in generating the strong correlation between productivity growth and inflation in the medium run is developed in a textbook model based on an expectations-augmented Phillips curve. The model's main empirical predictions are confirmed: (1) Inflation, especially expected inflation, should fall when trend productivity growth rises; and (2) nominal income and nominal wage growth should not change when trend productivity growth changes. The model also implies that productivity growth enters a reduced-form Phillips-curve relationship as a proxy for inflation expectations. This implies that traditional estimates of the nonaccelerating inflation rates of unemployment (NAIRU) should fall when productivity growth accelerates--an empirical regularity that has received a great deal of academic and policy attention in recent years and is typically explained via some type of irrationality. Perhaps surprisingly, these empirically regularities do not rely on the "Great Inflation" of 1965-79, when inflation accelerated and productivity growth decelerated.

Recent discussions of Phillips-curve reduced-form relationships have placed a strong emphasis on structural explanations that may explain a link between productivity growth, the NAIRU, and hence inflation. Staiger et al. (2001) present evidence that the time-series techniques they employ to estimate trend productivity growth and the NAIRU yield a strong correlation between the NAIRU and trend productivity growth. Ball and Moffitt (2001) and Ball and Mankiw (2002) provide a structural interpretation: Labor market institutions--for some reason, perhaps irrationality--make the real wage aspirations of workers respond very sluggishly (with a lag of perhaps 10 years or more) to productivity growth, and hence an acceleration in productivity growth leads to a prolonged period of downward pressure on labor costs and hence inflation. Similar reasoning has been used in policy circles for years--at the Council of Economic Advisors (1997; 2000) and the Federal Reserve Board (Meyer, 2000), reflecting the reasoning in Grub b et al. (1982) and Braun (1984). The focus herein, the behavior of policy, is consistent with the evidence on inflation, productivity growth, and empirical estimates of the NAIRU. …

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