Academic journal article Economic Perspectives

Does Inflation Reduce Productivity?

Academic journal article Economic Perspectives

Does Inflation Reduce Productivity?

Article excerpt

What would be the long-run economic benefit of reducing the rate of inflation, or eliminating it entirely? Conversely, what would be the cost of allowing inflation to rise above its current rate? Answering these key monetary policy questions requires an assessment of inflation's real effects. The case for zero inflation rests on the presumption that the real costs of inflation are substantial, while arguments for de-emphasizing the zero-inflation goal presume the opposite.

Many economists have argued that high rates of inflation create distortions that lead to inefficient resource allocation and hence lower productivity. Feldstein (1982), for example, has contended that given the existing tax structure, inflation lowers the real return on capital, discouraging capital formation. Other often-cited efficiency losses are associated with the unproductive activities required to cope with ever-rising prices. These include the costs of changing posted or printed prices, and the "shoe-leather" costs associated with holding less cash.(1)

The empirical evidence on the inflation-productivity relationship has been inconclusive. While many studies have sought a link between average inflation and real growth rates across countries, the results are mixed and tend to be sensitive to the inclusion of additional variables as determinants of productivity growth.(2) A recent paper by Rudebusch and Wilcox (1994) documented a strong inverse relationship between inflation and productivity in the U.S. More importantly, it added a causal interpretation and policy conclusion: Reducing inflation, it argued, would increase productivity. These results and conclusion received a great deal of attention in the business press and were cited by Federal Reserve Chairman Alan Greenspan in congressional testimony in May.

Our article examines the postwar evidence on the relationship between inflation and productivity in the U.S., paying particular attention to two questions that the existing literature has not resolved. One is whether the negative correlation documented by Rudebusch and Wilcox is a long-run phenomenon or simply reflects cyclical co-movements. The second question is what assumptions are required to interpret the correlation as a causal relationship and conclude that a permanent decrease in inflation would bring about a permanent increase in productivity.

In the first section we describe the statistical properties of inflation and productivity and corroborate the negative correlation at cyclical and long-run horizons. We then take up the interpretation of this correlation. Simple "Granger causality" tests suggest a causal link between inflation and productivity when only those two variables are included in the analysis. Controlling for other factors--monetary policy, in particular--destroys that relationship, however. In a four-variable vector autoregression (VAR) model, increases in the federal funds rate cause productivity to fall, while inflation lacks any predictive power.

The next section takes up the long-run relationship between inflation and productivity, using a bivariate time-series model to estimate the ultimate effect on productivity of a permanent shock to inflation. An important conclusion of this analysis is that the size and sign of the estimated effect depend heavily on the identifying assumptions used to distinguish inflation shocks from productivity shocks. This result illustrates the dangers in drawing policy conclusions from bivariate correlations. In addition, robustness checks show that the strength of the long-run effects depends on the inclusion of the oil-shock episodes.

The article also discusses the economics that may underlie the strong negative cyclical relationship between inflation and productivity observed in the data. A box sketches the elements of a model that would exhibit this property. In such a model, a monetary policy rule that raises short-term interest rates in anticipation of future inflation can generate a negative correlation at cyclical frequencies. …

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