Academic journal article New England Economic Review

U.S. Economic Performance: Good Fortune, Bubble, or New Era

Academic journal article New England Economic Review

U.S. Economic Performance: Good Fortune, Bubble, or New Era

Article excerpt

The performance of the U.S. economy in the late 1990s was very good by most measures. Overall growth was robust; and both the unemployment rate and inflation were at the lowest levels in over 30 years. But for many economists, delight in the economy's strong performance was tempered by puzzlement, even consternation. Since the 1960s, unemployment rates below 6 percent or so had been associated with rising rates of inflation. Yet in the late 1990s, with unemployment rates around 4 percent, inflation declined.

Explanations for the breakdown in the historic link between inflation and unemployment tend to fall into two categories:(1)

The U.S. economy has been the beneficiary of a number of temporary factors that have held down the inflation rate; and

The U.S. economy has entered a new era of intense competition and high productivity growth in which inflation is much less of a threat.

In addition, some observers have suggested that the U.S. economy is experiencing an asset price bubble somewhat similar to that in Japan in the late 1980s.(2) While a stock market bubble cannot explain recent low inflation rates, it may help to explain why growth has surpassed most forecasters' expectations. Additionally, one can conceive of circumstances under which a decline in inflation would boost equity prices and possibly create conditions conducive to a bubble. Clearly, these three explanations for our recent good fortune have very different implications for the conduct of monetary policy and for other policies as well. However, as the following will show, determining the true state of affairs is no simple task. The article begins with a very brief overview of the link between unemployment and inflation and then proceeds to discuss some of the arguments surrounding each of the three views of the economy.

Inflation and Unemployment

Historically, low rates of unemployment in the United States have been associated with rising inflation, while high rates of unemployment have been associated with declining inflation. Figure 1 shows the pattern since 1960. Particularly noteworthy is the episode in the 1960s, when the very low unemployment rates of that decade gave rise to a sharp escalation in inflation. It was that episode that focused attention on, and seemingly validated, what came to be known as the Phillips curve, named after A. W. Phillips, who published an article in 1958 showing a statistical link between unemployment rates and wage growth in the United Kingdom over a hundred-year span.

The combination of high inflation and high (by historic standards) unemployment rates in the 1970s for a time confounded believers in the Phillips curve. However, once account was taken of the oil price shocks and expectations of future inflation, typically measured by past experience, the link between inflation and the unemployment rate was reestablished. Phillips himself had pointed out that price shocks from imports or agricultural commodities could alter the normal relationship between wage changes and unemployment.

The experience of the 1980s seemed consistent with the Phillips curve. The sharp escalation in unemployment in the early 1980s was associated with a marked slowing in the rate of inflation, and the relatively low unemployment rates of late 1980s were associated with a pickup in inflation. Not all economists interpreted the changes in inflation in this light, however. Some attributed the pronounced decline in inflation early in the 1980s to the Federal Reserve's decision to focus on controlling the money supply rather than interest rates. Others emphasized the effect of more aggressive Fed leadership in combating inflation on expectations of future inflation. It was not the rise in unemployment per se that caused inflation to come down, but the increase in the Fed's credibility as an inflation-fighter that altered expectations. However, credibility is impossible to measure and the financial innovations of the 1980s caused the historic relationship between money growth and the economy to fall apart. …

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