The Long-Run Effects of Monetary Policy on Output Growth
Smith, Christie, The Reserve Bank of New Zealand Bulletin
This article looks at how interest rates and inflation affect growth in the capital stock, labour supply, and technology, the main determinants of long-run economic growth. Many additional factors affect long-run economic growth, but most of these factors lie outside the sphere of monetary policy. Monetary policy therefore has only a limited capacity to contribute to economic growth over the longer term. However, the evidence does indicate that keeping inflation low and stable makes a positive contribution to long-run economic growth, and that this is the most effective contribution that monetary policy can make to the economy's performance over time. This finding supports the monetary policy framework operational in New Zealand, which is focused on keeping inflation between 1 and 3 per cent on average over the medium term.
As Nobel Laureate Robert Lucas has noted, once you start to think about output growth it is hard to think about anything else. (2) Because of the miracle of compounding, over long periods of time small changes in average growth rates cumulate into large differences in income levels.
New Zealand's growth experience over the last 40 years shows how important small differences in per capita growth rates can be. In 1960, New Zealand's per capita income was about the sixth highest in the world. However, over the next 40 years many other economies grew faster, overtaking New Zealand. As a result, New Zealand is now ranked twentieth in terms of per capita income and has a per capita income level about 60 per cent of the United States'. (3)
Economic growth and development are complicated processes that reflect a myriad of important factors. Conway and Orr (2000) provide a synopsis of the key events that have affected New Zealand's output growth over the past half century, including the economic reforms that took place over the last two decades.
In light of New Zealand's economic experience, a natural question to ask is whether there are policy interventions that can be adopted to improve New Zealand's growth performance. Since the Reserve Bank's primary domain is monetary policy, it is appropriate to critically assess the contribution monetary policy can make to New Zealand's long-run economic growth. To date, the consensus view is that achieving and maintaining price stability, whilst seeking to minimise volatility in other macroeconomic variables, is the most suitable monetary policy objective.
The primary focus of this article is thus on the long-run effects of monetary policy on the real economy. In particular, we wish to assess whether monetary policy can have sustained effects on real per capita income growth. Sustained differences in growth rates will unambiguously lead to substantial differences in income levels. Similarly, if New Zealand's per capita income grows faster than richer foreign countries', then New Zealand's per capita income should converge on that of richer countries.'
Section 2 begins by briefly looking at the traditional drivers of growth in economic theory. (4) The main determinants of growth are the accumulation of capital, growth in labour force participation, and the accumulation of knowledge and technology, though these near-determinants of growth are affected by a host of other factors. Section 3 looks at how monetary policy affects the economy, with particular emphasis on the key factors identified above. The article then discusses the empirical evidence regarding the drivers of growth, and explores how this empirical literature relates to monetary policy.
2 Growth accounting and growth theories
Measuring economic growth
Growth accounting frameworks have been used since the 1950s to decompose output growth into contributions from:
* growth in labour supply;
* growth in capital; and
* growth in total factor (multifactor) productivity. …