South-Western College Publishing - Economics  
The Tradeoff Between Productivity (Employment) and Inflation
Topic Productivity and Growth
Subject Consumer Spending
Key Words Productivity, Economic Growth, and Inflation
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Reference ID: A134932420

News Story Productivity measures average output per worker and this measure has grown rapidly over the past ten years. As this trend began, Federal Reserve chairman Alan Greenspan broke with tradition and correctly recognized that the U.S. had entered an era of faster growth in productivity and that Fed policy should reflect the new trend. Now, ten years later, many analysts worry that the productivity growth of the past may be coming to an end. Couple this concern about decreasing productivity with rising labor costs and the Fed's goal of a neutral monetary policy may be more difficult to achieve. A neutral monetary policy would be one that neither hinders economic growth nor allows for significant inflation.

July posted a large increase in new jobs--up 207,000 from June--and topped off the jobs added this year at 1.3 million. As companies increase hiring, the pool of unemployed workers dwindle and wages begin to rise. The end result of higher wages is what economists call cost-push inflation, a condition in which rising labor costs result in higher consumer prices.

From about 1973 to 1995, productivity rose an average of about 1.5 percent per year. Then the pace nearly doubled after 1995, rising at about 3.0 percent per year. The main engine of productivity growth was the continually decreasing cost of computer technology, which allowed companies to invest heavily in information technology. The pace of productivity grew from 2001 to 2004 at a pace of about 4.0 percent and continued firms' ability to increase production without adding workers. The Fed's big question is whether productivity will continue to rise in the face of increasing unit labor costs. If productivity does not continue to increase, the economy will experience more inflationary pressures. An increasing trend in labor costs will also add inflationary pressure. Both trends would likely cause the Fed to raise interest rates faster than Greenspan's "measured pace" would warrant. Currently they stand by their position to raise rates at a "measured pace" and maintain a neutral monetary policy. If the Fed is required to raise interest rates faster, it could be a hindrance to further economic growth.

Mr. Greenspan has hinted about the Fed's concern in a statement to the Senate Banking Committee last month. "Over the past decade, the U.S. economy has benefited from a remarkable acceleration of productivity," Mr. Greenspan said. "But experience suggests that such rapid advances are unlikely to be maintained in an economy that has reached the cutting edge of technology."

1. Use a supply and demand for labor model to explain the rising wages as firms increase their hiring.
2. Discuss the notion of a "neutral monetary policy."
3. Define the term "cost-push inflation."
Source Edmund Andrews, "Productivity Is the Issue of the Hour for the Fed," The New York Times Online, August 8, 2005.

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