[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

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PRODUCTIVITY GROWTH AND THE PUNCH BOWL
To prevent inflation from rising, the Fed must not let the economy
overheat—if output rises above potential, the tight labor
market will lead wages to rise in excess of productivity growth.
As firms face increasing labor costs, they will boost their
prices, and inflation will rise. Sometimes it seems that just
when the good times of low unemployment arrive, the Fed
starts raising interest rates to slow things down. An old adage
about monetary policy is that the job of the Fed is to take the
punch bowl away just when the party really gets going.
Increases in productivity growth brought on by new technologies
will enable the Fed to leave the punch bowl out a bit
longer during booms.
The Fed’s actions have to do with the relationship between
wage increases, productivity, and inflation. As long as
wages do not increase faster than productivity, firms’ costs
of production will not rise. The reason is simple—firms may
have to pay more to their workers, but their workers are
producing more. The labor costs of producing each unit of
output—unit labor costs—do not increase when wages
rise at the same rate as productivity. The faster productivity
grows, the faster wages can rise without fueling price
increases.
Sometimes the Fed is criticized for raising interest rates
whenever wages start to rise. It is not wage increases themselves
that concern the Fed, however, but inflation. As long as
wage increases are in line with increases in productivity, they
do not increase firms’ costs or contribute to inflation. So the
Fed looks at unit labor costs to determine if wage increases
are inflationary or not. As the chart illustrates, during the
early 1980s, wage increases far outstripped increases in productivity,
causing unit labor costs to rise rapidly. The opposite
occurred during the 1990s. While wages started rising
faster in the late 1990s, so did productivity.
The years 1999 and 2000 illustrate some of the difficulties
facing the Fed as it makes its policy decisions. Wage growth
had increased. If the observed increases in productivity
growth heralded the arrival of a “new economy” in which
such growth would remain strong, then wages could rise
much faster than previously without arousing concerns that
they would ignite a new bout of inflation. If the increased
productivity growth turned out to be only temporary, then
the faster wage growth would start to push up unit labor
costs and prices. Information and computer technologies
are transforming the economy, and if these changes lead
growth and the growth rate of productivity increased. These developments were
consistent with a supply shock that lowered the unemployment rate at full employment
and shifted the inflation adjustment curve down, as illustrated in Figure 31.11.
As our model predicts, this resulted in lower unemployment and lower inflation.
The prime candidate for such a favorable supply shock is the new computer and
information technologies that have transformed so many parts of the American
economy.
As the 1990s ended, the Fed was concerned that the booming economy would
eventually lead to higher inflation. To guard against this, the Fed raised interest
rates several times in 1999 and 2000. These interest rate hikes were designed to
slow the economy by reducing demand, and signs that the economy’s strong growth
was weakening appeared by the end of 2000. The year 2000 also saw the collapse
708 ∂ CHAPTER 31 AGGREGATE DEMAND AND INFLATION