An examination of how inflation reduces economic welfare by causing people to work harder.Inflation (Finance) ; Productivity

Michael F. Bryan

English

Research Papers in Economics

August 15, 1990
eCONOMIG
COMMeNTORY
Federal Reserve Bank of Cleveland
Inflation and Growth: Working
More vs. Working Better
by Michael F. Bryan
r\.lice looked round her in great
surprise. "Why, I do believe we've been
under this tree the whole time! Every-
thing's just as it was!"
"Of course it is," said the Queen.
"What would you have it?"
"Well, in our country," said Alice, still
panting a little, "you'd generally get to
somewhere else—if you ran very fast
for a long time as we' ve been doing."
"A slow sort of country!" said the
Queen. "Now, here, you see, it takes
all the running you can do, to keep in
the same place. If you want to get some-
where else, you must run at least twice
as fast as that!"
from Through the Looking-Glass,
Lewis Carroll.
Economic growth springs from two
sources: either we work more or we
improve our productivity. It is impor-
tant to distinguish between the two
origins of growth because they have dif-
ferent implications for public welfare.
Economic growth that stems from
productivity is unquestionably benefi-
cial; it creates both wealth and leisure
time. Growth derived from effort
creates wealth at the expense of leisure
time, the welfare implications of which
are uncertain.
This Economic Commentary examines
trends in the sources of growth and
argues that inflation alters the long-term
composition of growth in a detrimental
way. Inflationary periods are shown to
correspond with periods of relatively
lower productivity growth and greater
work effort.
• Taking a Look Around
Growth in the current economic expan-
sion, at an inflation-adjusted or real
rate of just under 4 percent per year,
has been comparable to the 4.4 percent
average of the previous five expansions
since 1955 (figure 1). But by how
much has the current expansion
benefited the typical U.S. worker?
Regrettably, the record here has been
below par. Real income per worker, for
instance, has grown relatively slowly
during the current expansion (0.7 per-
cent annually vs. 1.7 percent for the
previous five expansions). Likewise,
the growth rate of real hourly compen-
sation in this expansion has been about
1 percent less per year than the average
of other expansions of the past 35
years. Indeed, in terms of the growth
rate of real GNP, expansions since
1955 have been remarkably similar,
deviating from the average rate by no
more than 1 percent per year and show-
ing no clear trend. However, the record
of recent expansions clearly shows a
decreasing propensity to generate real
gains per worker, or per hour of work.
The record of recent economic expan-
sions shows that work effort has sup-
planted productivity as a source of
growth. Inflation may be one of the
prominent causes of this trend, be-
cause it promotes errors in resource
allocation and discourages capital
development, eventually leading to
loss of wealth in the economy. Instead
of producing a faster rate of eco-
nomic growth, then, higher rates of
inflation reduce economic welfare by
causing us to work harder rather
than better.
In a competitive environment, workers'
income is commensurate with their con-
tribution to the economy. Simply put,
workers take from the economy a sum
equal to the value of their output; over
time, their hourly earnings should
reflect their hourly output, or produc-
tivity. It follows, then, that the
downward trend in the growth of real
hourly earnings stems from a decline in
the growth of productivity, a pattern
that is strongly supported by the data
(figure 2). Similarly, the failure of com-
pensation to keep pace with total output
suggests that recent expansions have
been associated with slower produc-
tivity growth and a rise in the growth of
total hours worked, or "work effort."
ISSN 0428-1276FIGURE 1 EXPANSION COMPARISONS
Percent change, annual rate
6
5
4
3
2
1
0 Mid 1950s Late 1950s 1960s Mid 1970s Late 1970s
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis, and U.S. Department of Labor, Bureau of Labor Statistics.
Real GNP
Real compensation per hour
1980s
Examination of the relative contribu-
tions of work effort and productivity to
the trend growth rate of real private out-
put, shown in figure 3, reveals that a
striking shift has occurred in the origin
of growth. In the early 1960s, nearly
all of the trend growth in the economy
came from improved productivity. Dur-
ing the 20 years that followed, the role
of productivity diminished and work
effort became an increasingly important
source of growth; by the late 1970s, vir-
tually all of the private growth trend
was the result of greater work effort.
• You'd Generally Get to
Somewhere Else
The trend decline in productivity
growth is one of the more puzzling and,
admittedly, more controversial issues in
the analysis of recent business cycles.
But there seems to be sufficient
evidence to claim that inflation may be
one of its more prominent causes. To
understand how inflation affects produc-
tivity, we need to appreciate the damage
that inflation inflicts on an economy.
Prices are the mechanism by which mar-
kets allocate an economy's resources.
Specifically, price increases guide addi-
tional resources to markets, while price
decreases direct resources away from
markets. These market signals, or rela-
tive price movements, are the primary
channel through which market informa-
tion is transmitted and are therefore
FIGURE 2 REAL COMPENSATION AND PRODUCTIVITY TRENDS
IN NONFARM BUSINESS
Percent change, annual rate
5
Real compensation per hour
-1 I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I
1955 1960 1965 1970 1975 1980 1985 1989
NOTE: Data are trends in real compensation per hour and productivity in nonfarm business. Trends are
calculated over a five-year period, corresponding roughly to the length of the average postwar business cycle.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.FIGURE 3 EFFICIENCY VS. EFFORT
Shares of Trend Growth, 1951-1989
Percent
100
1955 1960 1965 1970 1975 1980 1985 1990
Productivity Hours
NOTE: Data are for nonfarm business. Trends are calculated over a five-year period to correspond roughly to the average length of the business cycle. Shares were
constrained to a minimum of 0 percent and a maximum of 100 percent.
SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.
vitally important to the operation of
markets. Inflation, however, has nothing
to do with the transmission of market
information, but is instead a general
reduction in the purchasing power of
money.
If unanticipated, inflation can be mis-
interpreted as a relative price signal,
making the transmission of market
information less accurate and leading to
errors in the allocation of resources.
Inefficiency is compounded as time and
other resources are redirected into the
wasteful enterprise of filtering inflation-
ary noise from prices. Even if antici-
pated, inflation may impede productiv-
ity growth as households and firms are
forced into various protective
maneuvers.
There may also be a link between infla-
tion and productivity growth through
the tax code. A recent study indicates
that fully anticipated inflation reduces
the after-tax rate of return on human
and physical capital in a substantial
way and thus discourages capital
development."
These linkages between inflation and
productivity suggest that inflation
reduces an economy's potential output
by reducing its accumulation of
resources—its wealth. One possible
implication is that the inflation-induced
reduction in wealth may be compen-
sated for by an increase in work effort.
In this way, we might think of the
growth implications from inflation in
the same light as we do a natural dis-
aster. When Hurricane Hugo swept
through the Southeast last fall, it caused
losses of billions of dollars in property
damage and in lost work time. Accord-
ing to many estimates, though, the hur-
ricane actually had a small net positive
impact on real GNP growth. How does
a natural disaster produce growth?
One response is that the economy is
called upon to repair buildings and
other damaged structures. But this
answer isn't particularly appealing,
because it assumes surplus resources
are ready and waiting for a disaster to
call them into service (not to mention
the frightful policy implications). A
more sensible explanation is that the
substantial wealth loss caused by the
catastrophe prompts people to work
harder than they otherwise would.
That is, households are motivated to
sacrifice some of their leisure in order
to rebuild. It follows, then, that as infla-
tion lowers the trend in productivity
growth, it diminishes the nation's
wealth potential, part of which will be
compensated for by an increase in
work effort.
• It Takes All the Running You
Can Do
The rate of inflation and the growth
rates of output, productivity, and hours
for the expansionary years between
1951 and 1989 are shown in figures 4a
to 4c. Over this period, no statisticallyFIGURE 4A
Output
FIGURE 4B
Productivity
FIGURE 4C
Hours
FIGURES 4A TO 4C INFLATION AND GROWTH
RATES OF OUTPUT, PRODUCTIVITY, AND HOURS
Percent change
10
9
8
7
6
5
4
3
2
1
0
-1
1
_
-
-
- ^
-
- •
- £A
-
_
i
I
• ••
•
i i i i I I i I I
0123456
Inflation
Percent change
789 10
"0 1 23456
Inflation
Percent change
789 10
10
9
8
7
6
5
4
3
0
c.
1
0
-1
-
-
-
-
-
- •
1 1 1
•
w
1 1 1 1 1 1 1
"0123456
Inflation
789 10
NOTE: Data are for expansion years only, 1951 to 1989. Inflation is measured by the change in the GNP im-
plicit price deflator. Output, productivity, and hours are measured for nonfarm business. Solid line represents
tendency implied by an ordinary least squares regression.
SOURCES: U.S. Department of Commerce, Bureau of Economic Analysis, and U.S. Department of Labor,
Bureau of Labor Statistics.
significant relationship between infla-
tion and output can be detected, a
result that seems broadly consistent
with previous research on the impact of
inflation on trend real GNP growth. Yet
a significant, negative correlation can
be found between inflation and produc-
tivity growth. Specifically, for every 1
percentage point of inflation, produc-
tivity growth in expansions has tended
to decline by 0.3 percent. Further, the
inflation-induced drop in productivity
growth seems to have been offset by an
equal rise in work effort.
If we separate work effort into four
components—the length of the work-
week, the rate of labor-force partici-
pation, the size of the working-age
population, and the level of surplus
unemployment—we can identify more
clearly the source of the additional
effort.
7 While the association is some-
what crude, there has been a strong ten-
dency for the rate of labor-force par-
ticipation to rise and fall with the rate
of inflation (figure 5). Linkages be-
tween the rate of inflation and the other
sources of work effort were unsubstan-
tiated by the data.
• Correlation, Causality, and
Other Caveats
The patterns outlined in the previous
section show correlation between infla-
tion and the origins of growth, but in
all fairness, there has been no demon-
stration of causality. Thus, we must ask
whether the increase in effort or the
slowdown in productivity growth could
be "causing" inflation. One way to
address these issues is through a simple
supply-and-demand framework. An
increase in aggregate spending could
explain rising hours, lower productiv-
ity, and higher prices if resource mar-
kets respond sluggishly to changes in
aggregate conditions. But if aggregate
spending is driving hours growth and
reducing the marginal productivity of
labor, the growth rate of output would
tend to rise with the rate of inflation.
No such relationship was found.
Alternatively, it could be that the
decline in productivity resulting from
other factors might cause a rise in infla-FIGURE 5 INFLATION AND TREND LABOR-FORCE PARTICIPATION
Percent, annual rate Change, tenths
6.0
Labor-force
participation
(right axis)
-2.0
1955 1960 1965 1970 1975 1980 1985 1990
NOTE: Inflation is measured by the implicit price deflator (annual changes). The trend in the labor-force participation rate is for civilian workers. Trend changes are
calculated over a five-year period.
SOURCES: U.S. Department of Commerce. Bureau of Economic Analysis, and U.S. Department of Labor, Bureau of Labor Statistics.
tion. Certainly a drop in the rate of
productivity growth would put upward
pressure on the price level if aggregate
supply fails to keep pace with aggregate
demand. However, a study of the
Canadian economy indicated that a 1
percent increase in inflation produced a
0.3 percent net decline in the rate of
productivity growth from 1963 to 1979,
the same magnitude as the results pre-
sented here. Similar conclusions were
later drawn on U.S. data.10
Another issue is whether inflation per
se or inflation uncertainty underlies the
growth shift from efficiency to effort.
While this is a critical issue for policy-
makers, it is less important for the rela-
tionships being examined here, because
both types of inflation phenomena can
explain the observed trends in labor
markets. Note, though, that many of the
theoretical linkages between inflation
and productivity growth hold even
when inflation is fully anticipated. This
conclusion is supported by the evidence
on the Canadian economy, where more
than 80 percent of the inflation-induced
decline in productivity growth was
attributed to inflation that was probably
anticipated."
Finally, it must be admitted that the
connections between inflation and the
growth rates of productivity and work
effort depicted earlier show consider-
able variation around trend. ~ Other
factors are obviously influencing these
variables. One noteworthy considera-
tion is that the impact of aggregate
price movements on work effort most
likely depends on the perceived per-
manence of the price movements. If the
rate of price increase is believed to be
transitory, its impact on trend produc-
tivity should be marginal and have lit-
tle effect on the work effort of
households. However, if the price rise
is thought to be a permanent feature of
the economy, such as in the case of a
monetary inflation, its influence on
wealth and work effort should be con-
siderably greater.
• If You Want to Get to
Somewhere Else
The pace of the longest peacetime
expansion in U.S. history has slowed
recently. According to preliminary esti-
mates, real GNP grew at a sluggish 1.2
percent annual rate in the second quar-
ter, and several prominent economists
see a continued flatness in the economy
over the next several quarters. The slow-
down in business activity has brought
forth calls for the Federal Reserve to
promote stronger growth by easing the
monetary reins: reducing interest rates
to stimulate spending. This prescription
reflects a traditionally accepted short-
run exchange of more growth today at
the risk of higher inflation tomorrow.
Correct or not, the implications of infla-
tion on future economic growth should
also be considered.
Experience has shown that there are no
quick fixes in the promotion of growth.
There is no evidence that a faster trend
rate of economic growth can be bought
with a higher rate of inflation. Indeed,
it seems likely that inflation reduces
the welfare implied by growth by alter-
ing the origin of growth from produc-
tivity to effort. Viewed in this light, a
monetary policy designed to eliminate
inflation may also be a policy that best
encourages productivity and so best
promotes welfare-enhancing growth.• Footnotes
1. This excludes the disputable two-quarter
mini-expansion of 1982.
2. Work effort is defined as total hours
worked in nonfarm business, and produc-
tivity is defined as output per hour in non-
farm business.
3. For a discussion of the linkages between
inflation and efficiency, see A. Leijonhufvud,
"Costs and Consequences of Inflation," in
G.C. Harcourt, ed., The Microeconomic
Foundations of Macroeconomics, proceed-
ings of a conference held by the International
Economic Association at S'Agaro, Spain,
Boulder, Colo.: Westview Press, 1977, pp.
265-98. The impact of inflation on produc-
tivity is discussed at length in Michael J. Bos-
kin, Mark Gertler, and Charles Taylor, "The
Impact of Inflation on U.S. Productivity and
International Competitiveness," NPA Report
#182, Washington, D.C.: National Planning
Association Committee on Changing Interna-
tional Realities, September 1980. For a par-
tial listing of articles linking inflation to
productivity, see J. Peter Jarrett and Jack G.
Selody, "The Productivity-Inflation Nexus in
Canada, 1963-1979," Review of Economics
and Statistics, vol. 64 (August 1982), pp.
361-67.
4. Some examples of protective maneuvers
include the redistribution of assets from debt
to equity, increased costs of cash manage-
ment, greater business inventory investment,
and increased contracting costs.
5. See David Altig and Charles T.
Carlstrom, "Inflation and the Personal Tax
Code: Assessing Indexation," Working Paper
9006, Federal Reserve Bank of Cleveland,
July 1990. This result is similar to that dis-
cussed in Boskin et al., "The Impact of Infla-
tion on U.S. Productivity," p. 29, and in
Martin Feldstein, Jerry Green, and Eytan
Sheshinski, "Inflation and Taxes in a Grow-
ing Economy with Debt and Equity
Finance," Journal of Political Economy,
vol. 86 (April 1978), pp. 553-70.
6. It has been suggested by a colleague that
inflation also reduces the rate of return on
physical capital relative to human capital,
and so causes a substitution between produc-
tivity and effort in production.
7. Surplus unemployment is defined as the
residual between the growth rate of total
hours and the growth of the workweek, the
working-age population, and the participa-
tion rate.
8. This effect was also documented by
Browne, who found that the labor-force par-
ticipation rate of women is positively corre-
lated to the rate of inflation. See Lynne E.
Browne, "Why Do New Englanders Work So
Much?" New England Economic Review,
Federal Reserve Bank of Boston. March/
April 1990, pp. 33-46. New entrants into the
labor force in recent years have predominant-
ly been adult women. There are many pos-
sible explanations for the rise of women in
the labor force, such as important legislative
changes and higher education levels, to name
but a few. These "causes" need not be com-
peting views to the inflation hypothesis
presented here. This hypothesis would seek
only to include inflation as one important
catalyst to these other explanations.
9. See Jarrett and Selody, "The Productivity-
Inflation Nexus in Canada."
10. See Rati Ram, "Causal Ordering Across
Inflation and Productivity Growth in the
Postwar United States," Review of
Economics and Statistics, vol. 66 (August
1984), pp. 472-77; and A. Aydin Cecen, "X-
Inefficiency, Productivity, and Inflation: An
Empirical Investigation," Atlantic Economic
Journal, vol. 17 (March 1989), pp. 43-46.
11. See footnote 9.
12. This is borne out by the statistical
evidence. Changes in the inflation rate are as-
sociated with only about 19 percent of the
variation in hours growth and 24 percent of
the variation in productivity growth.
Michael F. Bryan is an economist at the
Federal Resen'e Bank of Cleveland. The
author wishes to thank, without implicating,
David Altig, Richard Jefferis, and Katherine
Samolyk for their contributions and com-
ments. Lydia Leovic provided research assis-
tance.
The views stated herein are those of the
author and not necessarily those of the
Federal Resen'e Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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