Daniel L. Thornton

Robert H. Rasche

English

Research Papers in Economics

January 2006 MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
S
ince becoming Chairman of the Federal Reserve in 1987,
Alan Greenspan steadfastly has held to the view that low
and stable inflation is a prerequisite for maximum sus-
tainable economic growth. He has reiterated this belief many
times during his nearly two decades as Fed Chairman. In con-
gressional testimony in July 1988, he stated that “the strategy
for monetary policy needs to be centered on making further
progress toward and ultimately reaching stable prices,” which
he defined as “a situation in which households and businesses
in making their saving and investment decisions can safely
ignore the possibility of sustained, generalized price increases
or decreases.”1 In February 1989, Greenspan explicitly noted
that the Fed’s ultimate objective is “maximum sustainable eco-
nomic growth over time” and that “the primary role of monetary
policy in the pursuit of this goal is to foster price stability.”2
Greenspan’s definition of price stability implies that economic
growth is maximized with a stable price level (i.e., zero inflation).
He made this explicit at the July 1996 FOMC meeting, when he
responded to the question of what level of inflation no longer
alters decisionmaking: “I would say the number is zero, if
inflation is properly measured.”3 Hence, the Chairman suggests
that a sustained inflation rate above zero, properly measured,
will keep output growth below its maximum level. While never
explicitly stated, the idea of a maximum and the inclusion of
price decreases in his definition of price stability imply sustained
deflation also has deleterious effects on output growth.
Greenspan’s view of a long-run negative relationship
between inflation and output growth is unconventional.
Starting with the “Phillips curve,” economists came to believe
that lower rates of inflation could be obtained only by reducing
output. In the late 1960s Milton Friedman and Edmund Phelps
demonstrated that, if economic agents are rational, the trade-off
could not be maintained indefinitely—i.e., the steady-state level
of output is independent of the rate of inflation, so that the long-
run Phillips curve is vertical. Most economists believe that,
beyond some rate, inflation does reduce output; however, many
believe that the long-run relationship is vertical over a range of
“moderate” inflation. If inflation has no permanent effect on
the level of output, it cannot have a permanent effect on the
growth rate of output. Hence, Greenspan’s view that sustainable
output growth is maximized when inflation is zero is clearly
unconventional.
Replacing the vertical Phillips curve with a negatively sloped
one is not trivial for at least two reasons. First, there is no particular
reason for policymakers to pursue zero inflation if the long-run
relationship is vertical. Any low steady-state inflation rate will
do as well. Consequently, policymakers might be inclined to accept
some “moderate inflation,” if for no other reason than to appease
those who believe that a little inflation is good for growth.
Second, because it is commonly believed that the steady-state
inflation rate can be reduced only if the economy grows at a rate
below potential for the period of disinflation, it is frequently
suggested that, once inflation is established it is better to tolerate
some “moderate” inflation than to bear the economic costs of
reducing the inflation rate to zero. This argument is significantly
weakened, if not eliminated, if inflation causes the economy to
grow below its maximum rate.4
The Greenspan principle—maximum sustainable economic
growth is achieved at zero inflation—is not yet reflected in modern
monetary policy analyses. Nearly all theoretical analyses incorpo-
rate some variant of an “expectations-augmented Phillips curve,”
where inflation is influenced by the gap between actual and
potential output in the short-run. Most of these models assume the
economy’s long-run growth rate is driven by exogenous factors
(e.g., technology and the growth rate of the labor force) that are
independent of monetary policy. Therefore, the Greenspan prin-
ciple is not reflected in conventional models. Given Greenspan’s
success over the past two decades, it would seem desirable that
models be modified to allow for the unconventional Greenspan
principle. One possibility is to incorporate Greenspan’s observa-
tion that “as the inflation rate falls, it becomes increasingly diffi-
cult for producers to raise prices. They therefore tend to try to
reduce costs in order to maintain margins.”5
—Robert H. Rasche and Daniel L. Thornton
1 Testimony before the Committee on Banking, Finance and Urban Affairs, 
U.S. Senate, July 13, 1988.
2 Testimony before the Committee on Banking, Finance and Urban Affairs, U.S.
Senate, February 21, 1989.
3 Transcript of the FOMC meeting held on July 2-3, 1996, p. 51.
4 See Daniel L. Thornton, “The Costs and Benefits of Price Stability: An
Assessment of Howitt’s Rule,” Federal Reserve Bank of St. Louis Review,
March/April 1996, 78(2), pp. 23-38. 
5 Transcript of the FOMC meeting held on July 2-3, 1996, p. 46.
Greenspan’s Unconventional View of the
Long-Run Inflation/Output Trade-off
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Greenspan's unconventional view of the long-run inflation/output trade-off

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Greenspan's unconventional view of the long-run inflation/output trade-off

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