FRBSF Economic Letter
96-16; May 17, 1996
Economic Growth and Monetary Policy
This Economic Letter is adapted from recent speeches given
by Robert T. Parry, President and Chief Executive Officer of the Federal
Reserve Bank of San Francisco.
A controversy about the national economy has been in the headlines recently.
For example, in the Christian Science Monitor, one headline was
"What's the Economic Speed Limit?" As if in answer, the New
York Times featured an article entitled "It's a Slow-Growth
Economy." At the heart of the controversy is something called the
"potential growth rate"--that is, the rate the national economy
can sustain in the long run without generating inflationary pressures.
Potential growth is important because it is a measure (albeit an imperfect
one) of the pace at which the average standard of living grows in the
U.S. Even a small change in the potential growth rate will accumulate
into a large difference in living standards when sustained over decades.
The potential growth rate is controversial for several reasons. First,
it appears that potential growth in the 1990s is running in the 2 percent
range--a number that many people think is very low. Also, this estimate
represents a slowdown from earlier periods. In fact, some estimates going
back to the 1960s show that the rate has dropped from 4 percent to just
over 3 percent from 1973-1979, to just under 3 percent from 1979-1990.
This decline runs counter to people's expectation that potential growth
should increase over time, as computer technology improves and spreads
and as corporations streamline their organizations. A final reason for
the controversy over potential GDP is that some people blame the Fed for
slow economic growth. They assert that the reason that growth hasn't been
higher is that the Fed hasn't let the economy grow any faster.
I can't give you a complete explanation for the pattern of growth in
the U.S., but I can provide some insight into some of the controversies
underlying this issue, as well as a perspective on how it relates to monetary
policy.
As I said, potential growth is the rate that the economy can sustain
in the long run without generating inflationary pressures. It's measured
as the long-run trend of economic growth--that is, abstracting from the
ups and downs of the business cycle. It depends on two things: the trend
in the number of people available to work--that is, the size of the labor
force, and the trend in how much output those people can produce an hour--the
productivity of the labor force.
The official Commerce Department data on GDP suggest that for the 1990s,
there's no change in the productivity trend, but there's a noticeable
slowdown in the growth rate of the labor force. This slowdown is due in
part to the fact that the working age population is growing somewhat more
slowl--in the 1980s, the annual growth rate was around 1-1/4 percent,
and in the 1990s it dropped to about 1 percent.
But a more significant development has to do with the role of women in
the workforce. While the pattern of men's labor force participation has
been pretty much the same for the past 35 years, the pattern for women
has changed more dramatically. From 1960 to 1990, women's participation
rate--the proportion of working age women who are either employed or looking
for work--rose from under 40 percent to just under 60 percent. But since
then, it's stayed right about there. Whether this more or less flat growth
in women's labor force participation rate is likely to continue depends
on a number of things, many of which will be discussed in next week's
Economic Letter (Motley 1996).
To summarize those points briefly, it appears that since 1990, women's
participation rate has leveled off because of a leveling off in both the
number of women who have entered the workforce at all and the number of
weeks they've worked per year. There still is a lot of upside potential
for the number of women who choose to enter the labor force at all during
a given year. But there's not much upside potential in expanding the number
of weeks worked per year--for either women or men. For both, the average
is around 48 weeks per year. Overall, then, we can't say for sure what
will happen to women's participation in the future, but we can say that
the proportion of women working and the number of weeks they're working
recently has reached a plateau.
This story about a change in women's participation in the workforce would
seem to explain why the potential growth rate has slowed in the 1990s.
But a lot of people don't accept that explanation. It's not because they
aren't convinced about a change in women's participation rate. It's because
they're not at all convinced that the growth rate of productivity hasn't
changed in 20 years, as the data suggest.
According to the official Commerce Department data, the trend growth
rate is still about 1 percent a year, with no sign of a pickup in the
1990s. A lot of analysts would argue that productivity growth is underestimated.
They'd also say actual productivity growth has been rising faster in the
1990s. And they'd cite a couple of reasons. One has to do with computers.
People argue that current measures aren't accounting for the improvements
in productivity that computers have made. They focus on the fact that
much of the growth in computer use has been in the service sector, where
it's hard to measure exactly what the output is--for example, how do you
measure the output of a lawyer, or an economist? And if it's hard to measure
output itself, it's even harder to measure the improvement in quantity
or quality made by a faster, more powerful computer.
Unfortunately, there's no consensus on whether computers have led to
a major productivity surge. For example, some economists have done elaborate
studies looking for evidence of a pickup in productivity growth due to
computers. But they haven't found it. Their reasoning is that computers
make up only about 2 percent of the U.S. capital stock, and therefore
can't make a large, direct contribution to overall productivity even if
each computer is highly productive. Specifically, these studies show that
even if we assume extremely high rates of return to computer hardware
and software, communications equipment, photocopy equipment, scientific
instruments, office and accounting equipment, we obtain an increase in
potential GDP growth of only 0.5 percent per year.
At the same time, other economists don't find these results to be definitive.
For example, even though the direct contribution of the stock of computers
to productivity may be relatively small, computers also may contribute
to productivity through technological advances--that is, through the development
of entirely new ways of doing things. These effects are extremely difficult
to capture.
Another thing people point to as contributing to increased productivity
in the 1990s is the apparent trend toward downsizing. But here, too, there's
controversy. Despite all the news we hear about big companies laying off
thousands, the evidence shows that in the 1990s the proportions of workers
who have been laid off hasn't been strikingly higher than in previous
periods. On top of that, a study of individual firms showed that downsizing
has not been consistently associated with increased productivity. What
does seem to be new is that downsizing is concentrated more in white collar
jobs now, while before it was focused mainly on blue collar jobs. Finally,
even if downsizing improved the productivity of the corporation doing
it, that would not be sufficient to establish an increase in productivity
for the economy as a whole. The latter question also depends on how productive
the terminated worker is once he finds a new job. Given that job skills
often are tied to one's current job, it would not be surprising to find
a fall-off in productivity in a person who involuntarily changes jobs.
To sum up, we are left with a lot of uncertainty about productivity--and
that means there's also uncertainty about potential GDP.
Does this uncertainty about potential GDP have a big effect on monetary
policy? That is, if potential growth is underestimated, does that mean
monetary policy's likely to be too restrictive? The answer's "no."
The Fed uses potential GDP as a kind of benchmark. Although we don't
have a target for real GDP growth, we know that we're going to end up
with higher inflation if actual GDP grows above the potential rate for
too long. So what we look at is the gap between actual and potential GDP.
And since potential GDP is simply estimated from the GDP data itself,
it's probably not crucial if those data underestimate productivity. Both
figures are likely to underestimate productivity to about the same degree,
so the gap isn't likely to be seriously affected by measurement problems.
Moreover, although potential GDP is an important benchmark for the Fed,
it's certainly not the only thing we look at. So if it turned out we weren't
reading potential GDP correctly, we'd get signals about that from other
indicators. For example, if actual GDP had been below potential GDP in
recent years, we'd have seen increases in unemployment rates and unused
industrial capacity, as the demand for workers and capital fell short
of potential gains. At some point, this would have translated into downward
pressure on inflation. But, in fact, we haven't seen this happen.
Let me conclude by saying that the Fed certainly would be just as happy
as anybody to see faster growth in potential GDP. But it's important to
remember that the Fed can't create it for long by stimulative monetary
policies. If we were to try--by consistently pushing GDP growth beyond
its potential--the inevitable result would be higher inflation. What we
can create is an environment of low, stable inflation. It's that environment
that allows our market economy to function as efficiently as possible
and that leads to investment in capital and labor in the long run. Ultimately,
that's the kind of environment we need to promote productivity and improve
the living standards in the U.S.
Oliner, Stephen D., and William Wascher. 1995. "Is a Productivity
Revolution under Way in the United States?" Challenge (November-December).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
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