The economy does not seem to react to the same concerns that economists do. Economists look at a legion of potential problems including ten-year high oil prices, giant trade deficits and reputedly overvalued stocks, and worry about the magnitude of the resulting downturn. On the other hand, the economy appears to be shrugging off these events and extending each month the record for economic expansions. The reason that the economy continues to grow despite these seeming problems is worker productivity. The performance of the economy in the past few years has caused some economists to question whether recessions are inevitable; that is, can this expansion continue indefinitely?

Productivity improvements enable companies to produce more without adding additional workers. They also allow firms to pay their workers increased wages without having to pass these higher costs on to consumers in the form of higher prices. Firms continue to do this even if job markets tighten. Corporate earnings and ultimately stock prices rise with productivity improvements.

The latest data on productivity reported an increase of 5.7 percent on an annual basis for the second quarter of this year. Over the past 12 months ending in June, productivity had risen 5.2 percent, the largest increase since 1983, and unlike 1983, the reported gains follow almost a decade of economic growth. Productivity has increased steadily since 1996.

The implications of productivity growth for economic policy are profound. Some economists now estimate that the growth rate that can occur without a risk of higher inflation is 4.5 percent and might increase to 5 percent in the near future. A few years ago, the prevailing belief was 3 percent growth was all that the economy could sustain without inflation. Accordingly, those economists argue that there is currently no reason for Fed intervention.

(Updated October 1, 2000)

1. How is productivity measured?
2. Why does an increase in productivity allow a firm to pay higher wages without having to increase the price of the product?
3. How does an increase in interest rates affect the inflation rate? Explain the mechanism through which an increase in the interest rate would reduce inflationary pressure.
4. Why do some economists argue that productivity improvements decrease for the Fed to increase interest rates?