RDP 2003-10: Productivity and Inflation 3. Previous Research

Tim Bulman and John Simon

September 2003

Early research into the inflation-productivity nexus was stimulated by the experience of high inflation of the 1970s and the subsequent fall in productivity growth. Most of the literature has debated the statistical question of whether the data support any relationship, and if so, the causal direction. Minimal work explores the theoretical side, or how inflation may be transmitted into slower productivity growth and vice versa. By country, a range of literature examines the relationship in the G7 economies, but we are aware of no comprehensive and conclusive recent Australian study of the inflation-productivity relationship. Further, all these studies only observe the relationship at the aggregate level without gaining from potential industry-specific insights. Notwithstanding this, we glean some useful points from what's gone before. (Table 2 summarises the literature's findings.)

Table 2: The Productivity Growth-Inflation Relationship Survey of empirical evidence
Paper
 		 Sample
 		 Productivity
measure		 Significant
relationship		 Causal direction
 
  Inflation
productivity growth		 Productivity growth
inflation
Jarrett and Selody(1982) Canada aggregate:
1963:Q2–1979:Q4		 Labour (hours) Yes Yes Yes
Clark (1982) US aggregate:
1947:Q1–1981:Q2		 Labour Yes Yes No
Ram (1984) US aggregate:
1953:Q1–1982:Q4		 Labour (hours) Yes Yes No
Buck and Fitzroy (1988) West Germany (40 industries):
1950–1977 (annual)		 Multifactor Yes Yes No
Saunders and Biswas (1990) UK aggregate:
1977:Q3–1985:Q2		 Labour (hours) Yes Yes No
Sbordone and Kuttner (1994) US:
1947:Q1–1994:Q2		 Non-farm
business labour		 Yes Weakly, yes No
Smyth (1995a) West Germany aggregate:
1951–1991		 Multifactor Yes Not tested Not tested
Smyth (1995b) US: 1955–1990
Private business
Private non-farm business
Manufacturing 		Multifactor Yes
Yes
Yes		 Not tested Not tested
Cameron, Hum and Simpson (1996) US, UK, Canada:
1953–1991
West Germany:
1960–1991		 Labour
(employment)		 May affect
growth, not level
of productivity		 No No
Chowdhury and Mallik (1998) Australia: 1958–1996 and
1968:Q1–1997:Q3
New Zealand: 1968–1996 		Labour
(employment)		 No clear findings
for levels or growth		 Not tested Not tested
Freeman and Yerger (2000) 12 OECD economies(a):
1961–1994 (annual)		 Manufacturing
labour (hours)		 Only in a minority
of countries		 Only in a minority
of countries		 No
Tsionas (2001) European economies(b):
1960–1997		 Multifactor No long-run relationship Belgium, Finland,
France, Germany,
Greece, Ireland, UK 		Belgium,
France, Germany,
Greece, UK
Tsionas (2003) 15 European economies:
1960–1997		 Country-specific
productivity index
(Baltagi, Griffin and Rich 1995) 		In some countries Belgium, Finland,
France, Germany,
Greece, Ireland, UK		 Belgium,
France, Germany,
Greece, UK

Notes: (a) Economies studied were Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Norway, Sweden, UK, and US.
(b) Economies studied were Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, and UK.

The early view was a little circumspect about the nature of any relationship between productivity growth and inflation. Nonetheless, both Keynesian and neoclassical theory (e.g., Lucas's (1973) simple model of an output-inflation trade-off) suggest a negative relationship. Into this context, the earliest papers sought to reconcile the observed North American acceleration in inflation and following decline in productivity growth. Jarret and Selody (1982) proposed two rationales for this occurrence: that the tax system's lack of neutrality during periods of inflation increases the private sector's tax burden,[5] and that inflation's increasing variance with higher levels of inflation would cause sub-optimal resource allocations and increase the probability of ‘entrepreneurial error’, hence reducing investment. Using 1963–1979 Canadian data, Jarret and Selody found a bi-directional relationship, with the rise in inflation explaining nearly the entire slowdown in productivity growth. US data over the period 1948–1981 demonstrate a similar correlation, with causation running one-way from higher inflation to slower productivity growth (Clark 1982).[6] Methodologically, these studies apply Granger-type causality tests to OLS (Clark 1982; Ram 1984) or Full Information Maximum Likelihood (Jarret and Selody 1982) estimations.

A second group of papers took up the debate in the mid 1990s. These had the advantage of being able to observe the productivity growth-inflation relationship after the 1980s' disinflation, and also draw on the experience of a wider range of G7 economies. They are more equivocal about the existence of any relationship.

A further group of papers is sceptical of any inflation-productivity growth relationship. These papers take two tacks. One approach is to argue that the results show that the business cycle drives simultaneous variations in both productivity growth and inflation, not a long-run relationship.[7] The stylised facts have productivity growth peaking ahead of the business cycle, with inflation then accelerating. In response, the monetary authorities increase interest rates, thus slowing output growth hence productivity growth through the effects of labour hoarding. Inflation's slow-down lags that of the real economy. Thus, an appropriate model of the productivity growth-inflation relationship must absorb the business cycle through variables such as real interest rates, the output gap, or variations in GDP growth.

The other critique argues the statistical point that productivity growth and inflation have different orders of integration.[8] These studies claim inflation is non-stationary while productivity growth is stationary, and therefore there cannot be a long-run relationship. Statistically speaking, this seems a not unreasonable complaint. Nonetheless, there is much debate about whether inflation is better characterised as an I(1) process or as stationary around a broken trend. For example, Hendry (2001) finds that UK inflation is best characterised as I(0) but non-stationary due to regime breaks over a very long sample. If this is the case, the observation that one cannot reject that inflation is I(1) over a particular sample does not necessarily lead to the conclusion that it could not possibly be related to productivity growth.[9]

In summary, we take several points from the literature. Methodologically, the literature is uniform in its approach. Almost all the papers run Granger causality tests, or a close relative, VAR models. Second, there does appear to be a relationship between productivity growth and inflation, and, where it is determinable, the causality appears to flow from inflation to productivity growth. Third, two pitfalls are to be avoided: ignoring the macroeconomic context of the inflation-productivity growth relationship; and ignoring the statistical issues of correlating series with potentially different orders of integration. A final point is that we could find no comprehensive and satisfactory Australian study of the inflation-productivity growth relationship. Our study addresses this gap.

Footnotes

See, e.g., Feldstein (1982a, 1982b). [5]

Ram (1984) reaches the same conclusion, using a CPI-based measure of inflation. [6]

E.g., Sbordone and Kuttner (1994); Freeman and Yerger (2000). [7]

E.g., Sbordone and Kuttner (1994); Cameron et al (1996); Freeman and Yerger (2000); Tsionas (2003). [8]

Hall (1999) argues emphatically that inflation should be treated as mean-reverting, even if it may statistically appear otherwise. [9]