RDP 2003-10: Productivity and Inflation 2. Theoretical Preamble
September 2003
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The simplest models in macroeconomics generally assume that nominal and real variables are unrelated in the long run. ‘Inflation is always and everywhere a monetary phenomenon’ (Friedman 1956, p 4); productivity is a purely real occurrence. But upon reflection, we may reasonably think that inflation – or at the least, things associated with it – must matter for firms' ability to improve their productivity, for example. And in an effort to better model the behaviour of actual economies, much economic research has been directed at investigating the real effects of nominal fluctuations. This section discusses some possible explanations for the nexus.
In considering a link between inflation and productivity there are two possible causal directions: productivity affects inflation or inflation affects productivity. The first generally has higher productivity allowing cost reductions that flow through to product prices and thereby reduce inflation. Higher productivity growth thus represents a positive supply shock that lowers inflationary pressures.
The second effect posits that inflation affects productivity growth. From first principles, prices matter because they are a highly efficient means of transmitting the myriad of individual demand and supply decisions that occur throughout the economy.[3] In an inflationary environment, the price mechanism loses its efficiency. It seems plausible then, that when prices are changing frequently, firms may find it more difficult to distinguish an increase in the relative scarcity of their inputs from an across-the-board increase in prices. This may cause firms to direct resources previously devoted to research and development, and organisational and managerial improvements, towards making basic decisions about optimal input allocations and the price of outputs. Similarly, the reduced certainty brought about by inflation increases the risk of entrepreneurial errors and would potentially induce lower levels of investment. This would all lower the overall productivity of the firm.
There are also arguments based on the interaction of the tax system with higher inflation. During periods of high inflation the tax system distorts incentives through its treatment of depreciation and capital gains. These distortions are also likely to have negative effects on productivity.[4]