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Monetary Policy and Shifts in Long Run Productivity Growth ∗

The productivity slowdown in the 1970s and the speedup in the late 1990s presented difficult challenges to monetary policymakers. The productivity slowdown has been blamed for the 1970s stagflation episode—contemporaneous stagnant growth, high unemployment, and high inflation—while the productivity acceleration has similarly been credited with powering the disinflationary boom of the late 1990s. In both cases, monetary policy is believed to have been important in determining the economy’s response to the shift in long-run growth. Although there has been a great deal of study documenting these events, there has been surprisingly little formal analysis of the appropriate monetary policy response to shifts in the growth rate of productivity. Intuitively, it is clear that policy should somehow “accommodate” supply shocks such as these, but the question is, what does that imply for the setting of interest rates? In particular, should real interest rates—which will eventually move in the same direction as the change in the rate of productivity growth—rise or fall in response to technology shocks and how much does monetary policy matter for the evolution of real and nominal variables? A further challenge for monetary policy makers arises from the difficulty in identifying in real time shifts in the growth rate of productivity. In this paper, we examine the effects of (and appropriate policy response to) shifts in the growth rate of long-run multifactor productivity (MFP), where in doing so we recognize the important practical consideration that the underlying growth rate in MFP growth is unobservable in real time and must therefore be inferred from available data. We conduct our monetary policy analysis using the two-sector DGE model developed and estimated in Edge, Laubach, and Williams (2003), and modified here to allow for persistent changes in trend productivity growth. The model incorporates habit formation in consumption, investment adjustment costs, variable capacity utilization, sticky wages and prices, and imperfect information regarding the permanence of shocks to productivity growth. We find that shifts in the long-run productivity growth rate have sizable and highly persistent effects on the real economy and inflation. In addition, these responses, particularly those of employment and inflation, are sensitive to the specification of monetary policy. This latter result contrasts with that found using stylized New Keynesian models, in which the response to growth rate shocks is relatively insensitive to the particular specification of policy.