Should We Expect Higher Growth from Lower Inflation

When the Bank of Canada embarked on its drive for “price stability” in the early 1990s, it was well known both inside and outside the bank that obtaining the longterm benefits of low inflation would require suffering short-term costs in the form of temporarily lower output and higher unemployment. As it happened, inflation in Canada fell sharply, from about 6 per cent in 1990 to below 2 per cent in 1992, and a significant recession occurred. For the next six years, inflation fluctuated mildly between 1 per cent and 2 per cent, though it was more often below 1.5 per cent By the summer of 2000, low and stable inf la t ion had surely been achieved in Canada. Now both critics and supporters of the bank’s disinflation policy have begun to wonder when the longterm benefits will appear. Especially notable has been the different macroeconomic performances of Canada and the U.S. While the U.S. had slightly higher inflation than Canada in 1992-98, its unemployment rate was significantly lower and the rate of productivity growth slightly higher. This has led many to question whether Canada’s inferior macroeconomic performance is related to the Bank of Canada’s strong policy stance against inflation. Given the amount of effort devoted to researching inflation’s causes and effects, it is perhaps surprising there is little consensus about the benefits of low inflation. Though economists and the public agree that low inflation is desirable, there is much less agreement about why this should be so. Non-economists typically focus on how inflation affects their real purchasing power. As shown by a recent survey by Shiller (1997), it is common for them to conclude that increases in the overall price level generate a reduction in real purchasing power and thus a reduction in overall living standards. They often do not seem to realize that real incomes may be unaffected when changes in nominal incomes accompany changes in prices. Economists focus on other aspects of inflation. Some emphasize the benefits of low inflation that are, at least in principle, detectable in conventional macroeconomic data, such as a higher growth rate of productivity or real per capita gross domestic product. Others stress factors that are less visible and measurable, but nonetheless genuine, such as greater efficiency of the price system, which results in a welfare-improving reallocation of resources. Over the past few years, Bank of Canada Governor Gordon Thiessen and other senior bank officials have stated the case for attaining and maintaining low inflation. In his speeches, many of which are reprinted in the Bank of Canada Review, Mr. Thiessen clearly recognizes that some benefits of low inflation — such as greater efficiency of the price system — are probably impossible to discern in the readily available data. He has also argued, however, an important benefit of low inflation is that it leads to a greater rate of economic growth and, through this channel, to an improvement in living standards. Consider the following example from the first year of his stewardship at the Bank of Canada, when Canada’s inflation rate had been close to 2 per cent for two years: Why has price stability been chosen as the objective of monetary policy? The economy is more efficient, and this helps to support growth in output, high employment and rising living standards. (Bank of Canada Review, Summer 1994, p. 59)