Inflation and productivity - evidence from low inflation targeting countries

The coexistence of productivity slowdown and high inflation in the 1970s and for the most part of the 1980s served as a prima facie case for treating high inflation as one of the principal contributory factors to the observed productivity slowdown. Hence, zero or low inflation has become the only target of monetary policy in industrialised countries. This reflects two ideas: (1) high rates of inflation distort decision making which leads to slower economic growth; and (2) monetary policy is most effective in achieving price stability. Since adopting this stance of monetary policy, there has been a remarkable convergence of inflation rates - most OECD countries now have inflation rates of around 3 per cent or less. However, the expected rise in productivity as a result of low inflation has not yet materialised. This paper examines the inflation-productivity relationship in New Zealand, Canada, the UK, Sweden, Finland, Australia and Spain as these countries have adopted a 'formal' policy of a low or zero inflation target. Using cointegration analysis and an error correction mechanism, we find that the promised relationship between inflation and productivity is either fragile or missing.