There are essentially three perspectives on the current state of America’s continually expanding economy and the dilemmas it poses for policymakers.1 The first, the so-called “new era” view, holds that the spread of computers, the Internet, and other forms of information technology have increased productivity so much that we no longer have to worry about inflation, limits to economic growth, or the business cycle. As more goods are produced per hour of work, spending by consumers and producers will increase but it will not outstrip rising economic productive capacity; prices will remain steady or rise gradually. While this argument surely overstates the case, there is little question that the recent acceleration in productivity has helped keep inflation in check, and that, as Federal Reserve chairman Alan Greenspan believes, it “owes importantly to new information technologies.”2
The second, more traditional view claims that there are well-established limits to how low unemployment can fall, or how fast the economy can grow, without triggering ever-accelerating inflation. These limits are thought to be unemployment rates of 5 to 6 percent, or growth rates of about 3 percent, and we have exceeded them by a large margin. As shown in the chart on page 36, the unemployment rate is just over 4 percent, the lowest it has been since 1970, and the economy has been growing at approximately 4 percent a year since 1996, about a third faster than its average from 1991 to 1998, yet inflation has fallen to less than 2 percent a year. Most conventional economists and other experts who still maintain this position believe that inflation has been kept in check only by special factors such as the Asian financial crisis, falling commodity prices, and the lack of pressure for higher wages for workers, but that these forces are weakening, and the Federal Reserve should act to slow the economy before it is too late.3
The third perspective, articulated most forcefully by Robert Solow in Inflation, Unemployment, and Monetary Policy, admits that there are limits to growth and unemployment, but holds that we don’t know what they are. In his view the harm to the economy caused by restricting growth prematurely through higher interest rates is very great, and that caused by a rise in inflation relatively modest. Solow therefore believes that the Fed should not act to restrain inflation until it becomes a visible problem. Fortunately, Greenspan has basically followed a flexible, pragmatic course close to the one Solow recommends.
Greenspan’s power as head of the Federal Reserve—the Fed—is immense, but the institution he heads is not well understood. The Federal Reserve System is the central bank of the United States. It is essentially a bank both for other banks and for the federal government, with responsibilities to maintain the smooth functioning of the financial system and, through its monetary policies, to promote price stability and economic growth.…
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