Greenspan's Unconventional View of the Long-Run Inflation/Output Tradeoff

Robert H. Rasche , Daniel L. Thornton

From the time he became chairman of the Federal Reserve in 1987, Alan Greenspan steadfastly held to the view that low and stable inflation is a prerequisite for maximum sustainable economic growth.

Greenspan's focus on low and stable inflation helped keep interest rates low by reducing the inflation expectations and inflation uncertainty components of nominal rates. A commitment to price stability protects bankers (and others who borrowed short and lend long) who are hurt by unanticipated inflation.

Greenspan reiterated his belief in low and stable inflation many times during his nearly two decades as Fed chairman. In his first congressional testimony, in February 1988, Green-span stated that "the strategy for monetary policy needs to be centered on making further progress toward and ultimately reaching stable prices," which he defined as, "a situation in which households and businesses in making their saving and investment decisions can safely ignore the possibility of sustained, generalized price increases or decreases."[1]

In February 1989, Greenspan explicitly noted that the Fed's ultimate objective is "maximum sustainable economic growth over time" and that "the primary role of monetary policy in the pursuit of this goal is to foster price stability."[2] When asked at the July 1996 FOMC meeting about the level of inflation that no longer alters decision-making, Greenspan responded, "I would say the number is zero, if inflation is properly measured."[3] In so doing, he confirmed that the rate of inflation that results in maximum sustainable growth rate of output is zero.

Greenspan's view of a long-run negative relationship between inflation and output growth is unconventional. Starting with the Phillips curve in the late 1950s, economists came to believe that lower rates of inflation could be obtained only by reducing output. In the late 1960s Milton Friedman and Edmond Phelps demonstrated that, if economic agents are rational, the tradeoff could not be maintained indefinitely, i.e., the steady-state level of output is independent of the rate of inflation, so that the long-run Phillips curve is vertical.

Most economists believe that, beyond some rate, inflation does reduce output. However, many believe that moderate inflation has no effect on economic growth, and some believe that moderate is good for growth.

One implication of Greenspan's view is that, should policy-makers decide to adopt a specific numerical inflation target, the target inflation rate should be zero, appropriately measured. A second implication is that the idea that policymakers should tolerate some moderate inflation rather than to bear the economic costs of reducing the inflation rate to zero is significantly weakened, if not eliminated, if zero is the inflation rate consistent with maximizing economic growth.[4]

The Greenspan principle—maximum sustainable economic growth is achieved at zero inflation—is not yet reflected in modern monetary policy analyses. Nearly all theoretical analyses incorporate some variant of an "expectations-augmented Phillips curve," where inflation is influenced by the gap between actual and potential output in the short run. Most of these models assume the economy's long-run growth rate is driven by exogenous factors (e.g., technology and the growth rate of the labor force) that are independent of monetary policy.

Therefore, the Greenspan principle is not reflected in conventional models. Given Greenspan's success over the past two decades, it would seem desirable that conventional models be modified to allow for the unconventional Green-span principle. One possibility is to incorporate Greenspan's observation that "as the inflation rate falls, it becomes increasingly difficult for producers to raise prices. They, therefore, tend to try to reduce costs in order to maintain margins."[5]


  1. Testimony before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, Feb. 13, 1988. [back to text]
  2. Testimony before the Committee on Banking, Finance and Urban Affairs, U.S. Senate, Feb. 21, 1989. [back to text]
  3. Transcript of the FOMC meeting held on July 2-3, 1996, p. 51. [back to text]
  4. See Daniel L. Thornton, "The Costs and Benefits of Price Stability: An Assessment of Howitt's Rule," Federal Reserve Bank of St. Louis Review, March/April 1995, 78(2), pp. 23-38. [back to text]
  5. Transcript of the FOMC meeting held on July 2-3, 1996, p. 46. [back to text]


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