Today, Federal Reserve economists
use a number of measures to determine whether monetary policy
should be tighter or looser. One approach is to compare the actual and potential growth rates of the economy. Potential growth is presumed to equal the sum of the growth in the labor force plus any gains in productivity, or output per worker. In the late 1990s, the labor force was projected to grow about 1 percent a year, and productivity
was thought to be rising somewhere between 1 percent and 1.5 percent. Therefore, the potential growth rate was assumed to be somewhere between 2 percent and 2.5 percent. By this measure, actual growth in excess of the long-term potential growth was seen as raising a danger of inflation, thereby requiring tighter money.
The second gauge is called NAIRU, or the non-accelerating inflation rate of unemployment. Over time, economists have noted that inflation tends to accelerate when joblessness drops below a certain level. In the decade that ended in the early 1990s, economists generally believed NAIRU was around 6 percent. But later in the decade, it appeared to have dropped to about 5.5 percent.
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This article is adapted from the book "Outline of the U.S. Economy" by Conte and Carr and has been adapted with permission from the U.S. Department of State.