Productivity Shock

A productivity shock is an unexpected change in the productivity of the economy, which affects the relationship between inputs and output. Productivity shocks are a central source of fluctuations in the economy and a key driver of the business cycle.

Concept

A productivity shock changes the amount of output that can be produced from a given quantity of inputs. A positive shock raises productivity, so that more output can be produced, while a negative shock reduces it.

The shocks may be technological, arising from innovation or from the diffusion of new methods. They may be structural, arising from changes in the organisation of production or in the availability of inputs. They may be temporary, such as the disruption caused by a natural disaster, or permanent, such as the adoption of a new technology.

Sources

Productivity shocks arise from several sources. Technological innovation is a major source, as the development of new products and methods raises the productivity of the economy.

The shocks also arise from changes in the prices of inputs, particularly of energy, which affect the productivity of the economy. The oil price shocks of the 1970s are the classic example, and they contributed to the stagflation of that period.

The shocks also arise from changes in the regulatory and institutional environment, which affect the efficiency of production, and from the diffusion of technology across firms and countries.

Effects

The effects of a productivity shock depend on the nature of the shock and on the response of policy. A positive shock raises output and, if the demand does not adjust, may create inflationary pressure. A negative shock reduces output and may raise inflation, a combination known as stagflation.

The effects also depend on the response of the labour market. A positive shock raises the marginal product of labour and, in a competitive market, the real wage. A negative shock reduces the marginal product and the real wage.

In the real business cycle framework, productivity shocks are the main source of fluctuations, and the fluctuations are the efficient response of the economy to the shocks. In other frameworks, the shocks interact with nominal rigidities and with the financial system, and the fluctuations may be amplified.

Policy

The policy response to productivity shocks depends on the nature of the shock and on its effects. A negative shock that raises inflation and reduces output poses a dilemma for monetary policy, since the two objectives conflict.

The response also depends on whether the shock is temporary or permanent. A temporary shock may warrant a limited response, while a permanent shock may require adjustment of the productive capacity of the economy.

The policy must also consider the distributional effects of the shock, since the change in productivity affects the returns to the factors of production and thereby the distribution of income.

Real Business Cycle Theory

The real business cycle theory holds that the fluctuations in the economy are the efficient response to the productivity shocks, and that the shocks are the main source of the business cycle.

The theory assumes that the markets clear and that the prices are flexible, so that the fluctuations reflect the changes in the productive capacity and in the preferences. The theory implies that the policy should not attempt to smooth the fluctuations, since the fluctuations are the efficient response.

The theory has been influential in the development of the modern macroeconomics, and it has stimulated the analysis of the sources of the fluctuations. The theory has been criticised for its assumptions and for the difficulty of identifying the shocks.

The Identification of the Shocks

The identification of the productivity shocks is a central task of the empirical analysis. The shocks are not observed, and they must be inferred from the data on the output and on the inputs.

The methods include the estimation of the production function and the analysis of the residual, which is the part of the output that is not explained by the inputs. The residual is interpreted as the measure of the productivity, and its changes as the shocks.

The identification is subject to the problems of the measurement and of the specification. The measurement of the inputs is difficult, and the residual may capture the effects of the factors other than the productivity.

The Policy Response

The policy response to the productivity shocks depends on the nature of the shock and on the framework of the analysis. In the real business cycle framework, the policy should not respond, since the fluctuations are the efficient response.

In the frameworks with the nominal rigidities, the policy can improve the outcome by offsetting the effects of the shocks. The central bank can respond to the shocks through the changes in the interest rates, and the government through the fiscal policy.

The design of the response must take account of the uncertainty about the shocks and about the effects of the policy. The response must also consider the possibility that the shock is temporary or permanent, since the appropriate response differs.

Summary

Productivity shocks are the changes in the relationship between the inputs and the output, and they are a central source of the fluctuations in the economy. The analysis of the shocks, of the real business cycle theory, and of the policy response informs the understanding of the business cycle.

See also

• Macroeconomics
• Business Cycle
• Production Economics