Suppose the economy exhibits a large, unexpected increase in productivity growth that lasts for a decade. Policymakers are (quite reasonably) slow to learn what has happened to potential output and incorrectly interpret the increase in output as a boom that leads actual output to exceed potential. Suppose they adjust macroeconomic policy so that the mismeasured level of short-run output is zero.
(a) What happens to the true amount of short-run output Ỹ?
(b) What happens to inflation over time?
(c) This problem outlines a concern economists have had in recent years after the large increase in productivity growth that started around 1995. Now consider the opposite problem: suppose productivity growth declines for a decade. What would be predicted to happen? Has this ever happened to the U.S. economy?