Productivity and inflation dynamics

Ludovica Ambrosino, Jenny Chan and Silvana Tenreyro
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Ludovica Ambrosino: London Business School
Jenny Chan: Bank of England
Silvana Tenreyro: London School of Economics

No 1201, Bank of England Staff Working Paper series from Bank of England

Abstract: How does higher productivity affect inflation? Productivity shifts both supply and demand (through real incomes), and its effect on inflation depends on their relative magnitude and timing, as well as on the monetary policy response. We distinguish between a one-off level shock that increases productivity temporarily (relative to trend) and a persistent rise in productivity growth. A one-off, temporary increase in productivity lowers marginal costs and raises potential output, generating downward pressure on the price level. Once prices adjust however, inflation returns to target. By contrast, higher productivity growth raises expected permanent income and stimulates investment and consumption, increasing the natural real rate. Absent a tightening of monetary policy, inflationary pressures may emerge. Anticipation effects are central: if demand rises ahead of realised supply gains, inflation can increase despite higher productive capacity. In an open economy, the sectoral incidence of the shock also determines the impact on inflation. In summary, the inflationary consequences of productivity gains are a priori ambiguous and depend on the balance and timing of demand and supply responses, the composition of demand, and crucially, the monetary policy response.

Keywords: Monetary policy; productivity; inflation; natural rate of interest (search for similar items in EconPapers)
JEL-codes: E3 E4 E5 F4 O4 (search for similar items in EconPapers)
Pages: 31
Date: 2026-08-21
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