Final answer:
The high productivity growth in the late 1990s shifted the labor demand curve rightward, keeping unemployment below 4.5% as wages lagged. While this initially contained inflation due to efficient production, wages and employment levels eventually adjusted over time.
Step-by-step explanation:
The unexpectedly high rate of productivity growth in the late 1990s led to a significant change in the dynamics of the labor market. During this period, productivity rose from an annual rate of 1.7% from 1980-1995 to 2.6% from 1995-2001. Graphically, this can be represented as a shift of the labor demand curve from Do to D1. With productivity increasing, businesses had a higher demand for labor, which ideally would result in higher wages. However, wages were slow to adjust as they were still set according to prior expectations of stagnant productivity. Consequently, at the prevailing wage level (W), the quantity of labor demanded exceeded the quantity of labor supplied, leading to unusually low levels of unemployment. This situation contributed to the unemployment rate dropping below 4.5% from 1998 until 2001 when the U.S. entered a recession.
The high productivity also affected inflation, as the increased efficiency in production could allow for more goods and services to be produced at a lower cost, thereby applying downward pressure on prices. However, over time, wages tend to adjust to productivity gains, and the unemployment rate will normalize. The experiences in the 1970s and 1990s highlight how abrupt changes in productivity can significantly upset the labor market equilibrium and have lasting effects on employment and inflation.