Output Hysteresis and Optimal Monetary Policy Output Hysteresis and Optimal Monetary Policy

By Vaishali Garga and Sanjay R. Singh

When an economy experiences a business cycle contraction, economic activity falls. In the event of a severe economic downturn, the losses can be long-lasting, and perhaps even permanent. In the United States, the Great Recession resulted in a slowdown in productivity growth, investment in research and development (R&D), and new firm entries. Ten years after the Great Recession began, despite the US economic recovery, the nation’s real gross domestic product (GDP) was still 15 percent below its pre-recession trend level; other advanced economies also experienced a similar drop in GDP.

Standard monetary policy theory is largely silent on how monetary policy decisions may interact with and influence the economy’s productive potential. This paper offers a model that addresses this question, based on an endogenous growth framework embedded in a New Keynesian setting. A temporary shortfall in aggregate demand, if incompletely stabilized by the central bank, can result in a permanent loss in potential output, which the authors define as output hysteresis. The mechanism is that a contraction in aggregate demand reduces the incentives for firms to invest in R&D, which leads to lower innovation that results in an endogenous slowdown in total factor productivity growth. The main goal of this paper is to analyze whether it is optimal for monetary policymakers to engineer a recovery in potential output back to the pre-recession trend, and how this goal might be accomplished. The model-based quadratic welfare loss function is comprised of three key market distortions: a wage inflation gap, a labor efficiency gap, and a productivity growth rate gap, which is novel to the endogenous growth framework and offers an additional rationale for stabilizing short-run business cycle fluctuations. The model focuses on liquidity demand and monetary policy shocks because monetary policy can counteract these shocks and maintain the economy at the first-best level, the equilibrium allocation that maximizes welfare.

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