Combating Hysteresis With Output Targeting

Thomas Michl and Kayla Oliver ()
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Kayla Oliver: Department of Economics, Colgate University

No 2017-06, Working Papers from Department of Economics, Colgate University

Abstract: Hysteresis, path dependence, and multiple equilibria are characteristic features of post-Keynesian economics. This paper constructs an otherwise conventional three-equation model that includes a hysteresis-generating mechanism and an invariant output target. We use it to explore the implications for monetary policy of an output targeting policy framework that seeks to reverse the damage caused by hysteresis. We restrict ourselves to negative aggregate demand shocks and positive inflation shocks that in most instances require a disinflationary response from the central bank. One important finding is that as long as inflation expectations are to some degree anchored, the central bank can achieve its output target after an aggregate demand shock by overshooting its inflation target temporarily and running a ``high-pressure labor market." If expectations are unanchored, an aggregate demand shock will not have long-run hysteresis effects because the central bank is obliged to reflate aggressively, replacing on a cumulative basis all the demand that was lost through the shock. However, with unanchored expectations a pure inflation shock will create hysteresis effects since the central bank will need to disinflate and it does not have the option of running a high-pressure labor market. Anchoring gives the central bank this option, making inflation shocks manageable.

Keywords: monetary policy; hysteresis; path dependence; divine coincidence; inflation-expectations anchoring (search for similar items in EconPapers)
JEL-codes: E11 E12 O42 (search for similar items in EconPapers)
Date: 2017-11-01, Revised 2017-11-24
New Economics Papers: this item is included in nep-mac and nep-pke
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Related works:
Journal Article: Combating hysteresis with output targeting (2019)
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