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Output Hysteresis and Optimal Monetary Policy

Sanjay Singh ()

No 554, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: We analyze the implications for monetary policy when deficient aggregate demand can cause a permanent loss in potential output, a phenomenon termed as output hysteresis. We incorporate Schumpeterian endogenous growth into a business cycle model with nominal rigidities. In the model, incomplete stabilization of a temporary shortfall in demand reduces the return to innovation, thus reducing R&D and producing a permanent loss in output. Output hysteresis arises under a standard Taylor rule, but not under a strict inflation targeting rule when the nominal interest rate is away from the zero lower bound (ZLB). At the ZLB, a central bank unable to commit to future policy actions suffers from hysteresis bias: it does not offset past losses in potential output. A new policy rule that targets zero output hysteresis approximates the optimal policy by keeping output at the first-best level. Estimated structural impulse response functions for key variables align with predictions of the model. A quantitative model provides evidence of significant output hysteresis resulting from endogenous growth over the Great Recession.

New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:554

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