Output Hysteresis and Optimal Monetary Policy
Sanjay Singh ()
No 554, 2018 Meeting Papers from Society for Economic Dynamics
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.
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:554
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