Output Hysteresis and Optimal Monetary Policy

86 Pages Posted: 7 Oct 2018

See all articles by Vaishali Garga

Vaishali Garga

Brown University

Sanjay R. Singh

Federal Reserve Banks - Federal Reserve Bank of San Francisco; University of California, Davis

Date Written: July 13, 2018

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." In the model, incomplete stabilization of a temporary shortfall in demand reduces the return to innovation, thus reducing TFP growth and generating a permanent loss in output. The origin of output hysteresis is contingent on the monetary policy rule. When the nominal interest rate is constrained at the zero lower bound, 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.

Keywords: Hysteresis, Zero Lower Bound, Secular Stagnation

JEL Classification: E52, E32, O42

Suggested Citation

Garga, Vaishali and Singh, Sanjay R., Output Hysteresis and Optimal Monetary Policy (July 13, 2018). Available at SSRN: https://ssrn.com/abstract=3244088 or http://dx.doi.org/10.2139/ssrn.3244088

Vaishali Garga

Brown University

Box 1860
Providence, RI 02912
United States

Sanjay R. Singh (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

University of California, Davis ( email )

One Shields Drive
Davis, CA 95616-8578
United States

HOME PAGE: http://ssingh.ucdavis.edu

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