What Happens If Central Banks Misdiagnose a Slowdown in Potential Output

42 Pages Posted: 8 Nov 2019

Date Written: September 2019

Abstract

In the last few decades, real GDP growth and investment in advanced countries have declined in tandem. This slowdown was not the result of weak demand (there has been no shift along the Okun curve), but of a decline in potential output growth (which has shifted the Okun curve to the left). We analyze what happens if central banks mistakenly diagnose the problem as insufficient demand, when it is actually a supply problem. We do this in a real model, in which inflation is not an issue. We show that aggressive central bank action may revive gross investment, but it will not revive net investment or growth. Moreover, low interest rates will lead to an increase in the capital output ratio, a low return on capital and high leverage. We show that these forecasts are in line with what has happened in major advanced countries.

Keywords: Real sector, Real interest rates, Return on investment, Unemployment, Investment, Monetary policy, potential output, Solow-Swan, WP, investment rate, gross investment, net investment, output growth, capital stock

JEL Classification: E13, E22, E42, E52, O41, E01, G21, E2, D4, O4

Suggested Citation

Bakker, Bas Berend, What Happens If Central Banks Misdiagnose a Slowdown in Potential Output (September 2019). IMF Working Paper No. 19/208. Available at SSRN: https://ssrn.com/abstract=3482291

Bas Berend Bakker (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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