Demand Shocks, Hysteresis and Monetary Policy

Abstract

This paper builds a micro-founded general equilibrium model of hysteresis in which changing composition of firms with heterogeneous qualities in response to demand shocks alter the total factor productivity of the economy through a process of "creative destruction". Hysteresis fundamentally challenges existing consensus on stabilization policies: the complete stabilization of demand shocks becomes suboptimal as demand creates its own supply; fiscal multiplier can be substantially larger than 1; an opportunistic monetary policymaker, who adopts a lenient policy reaction to positive demand shocks, but provides decisive monetary stimulus in response to negative demand shocks, can bring large welfare gains.