Output hysteresis and optimal monetary policy

Abstract

We derive a fully quadratic approximation to welfare under endogenous growth and study optimal monetary policy. Away from the ZLB, optimal commitment policy sets interest rates to eliminate output hysteresis. A strict inflation targeting rule implements the optimal policy. At the ZLB, strict inflation targeting is sub-optimal and admits output hysteresis, defined as a permanent loss in potential output. A new policy rule that targets output hysteresis returns the output to the pre-shock trend and approximates the welfare gains under optimal commitment policy. A central bank unable to commit to future policy actions suffers from hysteresis bias: it does not offset past losses in potential output.