Output Hysteresis and Optimal Monetary Policy

Abstract

We analyze the implications for monetary policy when deficient aggregate demand can cause a permanent loss in potential output, a phenomenon termed as 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 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 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 resulting from endogenous growth over the Great Recession.