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 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. Using a purely quadratic approximation to welfare under endogenous growth, we derive normative implications for monetary policy. Away from the zero lower bound (ZLB), optimal commitment policy sets interest rates to eliminate output hysteresis. A strict inflation targeting rule implements the optimal policy. However, when the nominal interest rate is constrained at the ZLB, strict inflation targeting is sub-optimal and admits output hysteresis. 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.

Hysteresis and full employment in a small open economy

“…Figure 7: Dynamic response of output under alternative monetary policy (with hysteresis and credit constraints), % deviation from steady state, quarterly Interestingly, and consistent with Garga and Singh (2019), output is higher relative to steady state the lower the weight placed on output in the monetary policy reaction function.…”

“…6 Would a change in monetary policy framework have improved outcomes? Garga and Singh (2019) and Jordà et al (2020) consider alternative monetary policy rules in the presence of output hysteresis. Garga and Singh (2019) find output hysteresis arises away from the ZLB where monetary policy is conducted based on the Taylor rule, but not under strict inflation-targeting.…”

“…Garga and Singh (2019) and Jordà et al (2020) consider alternative monetary policy rules in the presence of output hysteresis. Garga and Singh (2019) find output hysteresis arises away from the ZLB where monetary policy is conducted based on the Taylor rule, but not under strict inflation-targeting. In our model the ZLB does not bind, and strict inflation-targeting offers only a minor improvement in output and employment outcomes in the domestic economy over the baseline monetary specification.…”

“…Henderson-McKibbin-Taylor type monetary reaction functions to lean against the accumulated gaps in TFP growth generated by hysteresis. Similarly, Garga and Singh (2019) suggest that an optimal monetary policy rule should target zero output hysteresis; however only when the ZLB binds. All of the monetary policy reaction functions considered below feature this quality, in that the central bank is assumed to react to the deviation of output from its initial trend.…”

“…In response to these observations, an emerging literature has explored the fiscal (Engler and Tervala, 2018;D'Alessandro et al, 2019) and monetary policy (Reifschneider et al, 2015;Moran and Queralto, 2018;Acharya et al, 2019;Bianchi et al, 2019;Garga and Singh, 2019;and Jordá et al, 2020) consequences of output hysteresis. Although, none of these papers have focused on the small open economy setting.…”