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 we term output hysteresis. In the model, the incomplete stabilization of a temporary shortfall in demand reduces the return to innovation, thus reducing total factor productivity 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 suboptimal and admits output hysteresis. A new policy rule that targets output hysteresis returns output to its pre-shock trend and approximates the welfare gains under optimal commitment policy. A central bank that is unable to commit to future policy actions suffers from hysteresis bias, as the bank's inconsistent policy does not offset past losses in potential output.

Monetary Policy, Markup Dispersion, and Aggregate TFP

“…An alternative explanation why aggregate productivity declines after monetary policy shocks is a reduction in R&D investment. In fact, Figure 8 in the Appendix shows that aggregate R&D expenditures fall after contractionary monetary policy shocks, which reconfirms the findings in Moran and Queralto (2018) and Garga and Singh (2019). Hence, there is scope for R&D to explain part of the aggregate TFP response.…”

“…Second, this paper relates to a literature that studies the productivity response to monetary policy, e.g., Christiano et al (2005), Comin and Gertler (2006), Moran and Queralto (2018), Garga andSingh (2019), andJordà et al (2020). We confirm the empirical finding that monetary policy shocks lower aggregate productivity, but provide a novel explanation based on markup dispersion.…”

“…Previously, Christiano et al (2005) show that variable utilization and fixed costs explain a relatively small fraction of the aggregate productivity response. Moran and Queralto (2018) and Garga and Singh (2019) show that R&D investment falls after monetary policy shocks, which may ultimately lower productivity. However, it is unclear whether the R&D response has a large impact on aggregate productivity at short horizons.…”

The Long-Run Effects of Monetary Policy

“…A similar setup was used by Stadler (1990) in his seminal work. A micro-founded model of innovation and productivity growth that yields this exact representation under monetary policy shocks can be found in the recent literature embedding endogenous growth into DSGE models (Bianchi, Kung, and Morales, 2019;Garga and Singh, Forthcoming). The effects of business cycles on TFP growth rate that are unrelated to nominal rigidities can be denoted by time varying values of µ t , which may depend on other shocks (markup shocks, stationary TFP shocks, discount factor shocks, capital quality shocks etc.).…”

Lower for Longer Under Endogenous Technology Growth

“…As discussed earlier, this paper predominantly contributes to both the literature on New Keynesian models with endogenous technology growth and to the literature on monetary policy strategies in a low interest rate environment. As to the former, this literature focuses in particular on the effect of aggregate demand and monetary policy on productivity-improving investment and thus the long-run (Benigno and Fornaro (2018), Moran and Queralto (2018), Anzoategui et al (2019), Bianchi, Kung and Morales (2019), Ikeda and Koruzumi (2019), Garga and Singh (2021), Elfsbacka Schmöller and Spitzer (2021)), as recently also reviewed by Cerra, Fatás and Saxena (2022). This literature has, however, not yet studied the performance of monetary policy strategies in a low r * environment under the non-linearity of the ELB, which is at the core of this paper.…”