HYSTERESIS IN POTENTIAL OUTPUT AND MONETARY POLICY DANIEL KIENZLER KAI D. SCHMID WORKING PAPERS ON FINANCE NO. 2013/28 SWISS INSTITUTE OF BANKING AND FINANCE (S/BF – HSG) JUNE 2013 Hysteresis in Potential Output and Monetary Policy∗ Daniel Kienzler and Kai D. Schmidy June 2013 Abstract We show that actively stabilizing economic activity plays a more prominent role in the conduct of monetary policy when potential output is subject to hysteresis. We augment a basic New Keynesian model by hysteresis in potential output and contrast simulation outcomes of this extended model to the standard model. We find that considering hysteresis allows for a more realistic propagation of macroeconomic shocks and persistent movements in output after monetary shocks. Our central policy implication of active output gap stabilization arises from stability analyses and welfare considerations. Keywords: Monetary Policy, Hysteresis, Potential Output, Output Gap Mismeasurement. JEL code: E32, E50, E52. ∗We are grateful to two anonymous referees, Ansgar Rannenberg, Silke Tober and Paul S¨oderlind for helpful comments. All errors are our own. yDaniel Kienzler: University of St.Gallen. E-mail:
[email protected]; Kai D. Schmid: Macroeconomic Policy Institute. E-mail:
[email protected]; Corresponding Author: Kai D. Schmid, Macroeconomic Policy Institute, Hans-B¨ockler-Str. 39, 40476 D¨usseldorf. 1 1 Introduction Due to the Great Recession the political and academic debate has experienced a revival of the so-called hysteresis phenomenon on a grand scale. In the face of the severe crisis a large number of major economic institutions and think tanks, such as for example the European Commission (2009), Furceri and Mourougane (2009), the IMF (2009) or Pisani-Ferry and van Pottelsberghe (2009), have addressed the negative implications of the economic downturn for the development of potential output.