Monetary Policy and Hysteresis in Potential Output

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.