ABSTRACT
This note provides a model framework for thinking about stabilization policies in the presence of hysteresis after a negative shock like the Covid-19 pandemic. Headline measures of the so-called potential GDP published by the Congressional Budget Office represent only one of many possible inflation-neutral trajectories for output. The term potential GDP is misleading since potential implies a unique limit on output. It is much more accurate to consider a range of possible trajectories or multiple equilibria. Repairing the damages from a shock will require overshooting the inflation target and running the economy above its inflation-neutral equilibrium in order to restore the status quo ante level of output and employment. The model assumes constant trend growth so that path dependence takes the form of pure output-level effects.
Acknowledgments
The author thanks Daniele Tavani, J.W. Mason and two referees from this journal for helpful comments on earlier drafts, while taking responsibility for any views expressed.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 For a primer on the CBO methods, see Shackleton (Citation2018). The Econbrowser blog (www.econbrowser.com) maintained by James Hamilton and Menzie Chinn is a good source for current thinking about the methodology of calculating potential GDP by conventional macroeconomists. The current note expands on Foley, Michl, and Tavani (Citation2019, Ch. 5).
2 To be more precise, setting will get us back to the baseline in period T + 1.
3 With anchoring in the Phillips curve it is not necessary to run the system above the equilibrium level of output to get inflation to recover the target since . Maintaining equilibrium implies that inflation gravitates toward the target as long-term expectations eventually prevail.
4 The exception occurs when there is no anchoring since then the cumulative stimulus needed to restore inflation just happens to be exactly what is needed to repair the damage from hysteresis so that there is no need to run a high-pressure labor market, assuming the central bank is following a Taylor rule that targets inflation. In this case, inflation converges on the target from below. See Michl and Oliver (Citation2019) for proof that combating hysteresis requires inflation overshooting.
5 Compare the middle panel of to Foley, Michl, and Tavani (Citation2019, Figure 2.1) showing actual and CBO potential GDP estimated after the GFC.