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Aggregate supply in the United States: recent developments and implications for the conduct of monetary policy

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  • Dave Reifschneider
  • William Wascher
  • David Wilcox

Abstract

The recent financial crisis and ensuing recession appear to have put the productive capacity of the economy on a lower and shallower trajectory than the one that seemed to be in place prior to 2007. Using a version of an unobserved components model introduced by Fleischman and Roberts (2011), we estimate that potential GDP is currently about 7 percent below the trajectory it appeared to be on prior to 2007. We also examine the recent performance of the labor market. While the available indicators are still inconclusive, some indicators suggest that hysteresis should be a more present concern now than it has been during previous periods of economic recovery in the United States. We go on to argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand—contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand, and we present optimal-control simulations showing how monetary policy might respond to such endogeneity in the absence of other considerations. We then discuss how other considerations--such as increased risks of financial instability or inflation instability--could cause policymakers to exercise restraint in their response to cyclical weakness.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2013-77.

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Date of creation: 2013
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Handle: RePEc:fip:fedgfe:2013-77

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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Monetary Policy and Financial Stability: Never Say Never
    by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2014-07-07 12:30:38
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Cited by:
  1. John Fernald, 2014. "Productivity and Potential Output Before, During, and After the Great Recession," NBER Working Papers 20248, National Bureau of Economic Research, Inc.

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