Hysteresis and the Welfare Costs of Business Cycles

Lucas (1987, 2003) finds that the welfare costs of business cycles are trivial, 0.008-0.05% of consumption in each period. I analyze the implications of hysteresis for the welfare costs of business cycles by extending the basic New Keynesian model with hysteresis. Hysteresis is defined as the negative effect of the negative, one-percentage point output gap on potential output. The net present value of the welfare cost of a recession in which the deviation of output from the trend is 3% is 0.6% of consumption without hysteresis. If the degree of hysteresis is 0.4, an empirical estimate for OECD countries, the welfare cost increases – by a factor of 121 – to 70%. The study of stabilization policy using New Keynesian models without hysteresis is pointless; the potential benefits of stabilization policy are notable only in the presence of hysteresis.