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Hysteresis and the welfare costs of recessions

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  • Tervala, Juha

Abstract

This article explores the implications of hysteresis for the welfare costs of recessions by extending the textbook New Keynesian model to include hysteresis. Hysteresis implies that recessions reduce the level of potential output. Famously Lucas (1987, 2003) argued that the welfare costs of business cycles are negligible without hysteresis. This article demonstrates that the welfare costs of recessions are huge (negligible) in the New Keynesian model with (without) hysteresis. The main finding is that an empirically observed degree of hysteresis increases the welfare costs of a recession by a factor of 121. The results are in contrast with Lucas (1987, 2003), who concluded that only changes in the long-term growth rate of consumption have a significant welfare effect. The welfare costs of recessions can be huge without a change in the long-term growth rate of consumption. Hysteresis therefore implies that stabilization policy should respond forcefully to recessions.

Suggested Citation

  • Tervala, Juha, 2021. "Hysteresis and the welfare costs of recessions," Economic Modelling, Elsevier, vol. 95(C), pages 136-144.
  • Handle: RePEc:eee:ecmode:v:95:y:2021:i:c:p:136-144
    DOI: 10.1016/j.econmod.2020.12.012
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    Cited by:

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    2. Robert Calvert Jump & Paul Levine, 2021. "Hysteresis in the New Keynesian three equation model," School of Economics Discussion Papers 0821, School of Economics, University of Surrey.
    3. Larch, Martin & Claeys, Peter & Van Der Wielen, Wouter, 2022. "The scarring effects of major economic downturns: The role of fiscal policy and government investment," EIB Working Papers 2022/14, European Investment Bank (EIB).
    4. Paternesi Meloni, Walter & Romaniello, Davide & Stirati, Antonella, 2022. "Inflation and the NAIRU: assessing the role of long-term unemployment as a cause of hysteresis," Economic Modelling, Elsevier, vol. 113(C).
    5. Kovalenko, Tim & Töpfer, Marina, 2021. "Cyclical dynamics and the gender pay gap: A structural VAR approach," Economic Modelling, Elsevier, vol. 99(C).

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    More about this item

    Keywords

    Business cycles; Costs of recessions; Hysteresis; Stabilization policy;
    All these keywords.

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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