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What Happens if Central Banks Misdiagnose a Slowdown in Potential Output

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  • Mr. Bas B. Bakker

Abstract

In the last few decades, real GDP growth and investment in advanced countries have declined in tandem. This slowdown was not the result of weak demand (there has been no shift along the Okun curve), but of a decline in potential output growth (which has shifted the Okun curve to the left). We analyze what happens if central banks mistakenly diagnose the problem as insufficient demand, when it is actually a supply problem. We do this in a real model, in which inflation is not an issue. We show that aggressive central bank action may revive gross investment, but it will not revive net investment or growth. Moreover, low interest rates will lead to an increase in the capital output ratio, a low return on capital and high leverage. We show that these forecasts are in line with what has happened in major advanced countries.

Suggested Citation

  • Mr. Bas B. Bakker, 2019. "What Happens if Central Banks Misdiagnose a Slowdown in Potential Output," IMF Working Papers 2019/208, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2019/208
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    References listed on IDEAS

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    1. Gros, Daniel, 2014. "Investment as the key to recovery in the euro area?," CEPS Papers 9821, Centre for European Policy Studies.
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    Cited by:

    1. Bakker, Bas & Ghazanchyan, Manuk & Ho, Alex & Nanda, Vibha, 2020. "The Lack of Convergence of Latin-America Compared with CESEE: Is Low Investment to Blame?," MPRA Paper 101287, University Library of Munich, Germany.

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