Switching-track after the Great Recession

Data suggests that the level of GDP shifted to a permanently lower trend following the Great Recession for most advanced countries, and researchers have not yet reached a consensus concerning the drivers of this phenomenon. We contribute to this literature by suggesting a DSGE model with financial frictions and endogenous growth through learning-by-doing. With an aggregate AK technology, a negative shock to the capital stock has the effect of moving the economy to a lower trend. A Taylor rule policy designed to reduce the output gap may counterbalance the shock, bringing the economy back to the past trend. However, when the recession is deep and persistent and the ZLB binds, a revision of potential output measures may weaken the recovering role of monetary policy, making the economy converge to a lower trend. We calibrate the model to the U.S. economy and find that GDP can fully recover from a textbook TFP shock under a standard Taylor rule, whilst large demand shocks can affect the supply side permanently. Our framework is thus consistent with episodes of economic recovery as well as episodes of no-recovery. Results rely on the observation that the measurement of U.S. potential output switched track as the Great Recession unfolded, because the severe and prolonged slump put downward pressure on estimates. As a consequence, the output gap closed following the switching-track of potential output, rather than faster GDP growth.