Working Paper

Demand Shocks, Hysteresis and Monetary Policy

Abstract: This paper builds a micro-founded general equilibrium model of hysteresis in which changing composition of firms with heterogeneous qualities in response to demand shocks alter the total factor productivity of the economy through a process of "creative destruction". Hysteresis fundamentally challenges existing consensus on stabilization policies: the complete stabilization of demand shocks becomes suboptimal as demand creates its own supply; fiscal multiplier can be substantially larger than 1; an opportunistic monetary policymaker, who adopts a lenient policy reaction to positive demand shocks, but provides decisive monetary stimulus in response to negative demand shocks, can bring large welfare gains.

Keywords: Demand shocks; Monetary policy; Hysteresis;

JEL Classification: E31; E32; E52; E58;

https://doi.org/10.17016/FEDS.2022.080

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2022-11-29

Number: 2022-080