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Hysteresis From Monetary Policy Mistakes: How Bad Could It Be?

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  • Dávila-Ospina, Andrés O.

    (Universidad de los Andes)

Abstract

What would happen if the central bank makes a mistake facing a crisis? This paper argues that it would leave scars in the long-run trend of production. If monetary policy is not expansionary-enough during crises, an inefficient rise of the interest rate intensifies the scarring effects of recessions. The hysteresis effect comes from higher innovation costs that induce a drop in productivity growth, an indiscriminate firms’ exit process, and a rise in unemployment. This article presents a theoretical model that rationalizes these mechanisms. The theory suggests that, in the longrun, even though growth recovers to its pre-shock rate and the economy converges to full firms’ survival and full employment, the long-term output level is persistently lower than the level it would have reached in the absence of errors.

Suggested Citation

  • Dávila-Ospina, Andrés O., 2023. "Hysteresis From Monetary Policy Mistakes: How Bad Could It Be?," Documentos CEDE 21003, Universidad de los Andes, Facultad de Economía, CEDE.
    • Handle: RePEc:col:000089:021003
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    More about this item

    Keywords

    Hysteresis; Monetary Policy; Endogenous Growth; Productivity; Firms’ Exit; Unemployment.;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • O11 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models
    • O42 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Monetary Growth Models
    • O47 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Empirical Studies of Economic Growth; Aggregate Productivity; Cross-Country Output Convergence

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