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The last few years have seen renewed interest in hysteresis - the idea that shifts in demand can have persistent effects on GDP, well beyond the period of the "shock" itself. But it seems to me we haven't distinguished clearly enough between two forms of this.
Demand could have persistent effects on output because demand influences supply - this seems to be what people usually have in mind. But it also could be because demand itself is persistent, i.e. aggregate spending behaves like a random walk with drift.
Anyone who follows me on twitter has seen lots of versions of this picture. But assuming we think the deviation is in some large part due to the financial crisis, are we imagining that output has persistently fallen short of potential, or that potential has fallen below trend?
It might seem like a semantic distinction, but it's not. In first case, we would expect monetary policy to be generally looser in period after a negative demand shock, in the second case tighter. In 1st case we'd expect lower inflation in period after shock, in 2nd case higher.
It seems to me that most of the literature on hysteresis does not really distinguish these. This recent IMF paper by Fatas and coauthors for instance defines hysteresis as a persistent effect of demand shocks on GDP, which could be either of the two cases. https://www.imf.org/en/Publications/WP/Issues/2020/05/29/Hysteresis-and-Business-Cycles-49265
In the text they seem to assume hysteresis means an effect of demand on supply, and not a persistence of demand itself, but they don't explicitly say this or make an argument for why the latter is not important.
You could imagine a model where, writing Z for total desired spending (demand), Z_t = (1+a)Z_t-1 + X where a is some trend growth rate and X is whatever we think influences demand. In this model, demand shocks will be persistent without any of the usual hysteresis mechanisms.
Obviously, a model like this would only make sense if one thought the central bank cannot or does not adjust demand to potential. The assumption that the central bank quickly and reliably closes output gaps is probably why this kind of persistence is not much discussed.
Imagine a hypothetical case where there is large increase in public spending for a few years, after which spending returns to its old level. For purposes of this thought experiment, assume there is no change in monetary policy - we're at the ZLB the whole time, if you like.
In the period after the high spending ends, will we have (a) lower unemployment and higher inflation than before, as the new income created during the period of high public spending leads to permanently higher demand?
Or will we have (b) higher unemployment and lower inflation than if the spending had not occurred, because the period of high spending permanently raised labor force participation and productivity, while demand returns to its old level?
Since the two forms of hysteresis imply diametrically opposite predictions in this case, seems important to be clear which one we are imagining. (Of course in real world, could see combination of both.)
One application to the present is obvious. Even if we agree that deviation from long-run trend is due to fall in spending in wake of financial crisis, that in itself doesn't tell us if higher spending today will be less inflationary than pre-crisis.
Another less obvious one is that if we think demand shocks are persistent because demand itself is persistent, we need to apply that to our analysis of fiscal multipliers too - conventional static multiplier is not enough.
For what it's worth, if you back out the effect of a fiscal shock with no monetary offset from the Fed's FRBUS model, you'll find that about a 1 percent of GDO increase in public spending has a long run effect on output of about 0.2 percent.
Obviously there's nothing sacred about this number but if you asked me what fraction of a demand shock is likely to be persistent in the contemporary US economy, I think 0.2 would be a reasonable baseline answer.
You can of course pick a different value. But whatever value you prefer, this parameter is going to be critically important if you want to estimate how much additional spending it would take to return to the pre-2007 trend.
