Thursday, January 17, 2013

Large GDP shocks are permanent

Fiscal policy being in complete disarray and unpredictable in the United Sates, economic policy is currently limited to monetary policy. But even there, it is not blindingly obvious what the Federal Reserve should do. If economic activity is below potential (and is forecasted to remain so beyond the "long and variable lags" it takes for monetary action to have an impact), the monetary easing is in order. Define potential, and there disagreement starts. If you look at the evolution of GDP, you cannot help thinking that it went through a permanent downward shift and is now tugging along at the usual growth rate, simply a step below. This would mean we are ready to get off the zero interest rates:



That would go against the idea that there are no permanent shifts in GDP. But while there are usually no such shifts, maybe there are rare circumstances where they happen. Mehdi Hosseinkouchack and Maik Wolters test the unit root of US GDP not only at the conditional mean but also at the tails of the distribution using a quantile autoregression based unit root test. Ad they find that sharp declines in output, like the one we recently experienced, do indeed look permanent. We should therefore not expect GDP to get on the previous path, and this not treat the latter as our current potential GDP. Would the FOMC believe this? I doubt it.

5 comments:

Anonymous said...

Some people in the FOMC would agree with you, but indeed not a majority.

Anonymous said...

Conventional lag selection procedures may miss gradual returns to trend at long lags. Holden (2012) uses a sparsely parametrized specification that can capture these lower frequency dynamics, and finds evidence against a unit root in output. (The paper's mostly concerned with the theoretical difficulties of getting a model to produce this.)

Anonymous said...

Why is someone showing a result that was shown 5 years ago in the AER paper (March 2008) by Cerra and Saxena "Growth Dynamics: The Myth of Economic Recovery" for about 200 countries in the world?

Anonymous said...

Here is Cerra and Saxena (2008). Hosseinkouchack and Wolters completely ignore it, indeed,

Aston Lockheed said...

About the path-dependency of the potential output, the articles of Haltmaier (2012) (http://www.federalreserve.gov/pubs/ifdp/2012/1066/ifdp1066.pdf) and Oulton & SebastiĆ”-Barriel (2013) (http://www.bankofengland.co.uk/publications/Documents/workingpapers/wp470.pdf) are good too!