What Happens if Central Banks Misdiagnose a Slowdown in Potential Output

September 27, 2019

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Format: Chicago

Bas B. Bakker What Happens if Central Banks Misdiagnose a Slowdown in Potential Output, (USA: International Monetary Fund, 2019) accessed December 26, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

In the last few decades, real GDP growth and investment in advanced countries have declined in tandem. This slowdown was not the result of weak demand (there has been no shift along the Okun curve), but of a decline in potential output growth (which has shifted the Okun curve to the left). We analyze what happens if central banks mistakenly diagnose the problem as insufficient demand, when it is actually a supply problem. We do this in a real model, in which inflation is not an issue. We show that aggressive central bank action may revive gross investment, but it will not revive net investment or growth. Moreover, low interest rates will lead to an increase in the capital output ratio, a low return on capital and high leverage. We show that these forecasts are in line with what has happened in major advanced countries.

Subject: Capital productivity, Financial institutions, Labor, Labor force participation, Potential output, Production, Production growth, Stocks

Keywords: Capital consumption, Capital output ratio, Capital productivity, Cost of capital, Europe, GDP growth, Gross investment, Investment, Investment rate, Labor force participation, Monetary policy, Potential GDP, Potential output, Production growth, Solow-Swan, Stocks, WP

Publication Details

Pages:

41
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2019/208
Stock No:

WPIEA2019208
ISBN:

9781513512532
ISSN:

1018-5941

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