Post-Crisis Slow Recovery and Monetary Policy
In the aftermath of the recent financial crisis and subsequent recession, slow recoveries have been observed and slowdowns in total factor productivity (TFP) growth have been measured in many economies. This paper develops a model that can describe a slow recovery resulting from an adverse financial shock in the presence of an endogenous mechanism of TFP growth, and examines how monetary policy should react to the financial shock in terms of social welfare. It is shown that in the face of the financial shocks, a welfare-maximizing monetary policy rule features a strong response to output, and the welfare gain from output stabilization is much more substantial than in the model where TFP growth is exogenously given. Moreover, compared with the welfare-maximizing rule, a strict inflation or price-level targeting rule induces a sizable welfare loss because it has no response to output, whereas a nominal GDP growth or level targeting rule performs well, although it causes high interest-rate volatility. In the presence of the endogenous TFP growth mechanism, it is crucial to take into account a welfare loss from a permanent decline in consumption caused by a slowdown in TFP growth.
In the aftermath of the recent financial crisis and subsequent recession, slow recoveries have been observed in many economies. GDP has not recovered to its pre-crisis growth trend in the U.S., while it has not returned to even its pre-crisis level in the Euro area. As indicated by recent studies, such as Cerra and Saxena (2008) and Reinhart and Rogoff (2009), financial crises tend to be followed by slow recoveries in which GDP scarcely returns to its pre-crisis growth trend and involves a considerable economic loss. Indeed, since the financial crisis in the 1990s, Japanís GDP has never recovered to its pre-crisis growth trend, and Japanís economy has experienced a massive loss in GDP. The post-crisis slow recoveries therefore cast doubt on the validity of the argument in the literature starting from Lucas (1987) that the welfare costs of business cycles are small enough that they do not justify stabilization policy. Thus our paper addresses the question of whether and to what extent monetary policy can ameliorate social welfare in the face of a severe recession that is caused by a financial factor and is followed by a slow recovery. Particularly, in that situation, should monetary policy focus mainly on inflation stabilization and make no response to output, as advocated in the existing monetary policy literature including Schmitt-GrohÈ and Uribe (2006, 2007a, b)?