Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy

• Published in: IMF economic review 2015-04, Vol.63 (1), p.71-109
• Main Authors: REIFSCHNEIDER, DAVE, WASCHER, WILLIAM, WILCOX, DAVID
• Format: Article
• Language: English
• Subjects: Aggregate demand; Analysis; Capital Markets; E230; E320; E520; Economic aspects; Economic conditions; Economic crises; Economic crisis; Economic models; Economic Policy; Economic recessions; Economic recovery; Economic theory; Economic trends; Economics; Economics and Finance; Employment; Forecasts and trends; GDP; Gross Domestic Product; Inflation; Inflation (Finance); Influence; International Economics; Labor force; Labor productivity; Macroeconomics/Monetary Economics//Financial Economics; Monetary policy; Phillips curve; Potential gross domestic product; Potential output; Production functions; Recessions; Studies; Supply side economics; Trends; Unemployment; United States
• ISSN: 2041-4161; 2041-417X
• DOI: 10.1057/imfer.2015.1

The recent financial crisis and ensuing recession appear to have put the productive capacity of the economy on a lower and shallower trajectory than the one that seemed to be in place prior to 2007. Using a version of an unobserved components model introduced by Fleischman and Roberts, we estimate that potential GDP in late 2014 was about 7 percent below the trajectory it appeared to be on prior to 2007. We argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand, and we present optimal-control simulations showing how monetary policy might respond to such endogeneity in the absence of other considerations. We then discuss how other considerations—such as increased risks of financial instability or inflation instability—could cause policymakers to exercise restraint in their response to cyclical weakness.