Dynamic hysteresis effects

Abstract

We study how the output gap affects potential output over time—i.e., the dynamic hysteresis effect. To do so, we introduce novel unobserved components (UC) models that consider hysteresis as a sequence of lagged effects, thus separating the long-run recession-induced adverse effects from other trend-cycle interactions. The proposed models nest several existing UC models in the literature and accommodate two key characteristics of output dynamics: non-neutrality in the long-run and time-to-build effects. Using Bayesian estimation methods, we find robust evidence supporting the presence of hysteresis effects after the 1970s, with the negative long-run effect of the Global Financial Crisis and the COVID-19 recessions robustly identified. Via Bayesian model averaging, we provide precise and intuitive output gap estimates that highlight the relationship between business cycle fluctuations and the decline in economic growth. Our findings indicate that output trend-cycle decompositions that do not consider hysteresis effects can alter stabilization policy trade-offs.