What Happens if Central Banks Misdiagnose a Slowdown in Potential Output

IMF Working Papers, September 27, 2019

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In the last few decades, real GDP growth and investment in advanced countries have declined in tandem.
The 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).
If central banks mistakenly diagnose the problem as insufficient demand when it is actually a supply problem:
- Aggressive central bank action may revive gross investment, but it will not revive net investment or growth.
- Low interest rates will lead to an increase in the capital output ratio, a low return on capital and high leverage.
The paper shows that these forecasts are in line with what has happened in major advanced countries.

The analysis is conducted in a real model, in which inflation is not an issue.
The paper contrasts shifts along the Okun curve (demand-driven) with shifts of the Okun curve itself (supply-driven via potential output).

Misdiagnosing a supply-driven slowdown as a demand deficiency can lead to prolonged low interest rates without restoring net investment or potential growth.
Reliance on monetary stimulus alone is insufficient to address declines in potential output; outcomes include higher capital output ratios, lower returns on capital, and increased leverage.

Subjects: 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