## What Happens if Central Banks Misdiagnose a Slowdown in Potential Output

_IMF Working Papers, September 27, 2019_

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## Bibliographic details
- Authors: Bas B. Bakker
- Published: September 27, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513512532.001

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### Summary findings
- 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.

### Model and analytical approach
- 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).

### Key policy implications
- 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.

### Subject areas and keywords
- 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

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_Source: https://www.imf.org/en/publications/wp/issues/2019/09/27/what-happens-if-central-banks-misdiagnose-a-slowdown-in-potential-output-48643_