Switching-track after the Great Recession

• Authors: Omar Licandro.
• BSE Working Paper: 110733 | May 21
• Keywords: great recession , monetary policy , endogenous growth , hysteresis , economic recovery , trend shift , switching-track , supply destruction prevention , economic capacity
• JEL codes: E12, E22, E32, O41, E52
• great recession
• monetary policy
• endogenous growth
• hysteresis
• economic recovery
• trend shift
• switching-track
• supply destruction prevention
• economic capacity

We propose a theoretical framework to reconcile episodes of V-shaped and L-shaped recovery, encompassing the behaviour of the U.S. economy before and after the Great Recession. In a DSGE model with endogenous growth, negative demand shocks destroy productive capacity, moving GDP to a lower trajectory. A Taylor rule policy designed to reduce the output gap may counterbalance the shocks, preventing the destruction of economic capacity and inducing a V-shaped recovery. However, when shocks are deep and persistent enough, like during the Great Recession, they call for a downward revision of potential output measures, the so-called switching-track, weakening the recovering role of monetary policy and inducing an L-shaped recovery. When calibrated to the U.S. economy, the model replicates well the L-shaped recovery and switching-track that followed the Great Recession, as well as the V-shaped recoveries that followed the oil shock recessions.