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posted on 16 August 2015

Monetary Policy Shocks And Aggregate Supply

by Kansas Fed

-- this post authored by Willem Van Zandweghe

During the past six years of slow economic growth, economists and policymakers have expressed repeated concern that the financial crisis and recession of 2007-09 may have harmed the U.S. economy's productive capacity. Workers' participation in the labor force declined in the recovery, and growth in labor productivity slowed from its historical trend. The disappointing performance of these and other supply-side indicators has led economists to revise down their estimates of the economy's potential output (CBO; Ball; Hall).

A sustained period of weak demand may have caused supply-side damage, eroding the economy's productive capacity through various channels. Many workers may have lost skills due to long spells of unemployment or labor force nonparticipation, and the business sector may have held back on capital formation, business formation, and innovation.

Traditionally, monetary policy is assumed to stabilize economic activity and inflation without affecting the economy's productive capacity - that is, its potential output. However, if weak demand erodes capacity, then monetary policy may be able to expand capacity by stimulating economic activity. Accommodative monetary policy raises demand for goods and services, thus promoting investment and labor market activity and improving the climate for innovation and new business startups. Indeed, recent remarks by policymakers recognize that supply-side damage could be reversible (Yellen; Powell).

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