Long-run Scarring Effects of Meltdowns in a Small-scale Nonlinear Quadratic Model

January 10, 2023

Paper | Over the last few years, economists have focused on the long-run effects of persistent shocks on economic output. In this paper, we use a small-scale macroeconomic model to show how the macroeconomy adjusts to a deep contraction and how credit dynamics, along with the monetary policy design, may influence the extent of these scars through numerical simulations. 

Authors: Francesco Simone Lucidi and Willi Semmler 

After the global financial crisis, the European economy never reverted to its pre-crisis time trend. Subsequent GDP slacks, one related to the sovereign crisis and the other to the Covid-19 shock, both appear in line with the post-crisis time trend. Despite the recent recovery phase, the upcoming downside effects of the energy crisis – exacerbated by the Russian–Ukrainian conflict in 2022 – are still invisible. Therefore, the adjustment path of output might be slower than the one expected just a few months ago. This paper focuses on the features contributing to such long-run scars and what central banks can do about them.

We build a small-scale nonlinear quadratic (NLQ) model in which credit feedback and regime switches in the output gap affect the adjustment path of the economy towards a steady state. The central bank solves a finite-horizon decision problem where the policy rate also can be zero or negative. We estimate this model by nonlinear seemingly unrelated regression method (NLSUR) and using the parameters to explore policy scenarios. The latter projects long-run dynamics after a large demand contraction leading to scarring effects on the economy. We point out three main results. First, while scars are dominant when the central bank follows a standard Taylor rule, unconventional monetary policy (UMP) – such as Quantitative Easing – mitigates the output decline in both the short and the long run. Second, a zero natural interest rate curtails the central bank’s ability to adjust the economy and mitigate scars. Third, financial constraints leave the deepest scars even if UMP is active.

Read the paper, published in the Journal of Macroeconomicshere.