Questioni di Economia e Finanza
(Occasional Papers)
Monetary policy in a low interest rate environment
by Giuseppe Ferrero and Stefano Neri
2017
September
Number

Questioni di Economia e Finanza
(Occasional papers)
Monetary policy in a low interest rate environment
by Giuseppe Ferrero and Stefano Neri
Number 392 - September 2017
The series Occasional Papers presents studies and documents on issues pertaining to
the institutional tasks of the Bank of Italy and the Eurosystem. The Occasional Papers appear
alongside the Working Papers series which are specifically aimed at providing original contributions
to economic research.
The Occasional Papers include studies conducted within the Bank of Italy, sometimes
in cooperation with the Eurosystem or other institutions. The views expressed in the studies are those of
the authors and do not involve the responsibility of the institutions to which they belong.
The series is available online at www.bancaditalia.it .
MONETARY POLICY IN A LOW INTEREST RATE ENVIRONMENT
by Giuseppe Ferrero* and Stefano Neri*
Abstract
The debate on the underlying causes of the decline of interest rates to historically low
levels is ongoing both in academia and among policy makers. Several explanations have been
put forward, ranging from those citing real and structural factors to those underscoring the
importance of cyclical and financial phenomena. However, the empirical evidence regarding
their relative importance is still limited. These different but complementary views can be
framed around the concept of the natural rate of interest and the monetary transmission
mechanism. The low interest rate environment that still characterizes advanced economies
raises important questions regarding the implications for monetary policy in the medium- and
long-run. Our work provides a systematic outline of the potential changes to monetary policy
strategies that could ensue.
JEL Classification: E43, E52, E58, G01.
Keywords: interest rates, natural rate, monetary policy, secular stagnation, financial cycle.
Contents
1. Introduction .......................................................................................................................... 5
2. Some stylized facts on nominal interest rates ....................................................................... 6
3. Identifying the causes and assessing their persistence ......................................................... 8
3.1 Real interest rates and natural rates of interest .............................................................. 9
3.1.1 The 'real/structural' view ................................................................................... 13
3.1.2 The 'financial/cyclical' view ............................................................................. 14
3.1.3 Uncertainty and hysteresis effects ..................................................................... 16
3.2 Inflation developments: facts and explanations .......................................................... 18
3.3 Risk premiums ............................................................................................................. 21
4. Challenges for monetary policy .......................................................................................... 25
4.1 Short-to medium-term challenges ............................................................................... 25
4.2 Long-term challenges .................................................................................................. 27
4.2.1 The 'real/structural' view ................................................................................... 27
4.2.2 The 'financial/cyclical' view .............................................................................. 31
5. Conclusions and key messages ........................................................................................... 36
References ............................................................................................................................... 38

'Having the right world view is essential if there is to be a chance of making the right
decisions.' Larry Summers, Tweet 6 July 2016
'One can debate whether the stagnation is secular or not, but short-lived it is certainly not.'
Coen Teulings, Vox.EU, 30 January 2015
'Fundamental drivers of the economic slowdown may prove crucial in evaluating potential
policies' Kenneth Rogoff, 13th Annual BIS Conference, June 27, 2014
1. Introduction*
The 'Great Moderation' and the debate on its causes seem light years away.
Macroeconomics has moved on from 'the end of the business cycle' and 'the conquest of
inflation' to 'secular stagnation', 'debt super-cycles', 'balance sheet recessions', 'deflationary
spirals', the 'de-anchoring' of inflation expectations and the 'effective lower bound'.
Money, credit and financial markets, which had disappeared from the macroeconomic
models used in central banks (Smets and Wouters, 2003) to guide monetary policy during
the 'Great Moderation' (Woodford, 2003 and Galí, 2008), have returned to the centre of the
'operating table'1 after the outbreak of the global financial crisis (Gertler and Kiyotaki, 2010,
Adrian and Shin, 2010, Christiano, Motto and Rostagno, 2014). Channels of the monetary
policy transmission mechanism that hinge on intertemporal decisions by households and
firms and that are at the heart of dynamic stochastic general equilibrium (DSGE) models,
suddenly turned out to be overvalued, while other channels working through wealth and
redistribution, which were judged to be less important, began to be considered as key to the
transmission of monetary policy (Kaplan, Mol and Violante, 2016). Models where
households are heterogeneous in terms of income and wealth started being used to better
assess the efficacy of monetary policy decisions (Nuno and Thomas, 2016, Cloyne Ferreira
and Surico, 2016) and banks, which in most macroeconomic models were simple institutions
intermediating already existing money between agents with an excess of funds (savers) and
those with a deficit (borrowers), came back as suppliers of inside money (Jakab and Kumhof,
2015, McLeay, Radia and Thomas, 2014).
Meanwhile, nominal and real short- and long-term interest rates were decreasing,
following a trend that started in the eighties. This trend has broadly continued until today,
leading to a greater focus on the implications for the natural rate of interest and the
effectiveness of monetary policy.
The conceptual framework commonly used to study the transmission of monetary
policy would suggest that low interest rates should, other things being equal, lead sooner or
later lead to higher inflation and stronger output growth. However, developments since the
outbreak of the global financial crisis do not provide support for such a view: nominal rates
are currently at or close to their historical minimums in advanced economies and long-term
expectations for inflation and real GDP growth are also low by historical standards. Several
years after Lehman Brothers filed for Chapter 11, the risk of falling into a
deflationarystagnation spiral such as that of the Japanese 'lost decades' were assessed as being high in
the euro area (OECD, 2015 and European Parliament, 2016), despite the very low policy
rates and the introduction of the asset purchase programme by the European Central Bank
(ECB).
Several explanations for the persistent decline of interest rates have been put forward
in the literature; some refer to structural changes in aggregate supply, others to those in
aggregate demand; some to temporary but persistent changes in the demand for and supply
of funds, also induced by regulatory and institutional changes, others to investors
exuberance. Some of the explanations concentrate on real interest rates and their natural
counterparts, others on nominal rates and their risk components.
Policy implications have been drawn. A plethora of 'very unconventional' monetary
policies has been proposed and discussed: from 'helicopter drops' to 'currency abolishment',
and from 'price level' targeting to the 'Neo-Fisherian' prescription. Some have been recently
adopted, such as 'yield curve targeting' and 'inflation-overshooting commitment' by the
Bank of Japan and the 'negative interest rate policy' by the ECB, the Swiss Bank, the Central
Bank of Denmark, the Sveriges Riksbank and the Bank of Japan.
The objective of this paper is to offer an organized discussion of the causes of the low
interest rate environment by relying on a common framework that can help the debate on
the implications for monetary policy-making going forward.
Section 2 presents some stylized facts on nominal interest rates in advanced countries
in the last three decades. Section 3 focuses on the main components of nominal interest
rates; it provides evidence on their evolution by grouping the explanations for the low level
of real interest rates in the literature; we end up with two groups that differ in terms of the
nature of the explanation, which may be 'structural/real' and 'cyclical/financial'. Finally, we
analyse the behaviour of the other components of the nominal interest rates (i.e. inflation
expectations and risk premiums) by using the above explanations. In Section 4 we use the
same grouping procedure to sort through the policy debate and to discuss the main
challenges monetary policy-makers need to address in the low interest environment. Section
5 offers some concluding remarks.
2. Some stylized facts on nominal interest rates
The current macroeconomic environment is characterized by exceptionally low
nominal rates in advanced economies (Figure 1). The decline of long and short-term nominal
rates started in the 1980s, as part of a global phenomenon and coincided with a decline in
real interest rates, a strong and persistent reduction of inflation and a period of low
macroeconomic volatility (the 'Great Moderation').
Figure 1 - Nominal interest rates in main the advanced countries: 1980-2016
Long-term interest rates Short-term interest rates
(per cent) (per cent)
Source: European Commission, AMECO.
The decline accelerated with the outbreak of the global financial crisis. Since late
2008early 2009, the slack in the economy and excessively low inflation have contributed to
further reducing nominal interest rates, as monetary policies have turned very
accommodative. In some countries a strong compression of risk premiums and flight to
quality phenomena have pushed nominal interest rates into negative territory at longer
maturities too (Figure 2).
Figure 2 - Nominal interest rates in the main advanced countries: 2008-2016
Long-term interest rates Short-term interest rates
(per cent) (per cent)
Source: Datastream.
Between 2013 and 2016 long-term interest rates in the euro area declined at a faster
pace than in the US due to the effects of the sovereign debt crisis and the new measures
adopted by the ECB to preserve the correct functioning of the monetary transmission
mechanism and to provide further stimulus to the economy when the policy rates had been
brought to their effective lower bound and the risks of a too-prolonged period of low
inflation where assessed as being high (Praet, 2014). The decline in short- and long-term
interest rates brought about a decline in the financing costs of banks, non-financial
corporations, households and governments, which reached historical minimums (ESRB,
2016).
3. Identifying the causes and assessing their persistence
The (net) nominal interest rate is the monetary price that borrowers pay to lenders to
use their money.
As credit contracts differ in terms of (i) a borrower's ability to repay its obligation, (ii)
the degree of liquidity (transferability) and (iii) the maturity of the contract, the nominal
zz
interest rates that a borrower j pays on a credit contract with maturity z, , can be
iijj,tt
decomposed into: a risk-free component (the theoretical rate of return of an investment
zz
with no risk of financial loss, over a given period of time), ; a risk premium component,
iiRRRR,tt
that includes a counterparty risk premium (the extra amount of money that is required in
zz
order to bear the risk of not being repaid), , and a liquidity premium to compensate for
ccccjj,tt
zz
the risk of not being able to transfer the contract quickly without affecting its price, :
llccjj,tt
zz zz zz
zz
= + + . (1.1)
iijj,tt iiRRRR,tt ccccjj,tt llccjj,tt
Absence of arbitrage in the economy also implies a relationship between short and
long term interest rates and between nominal and real interest rates.2
LL
The long-term risk-free nominal interest rates, , can be decomposed into two
iiRRRR,tt
components: the average between actual and future short-term nominal interest rates,
SS
for zz = 0, ... , LL, and a nominal term premium, LL, which measures the excess
iiRRRR,tt+zz ttcciitt
return that investors require to commit to holding the long-term risk-free bond instead of a
series of short-term risk-free bonds:
1
LL LL SS
=   + LL. (1.2)
iiRRRR,tt EEtt∑ zz=0 iiRRRR,tt+zz ttcciitt
LL
Finally, according to the Fisher no-arbitrage condition we may decompose the short
SS
term risk-free nominal interest rate, , into the sum of the risk-free real interest rate,
iiRRRR,tt+zz
SS
, and the expected inflation, the nominal term premia into the sum of the real
rrRRRR,tt+zz ππtt+zz;
LL
term premium, and the inflation risk premium, LL, which arises from the fact that
ttccrrtt iicctt
investors holding nominal assets are exposed to unanticipated changes in inflation:
SS SS
= + (1.3)
iiRRRR,tt+zz rrRRRR,tt+zz ππtt+zz
LL LL LL
= +
(1.4)
ttcciitt ttccrrtt iicctt
LL
Substituting (1.2), (1.3) and (1.4) into (1.1) and defining the risk premium, , as the
rrccjj,tt
sum of the four premia components described above,
LL LL LL LL LL
= + + +
. (1.5)
rrccjj,tt ccccjj,tt llccjj,tt ttccrrtt iicctt
we obtain an expression for the nominal interest rate on a contract with maturity L which is
made up by three components: the average between the current and the future expected
short-term risk free interest rates, the expected inflation, and the risk premia
1
LL LL SS LL
=   + + . (1.6)
EEtt∑ zz=0 rrRRRR,tt+zz EEttππtt,tt+LL
iijj,tt rrccjj,tt
LL
The following sections concentrate on the observed evolution of these three
components over the last three decades, in order to have a first assessment on their
contribution to the observed decline of nominal interest rates. For those components which
are not directly observable we provide also a brief description of the economic concept and
the main procedures commonly used to estimate them.
3.1. Real interest rates and natural rates of interest
Most of the analyses on low interest rates have focused on the factors that have been
affecting the real interest rates component over the past few decades. The main reason for
this is probably that the theory of optimal consumption and the classical growth theory
provide an intuitive and direct link between real interest rates, consumption, savings and
investment decisions.
The real interest rate in a market economy is an equilibrium concept determined by
the demand and the supply of (real) funds (Figure 3). In an overly simplified economy with
no uncertainty we can think of the supply of funds as the result of the optimal saving plan of
a representative household that maximizes the present value of her utility in terms of
current and future consumption subject to a sequence of budget constraints. The demand of
funds would instead be determined by the amount of investment that maximizes profits of a
firm for a given technology.
The supply of funds depends positively on nominal interest rates deflated by future
inflation (as the higher the growth rate of consumer prices the larger the loss of purchasing
power), while the elasticity of the supply depends on parameters characterizing the
intertemporal utility function, such as the discount factor (a measure of how much people
value current consumption relative to future consumption), the intertemporal elasticity of
substitution (a measure of the extent to which households are willing to give up
consumption today for consumption tomorrow), the level of financial wealth and the
present and future discounted labour income of the household.
The demand of funds depends negatively on nominal interest rates deflated by
future inflation, while its elasticity depends on parameters that characterize the production
function (to a large extent parameters underlying the technological and the demographical
processes) and influence the marginal product of capital per effective labor unit.
Figure 3 - The Real interest rate and the
"real/structural" view
Commonly used measures for the risk-free real interest rate are computed by
deflating nominal interest rates with expected inflation obtained either from financial
contracts or surveys3. However, since long time series of expected inflation are not always
available, a common proxy for inflation expectations is either ex-post realized inflation or
current inflation. Such measures of real interest rates have been decreasing since the 80s
(Figure 4). This trend prevailed also with the outbreak of the global financial crisis and, in the
euro area, after the sovereign debt crisis, even though in some countries, real interest rates
temporarily increased.
In assessing the behavior of real interest rates over time it is common use to look also
at the evolution of the natural rate of interest - which is defined as the real short-term
interest rate that equates the demand and supply of funds when output is at its potential,
unemployment is at its natural rate and inflation is on target - a measure of the long-run
efficient level of real interest rates used to assess the monetary policy stance (an
expansionary monetary policy implies a negative deviation of the market real interest rate
from the natural one, while a contractionary stance leads to a positive deviation).
In the highly simplified model described at the beginning of this section, with no
uncertainty, no other constraint than the intertemporal budget one and in the absence of
frictions, the real interest rate would always be at its "natural" level. In models with nominal
frictions (and uncertainty), the real interest rate may temporary deviate from the natural
one. To the extent that the central bank is able to affect not only nominal interest rates (i.e.,
the lower bound constraint on nominal interest rates is not binding) but also real ones (due
to the presence of nominal frictions), the central bank would lower the real interest rate
below the natural rate in response to deflationary shocks in order to bring back output to its
potential, unemployment to its natural level, inflation on target and the real interest rate to
its natural level.
Figure 4 - Real interest rates in main the advanced countries
(a) Long-term interest rates (b) Short-term interest rates
(per cent) (per cent)
Source: European Commission; AMECO.
According to most of the recent analyses also the natural rate of interest decreased
over the last three decades. Holston, Laubach and Williams (2016), by applying the Kalman
filter to the time series of real rates in order to distinguish trend and cycle and using the
above definition to give some structure to the estimating procedure, show that the natural
rate of interest decreased in the main advanced countries from around 3% in the 1980s to
close to zero in the US and to negative values in the euro area in 2016 (Figure 5).
Figure 5 - The natural rate of interest in advanced economies
(per cent)
Source: Holston, Laubach and Williams (2016). Note: two-year moving averages.
Curdia et al. (2015), using a more structural approach based on a dynamic stochastic
general equilibrium (DSGE) model, conclude that during and after the global financial crises,
the natural rate remained well below zero in the US as well; Christensen and Rudebusch
(2017) adopt a third approach, which consists in using a dynamic term structure model
estimated solely on the prices of inflation-indexed bonds with adjustments for real term and
liquidity risk premiums, and find that the gradual decline in investors' expectations for the
underlying natural rate of interest - between the end of the 1990s and December 2016, it
fell from 2.25% to 0.0% - accounts for about half of the general decline in long-term real
interest rates over the last two decades.
However, being the natural rate of interest an unobservable variable, there is no
consensus either on how to estimate it or on its specific estimates, in particular after the
outbreak of the global financial crisis.
According to some analyses the sharp decline in the estimates of the natural rates
between 2008 and 2016 may have been overstated due to the omission in the estimation
procedures of important variables and equations related to the presence of financial
frictions. Taylor and Wieland (2016) claim that "what appear to be trends in the equilibrium
interest rate may instead be trends in other policy variables that affect the economy" and
conclude that recent changes in the regulation and in monetary policy have made the issue
more complex. Cukierman (2016) argues that since the standard models used to estimate
the natural rate abstract from financial frictions, existing estimates "are likely to be biased
downward, particularly so since the onset of the crisis". Marked decrease in the value of
financial assets and in house prices during the global financial crisis reduced private sector
income and wealth and tightened households and firms' borrowing constraints, leading to a
contraction of credit and aggregate demand. Since the conventional models employed to
estimate the natural rate do not include credit frictions, a decrease in aggregate demand
would be interpreted by standard estimation procedures as a decrease in the natural rate of
interest. A similar conclusion is reached by Borio et al. (2016), who expand the Holston,
Laubach and Williams (2016) semi-structural model by incorporating information on
leverage and debt service. However, according to others (Pescatori and Turunen, 2016 and
Eggertsson et al, 2017), if we take into account constraints such as the lower bound on policy
rates, which limit the ability of central banks to react to adverse shocks to inflation, the
estimated natural interest rate during the financial crises would be lower than in most of the
estimates available in the literature.
The debate about the drivers of real interest rates over the past few decades is
ongoing, in particular at the policy-making level.4 Two views have been put forward in the
literature: a 'real/structural' and a 'cyclical/financial' one. Among the 'real/structural'
explanations, the 'secular stagnation' is the most known (Summers, 2014). As for the
'financial/cyclical' explanation, Borio (2012) and Lo and Rogoff (2015) are the key references.
These two views are not necessarily conflicting, but rather complementary. Looking
forward, however, they have different implications for the future path of nominal and real
interest rates, and therefore monetary policy. The uncertainty about their relative
importance of these views and the persistence of the underlying factors may also be
contributing to the low level of real interest rates; agents being uncertain on what drives the
real rate may increase savings and reduce investment, adding further downward pressure to
interest rates.
3.1.1. The 'real/structural' view
According to this view, advanced economies suffer from a persistent imbalance
resulting from an increasing propensity to save and a decreasing propensity to invest;
excessive savings act as a drag on growth and inflation and push real rates down (Figure 6).
A number of demand and supply factors have been considered to account for this
imbalance, all characterized by a high degree of persistence: adverse demographic
developments, the falling relative price of investment goods, the decline in investment due
to missing opportunities, the lower pace of technological innovation, the rise in savings rates
and the relative scarcity of safe assets in emerging economies, and increases in wealth and
income inequality.5 According to this view the global financial crisis just placed a further drag
on these structural factors.
Figure 6 - The real interest rate and the
'real/structural' view
This explanation implies that the natural interest rate has declined structurally over
the last few decades; this would explain why inflation remained on target during the Great
Moderation even if nominal interest rates were relatively low. This view also highlights that,
in recent years, when the natural rate further decreased, the presence of a lower bound on
policy rates has prevented central banks from providing the necessary accommodation
before the adoption of non-standard measures.
Looking forward, structural factors may keep real interest rates low for a long time,
even after the effects of the global financial crisis have faded away. This persistence would
depend on the factor behind such developments. For example, while demographics
developments are clearly highly persistent, technological progress and developments on
productivity are very difficult to predict and the debate about the persistence of the actual
low levels is open. On the one hand, according to the 'secular stagnation' view, the rate of
growth of potential output will slow down further in advanced economies, largely because
of a permanently slower pace of innovation (Summers, 2016 and Gordon, 2016); on the
other hand, supporters of the 'second machine age' claim that information technology and
digital communication still have a long way to go and may increase productivity in the future
(Brynjolfsson and McAfee, 2014).
3.1.2. The 'financial/cyclical' view
According to this view, low real interest rates are consistent both with periods of credit
expansion and of credit contraction.
An extended period of steady economic growth and/or rising asset prices encourage
relaxed attitudes toward leverage, deregulation in the financial sector, excessively
expansionary monetary policies and overly optimistic expectations about future returns; the
resulting large and persistent increase in the supply of funds compresses real interest rates,
and induces excessive debt accumulation (Figure 7, Phase 1).
As credit increases, asset prices also increase, raising their value as collateral, and
thereby relaxing borrowing constraints and helping to expand credit and raise asset prices
even more. According to Lo and Rogoff (2015) and Borio et al. (2015, 2016, 2017) this phase
of the financial cycle was observed, for example, between the mid-90s and the mid-2000s in
the main advanced economies.6
After a financial shock hits the economy, the supply and demand of funds decrease
(Figure 7, Phase 2). While credit reduces, the overall effect on real interest rates in this
phase is uncertain, depending on the relative effects on demand and supply (as shown in
Figure 4, during the global financial crisis in some countries there was initially a strong
increase and then a decrease of real interest rates).
When expansionary monetary policies begin exerting a positive effect on the supply of
funds, however, an extensive need for deleveraging and a high degree of uncertainty about
future income dampen investment and consumption, further reducing real interest rates
(Figure 7, Phase 3). Traditional channels of monetary policy that operate through
intertemporal substitution turn out to be less effective during this phase. Even if interest
rates are very low, a larger share of households and firms either cannot increase debt in
order to support aggregate demand because their borrowing constraints are binding (the
vertical part in the demand function in Figure 7, panel 3) or decide to reduce current
demand due to the uncertainty about future income (the downward movement of the
demand curve in panel 3): the result is a further reduction of real interest rates.
Figure 7 - The real interest rates and the 'financial/cyclical' view
Phase 1: Credit expansion Phase 2: Financial crisis
Phase 3: Slow recovery Phase 4: Back-to-normal
Concerning the effect of the deleveraging process Rogoff (2016) argues that 'weak
post-crisis growth reflects the post-financial crisis phase of a debt supercycle where, after
deleveraging and borrowing headwinds subside, expected growth trends might prove higher
than simple extrapolations of recent performance might suggest'. Eggerston and Krugman
(2012) formalize the notion of deleveraging crises in a new-Keynesian framework,
characterized by an abrupt downward revision of views about how much debt it is safe for
individual agents to have; this revision forces highly indebted agents to reduce their
spending sharply, also when monetary policies are very accommodative.
Concerning uncertainty, Bansal and Yaron (2004) show that a rise in uncertainty leads
to a fall in asset prices and an increase in precautionary saving both of which reduce
consumption expenditure. Basu and Bundick (2011) and Leduc and Liu (2012) show that
while the increase in precautionary savings should exert a downward pressure on interest
rates and output prices, thus stimulating an offsetting rise in investment, this effect does not
arise in an economy with price and/or wage frictions. In such an environment, prices and
interest rates do not fall enough to encourage the offsetting rise in investment, and output
falls and as a result.
Uncertainty not only reduces levels of investment, hiring and consumption, but it also
makes economic actors less sensitive to changes in business conditions. This can make
countercyclical economic policy less effective. For example, Bloom (2014) shows that in
lowuncertainty periods, the elasticity of investment is higher compared with periods of
heightened uncertainty. Foote, Hurst, and Leahy (2000) and Bertola, Guiso, and Pistaferri
(2005) show that higher uncertainty also makes consumers' expenditure on durables less
sensitive to demand and price signals.
Compared with a 'normal' recession, monetary policy needs to be more
accommodative during the downturn of a financial crisis. Therefore, even though the natural
interest rate is not affected in a permanent way under the 'financial/cyclical' explanation,
the risk of reaching the zero lower bound of interest rate and falling into a liquidity trap with
persistently low inflation is high. In this case, monetary policy should take advantage of
other channels, which operate through wealth and income effects.
Looking forward, according to the cyclical/financial view, interest rates will remain low
for an extensive period of time but, as long as the deleveraging process ends, uncertainty
diminishes and expansionary monetary policies are phased out, they will recover from
current levels (Figure 7, Phase 4).
3.1.3. Uncertainty and hysteresis effects
While it is not easy to assess which of these views is more likely to be true, none of
them can be dismissed a priori. Moreover, it is difficult to foresee how the factors affecting
real interest rates will evolve, particularly the structural ones such as the pace of
technological innovation and demographic developments, which in the past have been less
persistent than previously thought. As underlined by Pagano and Sbracia (2014) 'in
retrospect, it emerges that pessimistic predictions were wrong neither because they built on
erroneous theories or data, nor because they failed to predict new technologies, but because
they underestimated the potential of the technologies that already existed'. Finally, factors
behind one explanation may affect factors behind the other. On the one hand, hysteresis
effects may transform temporary reductions in aggregate demand caused by financial crises
into long-lasting losses in terms of productivity and growth,7 and a deceleration of
productivity could follow credit booms, regardless of whether a crisis materializes or not. On
the other hand, trends in demographic variables and total factor productivity may also
influence the financial cycle.
Hysteresis effects of financial busts on factor productivity and potential output
Financial crises characterized by deleveraging processes, tight credit conditions, great
uncertainty and followed by changes in regulations, not only have severe effects on
aggregate demand, but may also have long-lasting effects on potential output and real
interest rates.
Gourio, Messer, and Siemer (2016) show that a temporary decrease in new business
formation, due to a reduction of credit availability and to increased uncertainty, may result
in a persistent decline in productivity and