The recent financial crisis and ensuing recession appear to have put the productive capacity of the economy on a lower and shallower trajectory than the one that seemed to be in place prior to 2007. Using a version of an unobserved components model introduced by Fleischman and Roberts (2011), we estimate that potential GDP in late 2014 was about 7 percent below the trajectory it appeared to be on prior to 2007. We argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand-contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand, and we present optimal-control simulations showing how monetary policy might respond to such endogeneity in the absence of other considerations. We then discuss how other considerations-such as increased risks of financial instability or inflation instability-could cause policymakers to exercise restraint in their response to cyclical weakness. JEL: E23, E37, E52, E65
Currently, the near-term budgetary consequences of proposed changes to tax laws or federal spending are estimated under the implicit assumption that such changes have no measurable impact on output, prices, interest rates, or income. Consequently, feedback from the macroeconomy to federal expenditures and the tax base is ignored in scoring tax and spending proposals. This paper considers the advantages and complications involved in dynamic scoring of budget proposals. Such a procedure requires decisions concerning the appropriate macroeconomic model to use and the likely responses of both monetary policy and the public's expectations to the fiscal initiative.
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