Hysteresis is referred to the hypothesis that recessions may have permanent effects on the level of output relative to trend.
In a recent research “Inflation and Activity – Two Explorations and their Monetary Policy Implications”, Blanchard, Larry Summers and Eugenio Cerutti presented a strong case for the existence of hysteresis. Based on the data from 1960 in 23 advanced economies, the authors found that two-third of the recessions in the dataset are followed by lower output relative to the pre-recession trend, and almost one-half of those are followed not only by lower out, but also by lower output growth relative to the pre-recession trend. The authors suggested this result could have important implications for monetary policy.
In her speech “Macroeconomic Research After the Crisis”, Janet Yellen said that if we assume that hysteresis is in fact present, it may imply there are possibilities that policymakers can temporarily run a “high-pressure economy” to reserve the adverse supply-side effects caused by hysteresis. For example, Yellen postulated that running a “high-pressure economy” may result in a tight labor market and draw in potential workers who would otherwise sit on the sidelines to the labor force, and lead to a more efficient job market.