We specifically assess the effects of an unexpected increase in interest rates by 1%. We then trace the responses of output, labor, capital, and TFP over the next 12 years. Output is measured as real GDP. Labor is measured as total hours worked, capital stock is constructed from investment in machines and buildings, and TFP is a residual from an aggregate production function using capital and labor as inputs.
Figure 1 show that unexpected changes in monetary policy, known as shocks, can slow the pace of economic activity much more persistently than is commonly believed, all other economic factors being equal. For example, panel A shows that, in response to a 1% increase in interest rates, output would be about 5% lower after 12 years than it would otherwise be. To provide some context for these numbers, consider some data for the United States. A 5% decline in the output trend caused by the monetary intervention relative to the pre-intervention trend would reduce an individual’s income by $3,000 in today’s dollars on average. - San Fransico Fed Research
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