Introduction

Two competing views dominate the recent theoretical literature on the nature of the relationship between cyclical fluctuations and the long-run steady states of the key macroeconomic aggregates. On the one hand, the ‘natural rate hypothesis’ (NRH) holds that the decisionmaking of rational agents depends only on relative price movements with market clearing ensuring self-stabilisation of the economic system on a natural real equilibrium, about which cyclical variation will occur if agents cannot perfectly distinguish relative from general price movements. Consequently, demand management policies which seek to maintain a position away from the natural equilibrium will only affect nominal variables in the long run. In contrast, the ‘hysteresis hypothesis’ holds that actual changes in real magnitudes themselves alter underlying natural rates such that transitory shocks have permanent effects, implying ‘path dependence’ in the dynamics of the economic system in the sense that the steady state equilibrium is determined by how it is arrived at. Equilibria under hysteresis are therefore ephemeral, and the notion of a ‘natural’ rate tenuous. Moreover, policy actions which cause actual changes are capable of exerting real as well as nominal long-run effects.

More formally, hysteresis may be defined as occurring ‘when there are two quantities M and N such that cyclic variations of N cause cyclic variations of M …[and] the changes of M lag behind those of N … the value of M at any point of the operation depends not only on the actual value of N but on all the preceding changes (and particularly on the immediately preceding changes) of N …'.