This paper contributes to the body of research that explores the link between economic fluctuations and long-term economic performance. In an attempt to advance our understanding of the potential long-run benefits of macroeconomic stabilization policies, the paper studies the long-term effects of economic slowdowns. We construct a discrete-time endogenous growth model, in which a recession, defined as a reduction in resource utilization for a limited number of periods, may have long-lasting detrimental effects on the growth path of the economy. Our endogenous growth model allows us (1) to link business cycles with economic growth and (2) to calculate short-term and long-term output costs of economic slowdowns.
The paper considers a dynamic economy characterized by “creative destruction”, i.e., streams of entering and exiting firms, and the job creation and destruction that follow. Cyclical fluctuations result from changes in the entry and exit rates. During recessions exit rates accelerate and entry rates decelerate.  Exit implies that the firm’s resources become unemployed and should be redeployed to the rest of the economy. In changing uses, both capital and labor lose their "firm-specific" components. Hence the value of both physical and human capital reduces to their "generic" component. A way to model this additional loss of value is to model it as an increase in depreciation. The inverse argument can be made for the later stages of an expansion, resulting in a decrease in depreciation. The paper examines the effects of the counter cyclical behavior of the rate of depreciation in the traditional Solow model, as well as an endogenous growth model, expanded to explicitly consider human capital.
Thus our premise is that as businesses exit the market during a slowdown, part of their capital -- the firm specific part -- is non recoverable.  Also, the economy is losing firm specific human capital as skilled workers are forced to change jobs.  Symmetrically, during a period of overheating, firms may postpone retiring older, less efficient capital, which leads to reduced depreciation. Thus we introduce a cyclical depreciation rate in the growth model.
We study the long-term consequences of recessions of various durations and intensities by comparing an economy that grows at steady state rates to one that experiences a recession. The model is calibrated to the US economy's experience over the past four decades, and several simulation exercises are performed. The long-run effects of a recession are estimated as the discounted present value of the output differences of the two economies. Preliminary results indicated that even mild recessions, such as those observed in the last 50 years in the US, may have long-lasting adverse level effects on output.