DP13690 Resolving the Missing Deflation Puzzle
|Author(s):||Jesper Lindé, Mathias Trabandt|
|Publication Date:||April 2019|
|Keyword(s):||great recession, inflation dynamics, linearized model solution, liquidity trap, nonlinear model solution, Real rigidities, strategic complementarities, zero lower bound|
|JEL(s):||E30, E31, E32, E37, E44, E52|
|Programme Areas:||Monetary Economics and Fluctuations|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=13690|
We propose a resolution of the missing deflation puzzle. Our resolution stresses the importance of nonlinearities in price- and wage-setting when the economy is exposed to large shocks. We show that a nonlinear macroeconomic model with real rigidities resolves the missing deflation puzzle, while a linearized version of the same underlying nonlinear model fails to do so. In addition, our nonlinear model reproduces the skewness of inflation and other macroeconomic variables observed in post-war U.S. data. All told, our results caution against the common practice of using linearized models to study inflation and output dynamics.