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.