Resolving the missing deflation and inflation puzzles

From a VOX post by Jesper Lindé and Mathias Trabandt:

The alleged breakdown of the Phillips curve has left monetary policy researchers and central bankers wondering if we need to develop completely new models for price and wage determination. This column argues that a relatively small alteration of the standard New Keynesian model, combined with using the nonlinear instead of the linearised solution, is sufficient to resolve the two puzzles – the ‘missing deflation’ during the recession and the ‘missing inflation’ during the recovery – underlying the supposed breakdown.

The Great Recession has left macroeconomists with many puzzles. One such puzzle is the alleged breakdown of the relationship between inflation and the output gap – also known as the Phillips curve.

There are two main arguments underlying the hypothesis of a breakdown of the Phillips curve.

The first is the ‘missing deflation puzzle’. The Great Recession generated an extraordinary decline in US GDP of about 10% relative to its pre-crisis trend, while inflation dropped only by about 1.5% (see Figure 1).1 The modest decline in inflation was surprising to many macroeconomists. For instance, New York Fed President John C. Williams (2010: 8) wrote: “The surprise [about inflation] is that it’s fallen so little, given the depth and duration of the recent downturn. Based on the experience of past severe recessions, I would have expected inflation to fall by twice as much as it has.”

Continue reading here.

Posted by at 1:22 PM

Labels: Macro Demystified


Subscribe to: Posts