March 25, 2019, 17:00–18:30
Room MF 323
We propose a resolution of the missing deflation puzzle, i.e. the fact that inflation fell very little during the Great Recession against the backdrop of the large and persistent fall in GDP. Our resolution of the puzzle stresses the importance of nonlinearities in price and wagesetting using Kimball (1995) aggregation. We show that a nonlinear macroeconomic model with Kimball aggregation resolves the missing deflation puzzle, while a linearized version of the same underlying nonlinear model fails to resolve the missing deflation puzzle. 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-output dynamics when the economy is exposed to large shocks.