Resolving the missing deflation puzzle

• Published in: Journal of monetary economics Vol. 126; pp. 15 - 34
• Main Authors: Harding, Martín, Lindé, Jesper, Trabandt, Mathias
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.03.2022
• Subjects: Great recession; Inflation dynamics; Monetary policy; Nonlinear model solution; Zero lower bound; Zero lower bound; E31; E30; E52; E44; E32; Monetary policy; E37; Great recession; Inflation dynamics; Nonlinear model solution
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2021.09.003

•Our analysis focuses on nonlinearities in price and wage-setting using Kimball (1995) aggregation.•Our nonlinear New Keynesian model with Kimball aggregation resolves the missing deflation puzzle while the linearized version fails to do so.•Our nonlinear model generates nonlinear Phillips curves and reproduces the skewness of price and wage inflation observed in post-war U.S. data.•Our results caution against the common practice of using linearized models when the economy is exposed to large shocks. A resolution of the missing deflation puzzle is proposed. 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.