Modeling Inflation After the Crisis

PDF608 KB

Abstract:

In the United States, the rate of price inflation falls in recessions. Turning this observation into a useful
inflation forecasting equation is difficult because of multiple sources of time variation in the inflation
process, including changes in Fed policy and credibility. We propose a tightly parameterized model
in which the deviation of inflation from a stochastic trend (which we interpret as long-term expected
inflation) reacts stably to a new gap measure, which we call the unemployment recession gap. The
short-term response of inflation to an increase in this gap is stable, but the long-term response depends
on the resilience, or anchoring, of trend inflation. Dynamic simulations (given the path of unemployment)
match the paths of inflation during post-1960 downturns, including the current one.

Website

Last updated on 07/24/2012