Inflation In The Great Recession And New Keynesian Models

by Marco Del Negro, Marc Giannoni, Raiden Hasegawa, and Frank Schorfheide – Liberty Street Economics, Federal Reserve Bank of New York

Since the financial crisis of 2007-08 and the Great Recession, many commentators have been baffled by the “missing deflation” in the face of a large and persistent amount of slack in the economy. Some prominent academics have argued that existing models cannot properly account for the evolution of inflation during and following the crisis. For example, in his American Economic Association presidential address, Robert E. Hall called for a fundamental reconsideration of Phillips curve models and their modern incarnation—so-called dynamic stochastic general equilibrium (DSGE) models—in which inflation depends on a measure of slack in economic activity.

 

The argument is that such theories should have predicted more and more disinflation as long as the unemployment rate remained above a natural rate of, say, 6 percent. Since inflation declined somewhat in 2009, and then remained positive, Hall concludes that such theories based on a concept of slack must be wrong.

In an NBER working paper and a New York Fed staff report (forthcoming in theAmerican Economic Journal: Macroeconomics), we use a standard New Keynesian DSGE model with financial frictions to explain the behavior of output and inflation since the crisis. This model was estimated using data up to 2008. We find that following the increase in financial stress in 2008, the model successfully predicts not only the sharp contraction in economic activity, but also only a modest decline in inflation.

The left panel of the next chart shows the output growth forecasts made with information right after the collapse of Lehman Brothers, which sparked the recent financial crisis. The black solid lines show the available data at that time, the red solid line is the model’s forecast, and the black dashed lines correspond to realized data. When made aware of the financial consequences of the Lehman default with corporate bond spread data, the DSGE model predicts a sharp drop in GDP and a very sluggish recovery. Indeed, the model’s forecast for output in 2012:Q3 (right panel) is remarkably close to the actual value. Quite strikingly, based on the information available post Lehman, the DSGE model predicts output to be well below the pre-2008 trend four years after the financial crisis.