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April 26, 2017
Why prices didn’t plummet during the Great Recession
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The Great Recession in the U.S. officially ended nearly eight years ago, but the debate among economists about what it taught us is still going strong. One sticking point has been the mystery of the “missing deflation,” or the fact that inflation did not dip into negative territory for more than a few months at the depths of the crisis.
This is in contrast to the experience of profound deflation during the Great Depression and the predictions of New Keynesian macroeconomic models, which call for sharp price drops during a major economic downturn. These models were called into question when that deflation didn’t materialize.
Portion of Figure 10 from Christiano et al. (2015)
What accounts for this missing deflation? In a study that was recently named one of the 2017 AEJ Best Papers, authors Lawrence Christiano, Martin Eichenbaum, and Mathias Trabandt argue that the financial crisis at the onset of the Great Recession subtly propped up inflation. The unusually high cost of borrowing in late 2008 and 2009 (as indicated by elevated corporate bond spreads) put pressure on cash-poor businesses and prevented them from cutting prices. A recent study appearing in the American Economic Review found corroborating evidence that companies with less liquidity and more debt were more likely to raise prices even in the midst of the recession.
The authors develop a model that demonstrates the major effect this “financial wedge” had on the entire economy during this period (see figure above). When they remove the unusually high cost of borrowing from their model (dashed line), a much milder recession results, with a smaller drop in output and no sharp increase in unemployment.