NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Modeling Inflation After the Crisis

James H. Stock, Mark W. Watson

NBER Working Paper No. 16488
Issued in October 2010
NBER Program(s):   EFG   ME

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.

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Document Object Identifier (DOI): 10.3386/w16488

Published: James H. Stock & Mark W. Watson, 2010. "Modeling inflation after the crisis," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 173-220. citation courtesy of

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