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Modeling inflation after the crisis

  • James H. Stock
  • Mark W. Watson

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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Article provided by Federal Reserve Bank of Kansas City in its journal Proceedings - Economic Policy Symposium - Jackson Hole.

Volume (Year): (2010)
Issue (Month): ()
Pages: 173-220

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Handle: RePEc:fip:fedkpr:y:2010:p:173-220
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