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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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16488.

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Date of creation: Oct 2010
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Publication status: published as 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.
Handle: RePEc:nbr:nberwo:16488
Note: EFG ME
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