Missing Disinflation and Human Capital Depreciation

In line with New-Keynesian predictions and certain historical trajectories that tracked by inflation during past crises, the context of the Great Recession should have spurred a sharp fall in inflation or even deflation. On the contrary, the sensitivity of inflation to changes in unemployment has diminished, giving rise to the paradox of missing disinflation. By investigating this paradox, this article develops a variant of the New-Keynesian models where mechanisms of depreciation of human capital are implemented. In the model, rising unemployment translates into a relatively large increase in long-term unemployment. Unemployed people with low levels of human capital become dominant and more workers are now likely to suffer from depreciation of human capital. The depreciation weakens the intensity with which the unemployed prospect new jobs and moderates the decline in wages and prices. Calibrated to the United States economy, model simulations show that this model variant compares relatively better the highlights of missing disinflation than a New-Keynesian without depreciation of human capital. In response to shocks of the same size, the response of inflation in the model with depreciation of human capital is 3 to 4-fold less than in standard New-Keynesian models.