Inflation in a Nonlinear World

• Applicant: Professor Dr. Mathias Trabandt
• Subject Area: Economic Policy, Applied Economics ; Economic Theory
• Term: since 2024
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 546115829

In most advanced economies inflation rates have risen rapidly in 2021 - 2023. For example, U.S. and Euro Area inflation rates rose quickly during these years reaching peaks at 9% and 10%, respectively. The inflation surge was likely driven by an array of supply and demand shocks such as e.g. Covid pandemic-related supply chain disruptions and bottlenecks, limits to production capacities and trade barriers and import restrictions due to pandemic lockdowns, reductions in labor supply, shifts in consumer behavior, rising food and energy prices due to the war in Ukraine as well as monetary and fiscal responses to the Covid pandemic and its fallout. Even in light of the many supply and demand shocks, the inflation surge has caught many macroeconomists off guard, i.e. the size and duration of the inflation surge was surprising to many macroeconomists. Similarly, inflation dynamics during the 2007/2008 Global Financial Crisis and the ensuing Great Recession were puzzling to many macroeconomists. In light of the large drop in output, many macroeconomists expected deflation. In the data, however, inflation dropped relatively little with no deflation in e.g. measures of core inflation in many Western advanced economies. Therefore, the actual drop in inflation was much smaller than expected. This phenomenon is known as the "missing deflation puzzle". Taken together, inflation dynamics in times of deep crisis appear puzzling to many macroeconomists. Inflation fell less than expected in the Great Recession and rose more than expected in the post-Covid episode. Put differently, the dynamics of inflation appear to follow a nonlinear pattern, especially during extraordinary times of economic crisis. Standard monetary macroeconomic models such as the standard New Keynesian model have difficulties in accounting for these nonlinear inflation patterns. The majority of these models are linearized models, i.e. the equilibrium equations are linear. While standard linearized models work well for small shocks, representing "normal" business cycle fluctuations in the economy, they fail to account for inflation phenomena observed in the aftermath of deep economic crises when inflation dynamics appear to follow a nonlinear pattern. The proposed project aims to develop models that can better account for nonlinearities in inflation observed in the data. These models shall combine nonlinearities in product and labor markets, also taking into account household heterogeneity. These models shall be confronted with data via model estimation. Finally, the models to be developed shall be used to study the optimal conduct of monetary policy during e.g. the Great Recession and post-Covid inflation surge.

• DFG Programme: Research Grants