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Why, during the Great Recession, with a sputtering economy and increased unemployment, didn’t prices fall in the US? Instead, prices have risen, albeit much slower than normal. A new paper by economists Olivier Coibion and Yuriy Gorodnichenko puts that question in more precise, academic terms: why has the US had really low levels of inflation, when instead, they assert, economic theory says there should have been disinflation (falling prices)?
The reason prices didn’t fall in the Great Recession, the researchers find, is that businesses follow households’ lead on inflation expectations. And households have an unorthodox way of setting their inflation expectations: they pay a lot of attention to gas prices, which rose after the financial crisis. This is a marked difference from how academics and businesses gauge inflation: they intentionally exclude oil prices from their primary inflation metrics, in part because they are so volatile.
Coibion and Gorodnichenko’s findings suggest a new relationship between consumer inflation expectations and unemployment. Previously, both business and consumer inflation expectations and unemployment had been strongly correlated. But in the Great Recession, this relationship broke down. Unemployment increased dramatically, and inflation stayed higher than predicted.
James Hamilton writes that the researchers’ findings are a significant update to economic thinking on inflation. “For nearly a century, many economists have viewed variation in the unemployment rate as a key determinant of why inflation is higher in some years than in others,” he writes. Then the 1970s happened, and economists began to pay more attention to inflation expectations.