International Finance Discussion Papers (IFDP)
June 2014 (Revised June 2015)
Understanding the Great Recession
Lawrence J. Christiano, Martin S. Eichenbaum, and Mathias Trabandt
Abstract:
We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions. We reach this conclusion by looking through the lens of an estimated New Keynesian model in which firms face moderate degrees of price rigidities, no nominal rigidities in the wages and a binding zero lower bound constraint on the nominal interest rate. Our model does a good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the rise in the cost of working capital played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.
Keywords: Inflation, unemployment, labor force, zero lower bound
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