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Financial shocks and inflation dynamics

Published online by Cambridge University Press:  11 November 2021

Angela Abbate ,
Sandra Eickmeier  and
Esteban Prieto
Angela Abbate
Affiliation:
Swiss National Bank
Sandra Eickmeier*
Affiliation:
Deutsche Bundesbank, CAMA, CEPR
Esteban Prieto
Affiliation:
Deutsche Bundesbank, IWH, CEPR
*
*Corresponding author. Email: sandra.eickmeier@bundesbank.de.
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Abstract

We assess the effects of financial shocks on inflation, and to what extent financial shocks can account for the “missing disinflation” during the Great Recession. We apply a Bayesian vector autoregressive model to US data and identify financial shocks through a combination of narrative and short-run sign restrictions. Our main finding is that contractionary financial shocks temporarily increase inflation. This result withstands a large battery of robustness checks. Negative financial shocks help therefore to explain why inflation did not drop more sharply in the aftermath of the financial crisis. Our analysis suggests that higher borrowing costs after negative financial shocks can account for the modest decrease in inflation after the financial crisis. A policy implication is that financial shocks act as supply-type shocks, moving output and inflation in opposite directions, thereby worsening the trade-off for a central bank with a dual mandate.

Keywords

Financial shocksinflation dynamicsmonetary policyfinancial frictionscost channelsign restrictionsE31E44E58
Type
Articles
Information
Macroeconomic Dynamics , Volume 27 , Issue 2 , March 2023 , pp. 350 - 378
Copyright
© The Author(s), 2021. Published by Cambridge University Press

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