Can loss aversion shed light on the deflation puzzle?

Abstract

This paper argues that the application of loss aversion to wage determination can explain the deflation puzzle: the failure of persistently high unemployment to exert a persistent downward impact on the rate of inflation in money wages. This is an improvement on other theories of the deflation puzzle which simply assume downward wage rigidity, namely the hysteresis theory, the lubrication theory and the efficiency wage theory. The paper presents estimates that support the loss-aversion explanation of the deflation puzzle for both the US and Australia. Furthermore, our estimation approach gives a more precise estimate of the potential rate of unemployment than does the natural rate approach and reveals potential rates of unemployment for the US and Australia at the end of 2017 of about 4 per cent and 3.3 per cent respectively.

A Keynesian model of aggregate demand in the long‐run

“…Hysteresal patterns are observed. Perhaps one reason is the fear by policymakers of “letting the inflation genii out of the bottle”, Solow (1998), although the empirical analysis in Lye and McDonald (2021) supports Solow's skepticism about the importance of this fear. In considering this puzzle, these results suggest that breaking away from models anchored to the natural rate and instead focusing on the determination of aggregate demand in the long‐run should yield insights.…”

“…At the aggregate level, Driscoll and Holden (2004), Lye et al. (2001) and Lye and McDonald (2021) find evidence for wage rigidity that supports the loss aversion approach to wage setting. At the industry level, Holden and Wulfsberg (2009) find evidence for downward wage rigidity which they relate to the role of loss aversion by workers.…”

The Australian Economy in 2023–24: Navigating a Narrow Path

“…However, the true NAIRU is unobservable and empirical estimates of the NAIRU vary considerably. In Australia, examples include as low as 3.3 per cent in Lye and McDonald (2021) and around 4.5 per cent in Ellis (2019). Estimates of the NAIRU also change over time as the structure of the economy and labour market evolves (Bullock 2023b).…”

The Australian Economy in 2022–23: Inflation and Higher Interest Rates in a Post‐COVID‐19 World

“…RBA estimates of the NAIRU (Non‐accelerating Inflation Rate of Unemployment) prior to COVID‐19 suggest an estimate of a little above 4 per cent (Ellis 2019). Lye and McDonald (2021) estimate that the NAIRU could be as low as 3.3 per cent. We also note that the NAIRU is unobservable, typically estimated using filtering, and its estimation can be subject to large standard errors.…”