Can Loss Aversion Shed Light on the Deflation Puzzle?

36 Pages Posted: 17 Jun 2019

See all articles by Jenny Lye

Jenny Lye

University of Melbourne

Ian M. McDonald

University of Melbourne - Department of Economics

Date Written: June 17, 2019

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; which are 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 a potential rate of unemployment for the US and Australia at the current time (end of 2017) of about 4% and 3.3% respectively.

Keywords: unemployment, inflation, Phillips curve, hysteresis, loss aversion, behavioural macroeconomics

JEL Classification: E12, E24, E31, E71

Suggested Citation

Lye, Jenny and McDonald, Ian M., Can Loss Aversion Shed Light on the Deflation Puzzle? (June 17, 2019). CAMA Working Paper No. 40/2019. Available at SSRN: https://ssrn.com/abstract=3405160 or http://dx.doi.org/10.2139/ssrn.3405160

Jenny Lye

University of Melbourne

185 Pelham Street
Carlton, Victoria 3053
Australia

Ian M. McDonald (Contact Author)

University of Melbourne - Department of Economics ( email )

Melbourne, 3010
Australia

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