Understanding Noninflationary Demand-Driven Business Cycles

In this paper we first point out a puzzle regarding the nature of US business cycles over the last thirty years. As is well known, over this period the economy experienced three main cycles. In each case, the common narrative behind these cycles has been that they were in large part driven by demand (residential investment demand in the 2000s, “tech” investment demand in the 1990s, and commercial real estate investment demand in the 1980s). The view that these cycles were to a large extent demanddriven is supported by the fact that both TFP (total factor productivity) and measured investmentspecific technological progress were either countercyclical or at most acyclical over the period, making a pure supplyside explanation unlikely. While the real economy experienced these cycles, inflation was very stable over the entire period and exhibited only a very small covariance with output. Such demanddriven cycles are not in themselves puzzling, but the associated inflation patterns are if one adopts a simple New Keynesian perspective for interpreting the period. In particular, using a standard calibration of a baseline New Keynesian Phillips curve, we show that actual inflation exhibited a level of volatility two to seven times smaller than that predicted by the model. While it may be possible to explain these facts by relying on very infrequent changes in prices (much larger than that supported by microeconomic studies), or by adding sticky wages, we believe that it is desirable to explore more substantive changes to the New Keynesian paradigm, which may deliver more robust explanations to episodes of noninflationary demanddriven business cycles. This is the goal of the paper.