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.