Understanding the Great Recession

NBER Working Paper No. 20040

Issued in April 2014, Revised in August 2014

NBER Program(s):Economic Fluctuations and Growth, Monetary Economics



We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound. We reach this conclusion looking through the lens of a New Keynesian model in which firms face moderate degrees of price rigidities and no nominal rigidities in the wage setting process. Our model does a good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the rise in the cost of working capital played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.

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Document Object Identifier (DOI): 10.3386/w20040

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