Abstract
We assess the effects of financial shocks on inflation, and to what extent financial shocks can account for the missing disinflation during the Great Recession. We apply a vector autoregressive model to US data and identify financial shocks through sign restrictions. Our main finding is that expansionary financial shocks temporarily lower inflation. This result withstands a large battery of robustness checks. Moreover, negative financial shocks helped preventing a deflation during the crisis. We then explore the transmission channels of financial shocks relevant for inflation, and find that the cost channel explains the inflation response. A policy implication is that financial shocks that move output and inflation in opposite directions may worsen the trade-off for a central bank with a dual mandate.
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