Learning, Inflation Cycles, and Depression

Ryo Horii and Yoshiyasu Ono

No 06-14, Discussion Papers in Economics and Business from Osaka University, Graduate School of Economics

Abstract: This paper constructs a model that describes inflation cycles and prolonged depression as generated by the learning behavior of households who face a random liquidity shock in which money is needed. Households update the subjective probability of the shock based on the observation and change their liquidity preference accordingly. In this setting, we first derive a stationary cycles under perfect price adjustment, which is characterized by periods of gradual inflation and sudden sporadic falls of the price level. When the nominal stickiness is introduced, the liquidity shock is followed by a period of depression in which unemployment exists and deflation occurs gradually. Depression is deep and prolonged when the economy has experienced a long period of boom before encountering a liquidity shock.

Keywords: Bayesian Learning in Continuous Time; Hamilton-Jacobi-Bellman Equations; Markov Modulated Poisson Processes; Partial Delay Differential Equations; Liquidity Preference. (search for similar items in EconPapers)
JEL-codes: D83 E32 E41 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2006-05
New Economics Papers: this item is included in nep-mac and nep-mon
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