Resolving the missing deflation puzzle

• Our analysis focuses on nonlinearities in price and wage-setting using Kimball (1995) aggregation. • Our nonlinear New Keynesian model with Kimball aggregation resolves the missing deflation puzzle while the linearized version fails to do so. • Our nonlinear model generates nonlinear Phillips curves and reproduces the skewness of price and wage inflation observed in post-war U.S. data. • Our results caution against the common practice of using linearized models when the economy is exposed to large shocks. A resolution of the missing deflation puzzle is proposed. Our resolution stresses the importance of nonlinearities in price- and wage-setting when the economy is exposed to large shocks. We show that a nonlinear macroeconomic model with real rigidities resolves the missing deflation puzzle, while a linearized version of the same underlying nonlinear model fails to do so. In addition, our nonlinear model reproduces the skewness of inflation and other macroeconomic variables observed in post-war U.S. data. All told, our results caution against the common practice of using linearized models to study inflation and output dynamics.