Labor Market Policies and the "Missing Deflation" Puzzle: Lessons from Hoover Policies during the U.S Great Depression

We document the existence of a "missing deflation" puzzle during the U.S. Great Depression (1929-1941) and show that the solution of this puzzle lies in Hoover policies. Herbert Hoover made multiple public announcements asking firms not to cut wages, most of which complied. The consequences of such a policy are ambiguous since it affects aggregate fluctuations via two channels: as a negative aggregate supply shock this policy decreases output while increasing inflation, but more inflation can postpone the occurrence of a liquidity trap when the economy is hit by a large negative aggregate demand shock. We develop and estimate a medium scale New Keynesian model to measure the effect of Hoover policies during the Great Depression and we find evidence that without such polices the U.S. economy would have ended up in a liquidity trap two years before it actually did, suffering an even deeper recession with a larger deflation. In addition, the welfare effects of Hoover policy are found to be clearly positive.