The Liquidity Trap and a Price Dispersion Puzzle

The literature on liquidity traps suggests that a non-linear version of the new Keynesian model is better suited to capture the complex implications of the zero lower bound. However, our research reveals an exceptional level of price dispersion that exceeds previous empirical estimates by several orders of magnitude. This phenomenon, which we call the "price-dispersion puzzle," highlights the limitations of non-linear models in providing an accurate representation of data during a liquidity trap. Additionally, we find that non-linear models generate results that differ significantly from those produced by log-linear models, which eliminate price dispersion through linearization. Our study attributes the "price-dispersion puzzle" to the significant reduction in real wages. By incorporating downward wage rigidity in our analysis, we not only solve the "price-dispersion puzzle" but also address the "missing-deflation puzzle."