Inflation Dynamics During the Financial Crisis

Jae Sim, Raphael Schoenle, Egon Zakrajšek (egon.zakrajsek@bos.frb.org) and Simon Gilchrist

No 206, 2014 Meeting Papers from Society for Economic Dynamics

Abstract: Using confidential product-level price data underlying the U.S. Producer Price Index (PPI), this paper analyzes the effect of changes in firms' financial conditions on their price-setting behavior during the "Great Recession" that surrounds the financial crisis. The evidence indicates that during the height of the crisis in late 2008, firms with "weak" balance sheets increased prices significantly relative to industry averages, whereas firms with "strong" balance sheets lowered prices, a response consistent with an adverse demand shock. These stark differences in price-setting behavior are consistent with the notion that financial frictions may significantly influence the response of aggregate inflation to macroeconomic shocks. We explore the implications of these empirical findings within a general equilibrium framework that allows for customer markets and departures from the frictionless financial markets. In the model, firms have an incentive to set a low price to invest in market share, though when financial distortions are severe, firms forgo these investment opportunities and maintain high prices in an effort to preserve their balance-sheet capacity. Consistent with our empirical findings, the model with financial distortions—relative to the baseline model without such distortions—implies a substantial attenuation of price dynamics in response to contractionary demand shocks.

Date: 2014
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Citations: View citations in EconPapers (15)

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Related works:
Journal Article: Inflation Dynamics during the Financial Crisis (2017)
Working Paper: Inflation Dynamics During the Financial Crisis (2016)
Working Paper: Inflation dynamics during the financial crisis (2015)
Working Paper: Inflation Dynamics During the Financial Crisis (2015)
Working Paper: Inflation Dynamics During the Financial Crisis (2013)
Working Paper: Inflation Dynamics During the Financial Crisis (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed014:206

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