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Inflation Dynamics During the Financial Crisis

Author

Listed:
  • Simon Gilchrist

    (Boston University and NBER)

  • Raphael Schoenle

    (Brandeis University)

  • Jae W. Sim

    (Federal Reserve Board)

  • Egon Zakrajsek

    (Federal Reserve Board)

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.” The evidence indicates that during the height of the crisis in late 2008, firms with “weak” balance sheets increased prices significantly, 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 macroeco- nomic shocks. We explore the implications of these empirical findings within the New Keynesian general equilibrium framework that allows for customer markets and departures from the fric- tionless 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 oppor- tunities 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.Length: 59 pages

Suggested Citation

  • Simon Gilchrist & Raphael Schoenle & Jae W. Sim & Egon Zakrajsek, 2013. "Inflation Dynamics During the Financial Crisis," Working Papers 78, Brandeis University, Department of Economics and International Businesss School.
  • Handle: RePEc:brd:wpaper:78
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    Keywords

    Producer Price Inflation; Customer Markets; Financial Frictions;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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