Inflation Dynamics During the Financial Crisis

In this paper, we investigate the effect of financial conditions on price-setting behavior during the 2008-2009 financial crisis. Using confidential, individual producer prices from the Bureau of Labor Statistics, we match these prices to Compustat firm-level data and compare pricing behavior across firms with weak balance sheets relative to firms with strong balance sheets. We find strong evidence that at the peak of the crisis firms with relatively weak balance sheets increased prices while firms with strong balance sheets lowered their prices. We explore the implications of financial distortions on price-setting within the context of a New Keynesian framework that allows for customer markets. In this model, firms have an incentive to set a low price to invest in market share. When financial distortions are severe, firms forgo these investment opportunities and maintain high prices. The model with financial distortions implies a substantial attenuation of price dynamics relative to the baseline model without financial distortions in response to contractionary demand shocks.