Customer Markets and Financial Frictions: Implications for Inflation Dynamics

September 2015
Simon Gilchrist, Egon Zakrajˇsek

We study the influence of financial frictions on the cyclical dynamics of producer prices. Empirical results show that the response of industry-specific PPI inflation to changes in aggregate financial conditions depends importantly on differences in the ease of access to external finance across industries: In industries in which firms face a high likelihood of financial constraints, inflation is insensitive to changes in financial conditions; in industries where firms have a relatively unfettered access to external finance, by contrast, inflation declines significantly in response to a tightening of financial conditions. Firm-level pricing behavior during the 2008 financial crisis confirms these general findings: Firms’ pre-crisis internal liquidity positions had a significanteffect on firms that increased their prices relative to their industry average during this period.On the theoretical side, we use the model developed by Gilchrist, Schoenle, Sim, and Zakrajˇsek (2015b ) to analyze the implications of the interaction between customer markets and financial frictions for economic outcomes. Using a version of the model calibrated to study normal business cycle conditions, we confirm their original findings that this interaction significantly attenuates the response of inflation to demand shocks and produces a strong negative comovement between inflation and output in response to financial shocks. In light of the latter result, we also explore the macroeconomic implication of different interest-rate policy rules. In response to financial shocks, rules that put a significant weight on inflation stabilization lead to noticeably worse economic outcomes than rules aimed at stabilizing output.