Inflation Dynamics During the Financial Crisis

April 2016
Simon Gilchrist, Raphael Schoenle, Jae Sim, Egon Zakrajˇsek

Using a novel dataset, which merges good-level prices underlying the PPI with the respondents’ balance sheets, we show that liquidity constrained firms increased prices in 2008, while their unconstrained counterparts slashed prices. We develop a model in which firms face financial frictions while setting prices in customer markets. Financial distortions create an incentive for firms to raise prices in response to adverse financial or demand shocks. This reaction reflects the firms’ decision to preserve internal liquidity and avoid accessing external finance, factors that strengthen the countercyclical behavior of markups and attenuate the response of inflation to fluctuations in output.