Inflation Dynamics During the Financial Crisis

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 be-havior 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 im-plications 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 sub-stantial attenuation of price dynamics in response to contractionary demand shocks