|
on Central Banking |
| By: | Jochen Michaelis (University of Kassel); Jakob Palek (University of Kassel) |
| Abstract: | There is growing empirical evidence that the strength of the cost channel of monetary policy differs across countries. Using a New Keynesian model of a two-country monetary union, we show how the introduction of a cost channel (differential) alters the optimal monetary responses to union-wide and national shocks. The cost channel makes monetary policy less effective in combating inflation, but it is shown that the optimal response to the decline in effectiveness is a stronger use of the instrument. On the other hand, the larger the cost channel differential, the less aggressive will the optimal monetary policy be. For almost all parameter constellations, our welfare analysis suggests a clear-cut ranking of policy regimes: commitment outperforms the Taylor rule, the Taylor rule outperforms strict inflation targeting, and strict inflation targeting outperforms discretion. |
| Keywords: | cost channel; optimal monetary policy; monetary union; open economy macroeconomics |
| JEL: | E31 E52 F41 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:mar:magkse:201444&r=cba |
| By: | Paul H. Kupiec (American Enterprise Institute); Claire Rosenfeld (American Enterprise Institute); Yan Lee (American Enterprise Institute) |
| Abstract: | New bank regulations include macroprudential policies to control bank loan growth. We find bank funding costs and supervisory monitoring intensity to be the most important determinants of loan growth followed by loan portfolio performance and bank profitability. Bank capital and liquidity ratios have limited impacts, suggesting that macroprudential regulations are unlikely to be effective.� |
| Keywords: | AEI Economic Policy Working Paper Series |
| JEL: | G |
| Date: | 2013–12 |
| URL: | http://d.repec.org/n?u=RePEc:aei:rpaper:2075&r=cba |
| By: | Swamy, Vighneswara |
| Abstract: | In this study, using the World Bank’s Bank Regulation and Supervision Survey (BRSS) data, we draw insights about the bank regulatory/supervisory styles, illustrate the differences in regulation/supervision among crisis, non-crisis and BRICS countries, and highlight the ways in which bank regulation and supervision has changed during the crisis period. The study suggests that crisis-countries had weaker regulatory and supervisory frameworks compared to those in emerging countries during the crisis. BRICS countries as a distinct block has demonstrated uniqueness in the regulatory/supervisory styles which is neither similar to crisis-countries nor with the non-crisis countries. |
| Keywords: | Central Banks, Banking Regulation, Capital adequacy, Regulation, Risk, Supervision, Financial markets and governance, Crisis |
| JEL: | E58 G18 G20 G21 G32 G38 L51 O16 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:58295&r=cba |
| By: | Alex Mandilaras (University of Surrey) |
| Abstract: | The international macroeconomic policy trilemma suggests that de- spite the appeal of exchange rate stability, financial account openness and monetary sovereignty, these cannot be achieved simultaneously. Us- ing elements of Euclidean geometry, this paper proposes a new method for testing the trilemma and finds considerable evidence in support of it. Further tests indicate that, on average, policy configurations are not on the trilemma constraint, i.e. there is a degree of `trilemma- ineffectiveness’, which is costly for real output growth and price inflation. It is shown that these costs can be attributed to limited exchange rate stability and financial account openness, respectively. |
| JEL: | F33 |
| Date: | 2014–11 |
| URL: | http://d.repec.org/n?u=RePEc:sur:surrec:0814&r=cba |
| By: | Ardakani, Omid; Kishor, N. Kundan |
| Abstract: | This paper analyzes the performance of central banks in 27 inflation targeting countries by examining their success in achieving their explicit inflation targets. For this purpose, we decompose the inflation gap, the difference between actual inflation and inflation target, into predictable and unpredictable components. We argue that the central banks are successful if the predictable component in the inflation gap diminishes over time. The predictable component of inflation gap is measured by the conditional mean of a time-varying autoregressive model. Our results find considerable heterogeneity in the success of these IT countries in achieving their targets at the start of this policy regime. Our findings also suggest that the central banks of the IT adopting countries started targeting inflation implicitly before becoming an explicit inflation targeter. The panel data analysis suggests that the relative success of these countries in reducing the gap is influenced by their institutional characteristics particularly by fiscal discipline and macroeconomic performance. |
| Keywords: | Inflation targeting, inflation gap, predictability, time-varying autoregressive model, institutional characteristics |
| JEL: | C32 C53 E31 E37 E52 E58 |
| Date: | 2014–09–07 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:58402&r=cba |
| By: | Mahito Uchida |
| Abstract: | In this paper, I investigate the Bank of Japan's monetary policy effects under Abenomics at the initial stage. First, I describe briefly what is “Abenomics” and “New monetary policy under Abenomics” since April 2013. I also examine the causes of the sharp response of the yen and Japanese stock prices, the increase of consumer price index and the change of the public's expectations for economic activity and prices on surveys. In the second part I explain why the new monetary policy was effective in 2013, comparing the previous policy until 2012. Although there is not so big difference between monetary policies before and after 2012 theoretically, I point out the importance of the strong commitment by central bank, the cooperation with the government and “psychological impact” on public. The third part discusses the durability of the new monetary policy. The policy effects will be sustainable if a price becomes lastingly positive, which needs a durably positive output gap. Therefore, growth strategy by Abenomics plays an important role. I also point out that the BOJ has to perform the policy over side effects such as the impact on the government bond markets, the impact on other financial market and an outflow of money to overseas. |
| Keywords: | Abenomics; Monetary policy; Interest rates; Inflation target |
| Date: | 2014–04 |
| URL: | http://d.repec.org/n?u=RePEc:spo:wpmain:info:hdl:2441/7fp8n6moep83p9otmhc28tapl4&r=cba |
| By: | Rubén Albeiro Loaiza Maya; José Eduardo Gómez-González; Luis Fernando Melo Velandia |
| Abstract: | A regular vine copula approach is implemented for testing for contagion among the exchange rates of the six largest Latin American countries. Using daily data from June 2005 through April 2012, we find evidence of contagion among the Brazilian, Chilean, Colombian and Mexican exchange rates. However, there are interesting differences in contagion during periods of large exchange rate depreciation and appreciation. Our results have important implications for the response of Latin American countries to currency crises originated abroad. |
| Keywords: | Exchange Rates, Contagion, Copula, Regular Vine, Local correlation. |
| JEL: | C32 C51 |
| Date: | 2014–09–01 |
| URL: | http://d.repec.org/n?u=RePEc:col:000094:012105&r=cba |
| By: | Thomas Jobert (University of Nice Sophia Antipolis, France; GREDEG CNRS); Alexandru Monahov (University of Nice Sophia Antipolis, France; GREDEG CNRS); Anna Tykhonenko (University of Nice Sophia Antipolis, France; GREDEG CNRS) |
| Abstract: | We study the impact of prudential supervision on domestic credit in 27 countries throughout 1999-2012. We use the Empirical Iterative Bayes’ estimator to account for country heterogeneity. We find: (i) the interest rate not to be a fundamental variable in explaining domestic credit, (ii) negative relations between credit sensitivity to past investment and to financial dependence, (iii) the effects of supervision on credit differ by country, but (iv) without systematic negative impact of increased supervisory stringency. Our results are coherent with two interpretations: one encouraging regulatory set-ups where increased supervision positively affects credit, and another cautioning about the associated risks. |
| Keywords: | Prudential supervision, Supervision in the EU, Banking system supervision, Financial institution regulation, Bayesian shrinkage estimator |
| JEL: | C51 E65 G28 |
| Date: | 2014–10 |
| URL: | http://d.repec.org/n?u=RePEc:gre:wpaper:2014-30&r=cba |
| By: | Hirtle, Beverly (Federal Reserve Bank of New York); Lehnert, Andreas |
| Abstract: | This article describes the background, design choices and particular details of stress tests used as part of an overall supervisory regime; that is, their formal integration into the process of the ongoing prudential supervision of banks and other large financial institutions. We then describe how the U.S. CCAR/DFAST regime is designed and what that means for the macroprudential vs. microprudential nature of the U.S. exercises. We argue routine stress tests have the potential to substantially change the nature of the supervisory process. In addition, we argue that a great deal depends on the philosophy underpinning modeling decisions, which has not received as much attention as scenario design, disclosure or other stress test design choices. |
| Keywords: | stress tests; bank capital |
| JEL: | G01 G21 |
| Date: | 2014–11–01 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:696&r=cba |
| By: | Natalie Tiernan (Office of the Comptroller of the Currency); Pedro Gete (Georgetown University) |
| Abstract: | This paper is a quantitative study of two frictions that generate banks' underinvestment in screening borrowers and, thus, overlending: 1) Limited liability, and 2) Banks failing to internalize that their credit decisions alter the pool of borrowers faced by other banks. The resulting lax lending standards overexpose banks to negative economic shocks and amplify the effects of economic fluctuations. They generate excessive volatility in credit, banks' capital and output. We study a calibrated model whose predictions concerning the quantity and quality of credit are in line with recent U.S. business cycles. Quantitatively, limited liability is the friction that generates laxer lending standards. It induces 27% excess volatility in output relative to 8% from the other friction. Then we study three policy tools: capital requirements and taxes on banks' lending and borrowings. The three tools encourage banks to screen more and should be state-contingent because the frictions vary with macroeconomic conditions. In quantitative terms, we find that taxes are better tools than capital requirements because they do not reduce credit going to the more productive agents. |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed014:379&r=cba |
| By: | Mehmet Balcilar (Department of Economics, Eastern Mediterranean University, Famagusta, Northern Cyprus , via Mersin 10, Turkey; Department of Economics, University of Pretoria, Pretoria, 0002, South Africa); Rangan Gupta (Department of Economics, University of Pretoria); Charl Jooste (Department of Economics, University of Pretoria) |
| Abstract: | We compare inflation forecasts of a vector fractionally integrated autoregressive moving average (VARFIMA) model against standard forecasting models. U.S. inflation forecasts improve when controlling for persistence and economic policy uncertainty (EPU). Importantly, the VARFIMA model, comprising of inflation and EPU, outperforms commonly used inflation forecast models. |
| Keywords: | Inflation, long-range dependency, economic policy uncertainty |
| JEL: | C53 E37 |
| Date: | 2014–10 |
| URL: | http://d.repec.org/n?u=RePEc:pre:wpaper:201460&r=cba |
| By: | Swamy, Vighneswara |
| Abstract: | This study models the impact of new capital regulations proposed under Basel III on bank profitability by constructing a stylized representative bank’s financial statements. We show that the higher cost associated with a one-percentage increase in the capital ratio can be recovered by increasing lending spreads. The results indicate that in the case of scheduled commercial banks, one-percentage point increase in capital ratio can be recovered by increasing the bank lending spread by 31 basis points and would go upto an extent of 100 basis points for six-percentage point increase assuming that the risk weighted assets are unchanged. We also provide the estimations for the scenarios of changes in risk weighted assets, changes in return on equity (ROE) and the cost of debt. |
| Keywords: | Banks, Regulation, Basel III, Capital, Interest Income |
| JEL: | E44 E51 E61 G21 G28 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:58323&r=cba |
| By: | Taylor, John B. (Stanford University) |
| Abstract: | This paper starts from the theoretical observation that simple rules-based monetary policy will result in good economic performance in a globalized world economy and the historical observation that this occurred during the Great Moderation period of the 1980s and 1990s. It tries to answer a question posed by Paul Volcker in 2014 about the global repercussions of monetary policies pursued by advanced economy central banks in recent years. I start by explaining the basic theoretical framework, its policy implications, and its historical relevance. I then review the empirical evidence on the size of the international spillovers caused by deviations from rules-based monetary policy, and explore the many ways in which these spillovers affect and interfere with policy decisions globally. Finally, I consider ways in which individual monetary authorities and the world monetary system as a whole could adhere better to rules-based policies in the future and whether this would be enough to achieve the goal of stability in the globalized world economy. |
| JEL: | E5 F4 F5 |
| Date: | 2014–10–01 |
| URL: | http://d.repec.org/n?u=RePEc:fip:feddgw:200&r=cba |
| By: | Jan Willem van den End; Marco Hoeberichts |
| Abstract: | We empirically test whether there is a causal link between the real interest rate and the natural rate of interest, which could be a harbinger of secular stagnation if the real rate declines. Outcomes of VAR models for Japan, Germany and the US show that a fall in the real rate indeed affects the natural rate. This causality is significant for Japan, borderline significant for Germany and not significant for the US. The outcomes for Japan confirm that a prolonged period of low real rates can affect potential economic growth. The policy implication is that implementing measures that raise the natural rate will be more effective in avoiding secular stagnation than reducing the real rate through higher inflation expectations. |
| Keywords: | interest rates; financial markets and the macroeconomy; monetary policy |
| JEL: | E43 E44 E52 |
| Date: | 2014–10 |
| URL: | http://d.repec.org/n?u=RePEc:dnb:dnbwpp:444&r=cba |
| By: | Ojo, Marianne |
| Abstract: | The Basel III Leverage Ratio, as originally agreed upon in December 2010, has recently undergone revisions and updates – both in relation to those proposed by the Basel Committee on Banking Supervision – as well as proposals introduced in the United States. Whilst recent proposals have been introduced by the Basel Committee to improve, particularly, the denominator component of the Leverage Ratio, new requirements have been introduced in the U.S to upgrade and increase these ratios, and it is those updates which relate to the Basel III Supplementary Leverage Ratio that have primarily generated a lot of interests. This is attributed not only to concerns that many subsidiaries of US Bank Holding Companies (BHCs) will find it cumbersome to meet such requirements, but also to potential or possible increases in regulatory capital arbitrage: a phenomenon which plagued the era of the original 1988 Basel Capital Accord and which also partially provided impetus for the introduction of Basel II. This paper is aimed at providing an analysis of the recent updates which have taken place in respect of the Basel III Leverage Ratio and the Basel III Supplementary Leverage Ratio – both in respect of recent amendments introduced by the Basel Committee and proposals introduced in the United States. As well as highlighting and addressing gaps which exist in the literature relating to liquidity risks, corporate governance and information asymmetries, by way of reference to pre-dominant based dispersed ownership systems and structures, as well as concentrated ownership systems and structures, this paper will also consider the consequences – as well as the impact - which the U.S Leverage ratios could have on Basel III. There are ongoing debates in relation to revision by the Basel Committee, as well as the most recent U.S proposals to update Basel III Leverage ratios and whilst these revisions have been welcomed to a large extent, in view of the need to address Tier One capital requirements and exposure criteria, there is every likelihood,indication, as well as tendency that many global systemically important banks (GSIBS), and particularly their subsidiaries, will resort to capital arbitrage. What is likely to be the impact of the recent proposals in the U.S.? The recent U.S proposals are certainly very encouraging and should also serve as impetus for other jurisdictions to adopt a pro-active approach – particularly where existing ratios or standards appear to be inadequate. This paper also adopts the approach of evaluating the causes and consequences of the most recent updates by the Basel Committee, as well as those revisions which have taken place in the U.S, by attempting to balance the merits of the respective legislative updates and proposals. The value of adopting leverage ratios as a supplementary regulatory tool will also be illustrated by way of reference to the impact of the recent legislative changes on risk taking activities, as well as the need to also supplement capital adequacy requirements with the Basel Leverage ratios and the Basel liquidity standards. |
| Keywords: | credit risk; liquidity risks; global systemically important banks (G-SIBs); leverage ratios; harmonization; accounting rules; capital arbitrage; disclosure; stress testing techniques; U.S Basel III Final Rule |
| JEL: | D8 E3 G3 G32 K2 |
| Date: | 2014–08 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:59598&r=cba |
| By: | Helena Glebocki Keefe (Fordham University); Erick W. Rengifo (Fordham University) |
| Abstract: | Several central banks in emerging economies are concerned with excessive volatility in foreign exchange markets and would like to control the direction and speed with which the value of their currency changes. Historically, currency market interventions have consisted of using foreign exchange reserves to purchase and sell foreign currency directly in the spot market. However, these spot interventions are not the only type of interventions available to central banks. The Colombian central bank implemented various strategies to intervene into currency markets to smooth volatility, build reserves, and influence the direction of the exchange rate by issuing options contracts as well as using daily discretionary purchases of US dollars. In this paper we analyze these recent strategies employed by Colombia, with a special focus on the volatility option strategy. We argue that the abandonment of the options program was premature and that its success was not fully appreciated in previous literature. |
| Keywords: | Exchange Rates, Intervention, Foreign Exchange Markets, Currency Options, International. Reserves, International Finance. |
| JEL: | F31 G15 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:frd:wpaper:dp2014-06&r=cba |
| By: | Bergh, Andreas (Research Institute of Industrial Economics (IFN)) |
| Abstract: | This paper asks whether the sensitivity of market long-term interest rates and credit ratings is associated with cross-country differences in informal institutions, measured by social trust. We note a number of theoretical mechanisms that could imply that similar objective problems are more likely to be effectively dealt with in higher-trust societies. A set of panel estimates across middle and high-income countries reveal that interest rates and ratings are substantially more sensitive to inflation and growth problems in low-trust countries. This finding sheds light on the differential market reactions to economic problems in seemingly comparable countries. |
| Keywords: | Trust; Credit ratings; Interest rates; Economic reforms |
| JEL: | A13 G12 |
| Date: | 2014–09–03 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:iuiwop:1039&r=cba |
| By: | Joscha Beckmann; Ansgar Belke; Christian Dreger |
| Abstract: | Deviations of policy interest rates from the levels implied by the Taylor rule have been persistent before the financial crisis and increased especially after the turn of the century. Compared to the Taylor benchmark, policy rates were often too low. This paper provides evidence that both international spillovers, for instance international dependencies in the interest rate setting of central banks, and nonlinear reaction patterns can offer a more realistic specification of the Taylor rule in the main industrial countries. The inclusion of international spillovers and, even more, nonlinear dynamics improves the explanatory power of standard Taylor reaction functions. Deviations from Taylor rates tend to be smaller and their negative trend can be eliminated. |
| Keywords: | Taylor rule, international spillovers, monetary policy interaction, smooth transition models |
| JEL: | E43 F36 C22 |
| Date: | 2014–09 |
| URL: | http://d.repec.org/n?u=RePEc:rmn:wpaper:201410&r=cba |
| By: | SEKINO Masahiro; WATANABE Wako |
| Abstract: | Using the data of individual loan contracts extended by the Japan Finance Corporation for Small and Medium Enterprise (JASME), which is one of the predecessor institutions of the Japan Finance Corporation (JFC) that aimed at lending to small and medium enterprises (SMEs), we examine whether the JASME's lending substituted for the reduced lending supply by private banks during the period of the credit crunch. We find that the JASME made larger loans to the firms whose main bank reduced more lending due to losses on their capital. |
| Date: | 2014–10 |
| URL: | http://d.repec.org/n?u=RePEc:eti:dpaper:14063&r=cba |
| By: | Frenkel, Roberto; Rapetti, Martin |
| Abstract: | In recent years several authors have argued that developing countries should aim to target a stable and competitive real exchange rate (SCRER) to foster economic growth. A growing body of empirical research gives support to this claim. Although more theoretical work is needed, some ideas from development theory can help to explain the empirical findings. For instance, if modern tradable activities display some form of increasing returns to scale, market forces alone would deliver a set of relative prices that would make capital accumulation in these activities suboptimal. This paper supports the view that developing countries could target SCRER as a part of a development strategy that promotes the expansion of modern tradable activities. We review the empirical findings, discuss the channels through which a SCRER can stimulate economic growth, and describe the policies needed to pursue a strategy based on a SCRER. |
| Keywords: | Real exchange rate, development, macroeconomic policy |
| JEL: | E61 F41 F43 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:59335&r=cba |
| By: | Barnett, William A.; Duzhak, Evgeniya A. |
| Abstract: | This paper analyzes the dynamical properties of monetary models with regime switching. We start with the analysis of the evolution of inflation when policy is guided by a simple monetary rule where coefficients switch with the policy regime. We rule out the possibility of a Hopf bifurcation and demonstrate the existence of a period doubling bifurcation. As a result, a small change in the parameters (e.g., a more active policy response) can lead to a drastic change in the path of inflation. We demonstrate that while the New Keynesian model with a current-looking Taylor rule is not prone to bifurcations, a hybrid rule exhibits the same pattern of period doubling bifurcations as the basic setup. |
| Keywords: | New Keynesian, Taylor Rule, regime switching, bifurcation analysis, structural stability. |
| JEL: | C14 C22 E32 E37 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:58737&r=cba |
| By: | ibrahim, waheed; Jimoh, Ayodele |
| Abstract: | ABSTRACT The paper has provided theoretical extensions to the computations of nominal effective exchange rate and the real effective exchange rate over time. The extension took cognizance of the common base currency (USD) to which all currencies of the world is usually converted. The paper compared its computations with that of the CBN computations in attempt to provide a litmus test on the extensions. It was observed that the two computations were of preserving order with a very high correlation coefficient between the two computations. However, it was observed that the extensions perform better as it’s reflects more of changes in exchange rate of Nigerian economy. The difference was attributed to the increased in the number of trading partners that was involved in the latter. At the end from the result obtained, the paper recommends that the extension should always be taken into considerations in the computations of effective exchange rate especially for the developing nations like Nigeria; also, Central banks of these countries should endeavour to include as many trading partners as possible into their computations. The paper believes that until this done, their effective rates computations may not reflect the actual changes in the exchange rate of their respective countries. |
| Keywords: | Keywords: nominal, Real, Effective rates, CBN, correlation coefficients, trading partners |
| JEL: | F3 F31 |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:59428&r=cba |
| By: | Mariarosaria Comunale; Jeroen Hessel |
| Abstract: | The current account imbalances that are at the heart of the European sovereign debt crisis are often attributed to differences in price competitiveness. However, recent research suggests that domestic demand booms related to the financial cycle may have been more important. As this would have very different policy implications, this paper aims to investigate the relative role of price competitiveness and domestic demand as drivers of the current account imbalances in the euro area. We estimate panel error-correction models for exports, imports and the trade balance. We specifically look at fluctuations in domestic demand at the frequency of the financial cycle. We conclude that although differences in price competitiveness have an influence, differences in domestic demand are more important than is often realized. Fluctuations at the frequency of the financial cycle are more suitable to explain the trade balance than fluctuations at the frequency of the normal business cycle. Our results call for more emphasis on credit growth and macro prudential policy, in addition to the current attention for competitiveness and structural reforms. |
| Keywords: | Current account deficits; Economic and Monetary Union; competitiveness; domestic boom; financial cycle |
| JEL: | E32 F32 F41 F44 |
| Date: | 2014–10 |
| URL: | http://d.repec.org/n?u=RePEc:dnb:dnbwpp:443&r=cba |
| By: | Aydan Dogan |
| Abstract: | This paper re-assesses the problem of general equilibrium models in matching the behaviour of real exchange rate. We do so by developing a two country general equilibrium model with non-traded goods, home bias, incomplete markets and partial degrees of pass through as well as nominal rigidities both in the goods and labour markets. We combine this comprehensive framework with a data consistent shock structure. Our key finding is that presenting an encompassing model structure improves the performance of the model in addressing the behaviour of the real exchange rate but this improvement is at the expense of failing to replicate some other characteristics of the data, such as high consumption volatility and negative cross-country consumption correlation. We argue that the ability of a general equilibrium model to account for the features of the data is closely related to the predominant driving source of the fluctuations. |
| Keywords: | Real Exchange Rates; Non-traded goods; Incomplete Asset Markets; Imperfect Exchange Rate Pass Through; Nominal Rigidities |
| JEL: | F31 F32 F41 |
| Date: | 2014–10 |
| URL: | http://d.repec.org/n?u=RePEc:ukc:ukcedp:1409&r=cba |
| By: | 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. |
| Keywords: | Producer Price Inflation; Customer Markets; Financial Frictions |
| JEL: | E31 E32 E44 |
| Date: | 2013–09 |
| URL: | http://d.repec.org/n?u=RePEc:brd:wpaper:78&r=cba |