If you have taken Econ 82b, you know that standard macroeconomic theory suggests that when the economy is producing less its potential, firms have an incentive to cut prices and increase the quantity demanded for their products. This combination of falling prices and rising output tends to move the economy, as a whole, back to potential output.

However in a new paper Inflation Dynamics During the Financial Crisis, Professor Raphael Schoenle, along with co-authors Simon Gilchrist, Jae Sim and Egon Zakrajsek, find that during the Great Recession of 2008, firms that were in financial distress (i.e., firms that had borrowed heavily to finance their current inventory of goods on hand) were unable to cut prices since they needed to maintain their cash flow in order to pay their creditors. Raphael and co-authors argue that this inability of some firms to lower prices threw sand into the gears that would have naturally allowed the economy to recover from a recession. Further, this failure to cut prices could explain why inflation fell so little during the crisis and has stayed so low during the recovery.

Given the sluggishness of the current recovery, Raphael’s paper has received considerable attention. Most recently it was discussed in the German newspaper Handelsblatt (it’s the German equivalent of Wall Street Journal). To read the article in English click here.


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