schoenleProfessor Raphael Schoenle was awarded a collaborative research grant by the National Science Foundation (NSF). The grant supports his research project on “Inflation Dynamics During the Financial Crisis” with Simon Gilchrist (Boston University). The total amount awarded to the project is $315,000. The project will study the extent to which the massive tightening of financial conditions at the height of the crisis may help explain why inflation did not fall as much as expected given the large and sharp contraction of output during the financial crisis.

The underlying hypothesis of the project posits that some firms may strategically set low prices to attract customers, behavior implied by the “customer-markets theory,” which emphasizes the idea that price setting is a form of investment that builds the future customer base.  According to this theory, firms will in normal times maintain low prices relative to their competitors in order to attract new customers.  In turn, this implies low current mark-ups and hence lower cash flows.  However, in times of widespread financial distress, financially vulnerable firms will sacrifice their customer base by raising prices to stabilize current revenues. Thus in periods of acute financial distress, inflation may actually rise despite a drop in economic activity. This possibility that inflation and output move in opposite directions in response to an adverse demand shock has important implications for the appropriate conduct of monetary policy during financial crises.

 


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