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What accounts for the resilience for inflation in the face of substantial and long-lasting economic slack? This question has been thrust to the forefront of academic research and policy debate by the surprising behavior of inflation—in the United States in other advanced foreign economies—during the Global Financial Crisis and its aftermath. Using a novel dataset, which merges good-level prices underlying the U.S. producer price index (PPI) with the respondents' balance sheets, we show that liquidity constrained firms increased prices in 2008, while their unconstrained counterparts cut prices. More generally, we document that the response of industry-specific U.S. PPI inflation to changes in aggregate financial conditions depends importantly on differences in the ease of access to external finance across industries: In industries in which firms face a high likelihood of financial constraints, inflation is insensitive to changes in financial conditions; in industries where firms have a relatively unfettered access to external finance, by contrast, inflation declines significantly in response to a tightening of financial conditions. To rationalize these empirical findings, we develop a dynamic stochastic general equilibrium 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' decisions 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. By extending the model to an open-economy setting, we also analyze the economic consequences of forming a monetary union among countries with varying degrees of financial distortions, which interact with firms' pricing decisions because of customer-market considerations. In response to a financial shock, firms in financially weak countries (the periphery) maintain cashflows by raising markups, while firms in financially strong countries (the core) reduce markups, undercutting their financially constrained competitors to gain market share. When the two regions are experiencing different shocks, common monetary policy results in a substantially higher macroeconomic volatility in the periphery, compared with a floating exchange rate regime; this translates into a welfare loss for the union as a whole, with the loss borne entirely by the periphery.
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