Inflation Dynamics During the Financial Crisis

Firms with limited internal liquidity significantly increased prices in 2008, while their liquidityunconstrained counterparts slashed prices. Differences in the firms' price-setting behaviorwere concentrated in sectors likely characterized by customer markets. We develop a model, inwhich firms face financial frictions, while setting prices in a customer-markets setting. Financialdistortions create an incentive for firms to raise prices in response to adverse demand or financialshocks. These results reflect the firms' reaction to preserve internal liquidity and avoid accessingexternal finance, factors that strengthen the countercyclical behavior of markups and attenuatethe response of inflation to fluctuations in output.