The Effect of the Credit Crunch on Output Price Dynamics: The Corporate Inventory and Liquidity Management Channel

Abstract

I study how a credit crunch affects output price dynamics. I build a unique micro-level dataset that combines scanner-level prices and quantities with producer information, including the producer's banking relationships, inventory, and cash holdings. I exploit the Lehman Brothers' failure as a quasi-experiment and find that firms facing a negative credit supply shock decrease their output prices approximately 15% relative to their unaffected counterparts. I hypothesize that such firms reduce prices to liquidate inventory and to generate additional cash flow from the product market. I find strong empirical support for this hypothesis: (i) firms facing a negative bank shock temporarily decrease their prices and inventory and increase their market share and cash holdings relative to their counterparts, and (ii) this effect is stronger for firms and sectors with high initial inventory or small initial cash holdings. To discuss the aggregate implications of these findings, I integrate this micro-level study into a business cycle model by explicitly allowing for two identical groups of producers facing different degrees of credit supply shock. The model predicts that a negative credit supply shock leads to a large temporary drop in aggregate inflation - as a result of the aggressive liquidation of inventory - followed by an increase in inflation as producers eventually run out of inventory. This prediction for inflation and inventory dynamics is fully consistent with observations for the 2007-09 recession.