Financial Market Imperfections and the pricing decision of firms: Evidence, Theory, and Macroeconomic Implications

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This project investigates why and how financial market imperfections affect the behavior of firms, in particular with respect to setting prices and adjusting labor input. Existing research on this topic is relatively scarce both in terms of empirical and theoretical contributions. We explore rich plant-level data for Germany from the monthly ifo Business Survey for 2002-2014. The data allows us to document new stylized facts on the relationship between heterogenous financial frictions and the frequency and direction of price adjustments of firms both inside and outside recessions. The empirical investigation is complemented and guided by a partial-equilibrium menu cost model which provides an explicit rationale for the interactions between financial constraints and the frequency and direction of setting prices as well as adjusting labor input. The richness of the empirical results, the combination of menu-cost models and financial frictions as well as the close link between model and data are to our knowledge novel to the existing literature.Our insights from the empirical investigation and partial-equilibrium model are used to develop a general equilibrium framework with an explicit interaction between financial frictions and price setting. We use this model to answer whether and by how much the dispersion in the pricing decisions translates into heterogeneities in the responses of output and employment to idiosyncratic and aggregate economic shocks. Further, we seek to understand how macroeconomic volatility and welfare are affected by the interaction between financial constraints and price adjustment. Finally, we investigate how micro-level characteristics influence the transmission of monetary policy and, consequently, how optimal policy should be conducted taking this interaction in account.