SHORT-TERM INTEREST RATES, INFLATION DYNAMICS, AND PRICE-COST MARGINS: AN EMPIRICAL ANALYSIS

This dissertation investigates the possibility that monetary policy shocks have supply-side or “cost-channel” effects as well as demand-side effects. This dissertation specifically attempts to shed more light on the transmission mechanism of monetary policy to inflation dynamics and price-cost margins (PCMs). During a time of rising short-term interest rates, there is often discussion of rising inventory costs and deterioration of firms’ balance sheets, along with the possibility of firms passing these higher costs along to consumers in the form of higher markups. This study consists of two main empirical chapters, which analyze the effects of interest rates on inflation dynamics and PCMs. Chapter 5 conducts a macro-level analysis based on some of the theoretical models in Setterfield and Lima (2010), who suggest different ways of incorporating interest rates into a short-run Phillips curve (SRPC). Different sets of assumptions can give rise to qualitatively different specifications. A two-stage generalized method (GMM) of moments model is employed focusing on data from 1960:Q1 to 2014:Q4 for the United States. The results for the SRPC suggest that cost channel does exist and the estimated effect is stronger when the prime loan rate is used for the interest rate. The SRPC equation is also estimated simultaneously with a Taylor rule equation and with various other sensitivity tests, and the estimated cost-channel effects generally remain significant. The cost-channel effect is larger in periods associated with a tighter credit constraint. The existence of cost-channel effects suggest that interest rate changes intended to stabilize the output gap may also lead to unintended fluctuations in inflation. The industry-level analysis in chapter 6 tests whether a change in overhead costs, due to a rise in interest rates, may increase PCMs. This chapter uses 4-digit industry-level data for the US. PCMs are first calculated based on an accounting measure, which implicitly assumes that average variable costs are equal to marginal costs. As a robustness check, a model based on Domowitz et al. (1988) is estimated in order to measure margins in terms of marginal costs rather than average costs. The results suggest that both accounting and estimated margins are positively affected by changes in short-term interest rates. Industries that produce durable goods, investment-intensive industries, and industries with higher working capital are more affected by changes in interest rates. Moreover, the results suggest that when the corporate cost of borrowing is higher, the coefficients for interest rates are larger.