Robert Hall’s seminal work on firms’ marginal cost and price strategies shook the foundations of market competition. Hall found firms fix prices above marginal costs when output increases. 

Firms seek to maximise profits, forecasting profit as a consequence of its pricing decision. Demand is assumed with constant elasticity such that a lower price shall increase revenues regardless of volume. 

This profit forecast mechanism helps understand what happened to consumer prices in the recession, plotted below (US in blue, EU in red)

The behaviour of price indexes between 2012 and 2015 (an expansion) is more puzzling and research concludes price stickiness may be the culprit.

A possible explanation is the high inventory-to-sales ratio observed after 2012.

After 2008, monetary expansion increased markups that in turn “increase the inventory-sales ratio to an even greater extent by reducing sales“, an effect amplified after 2012 by a slower pace of wage gains until 2014.

Furthermore, when wages picked up pace after 2014, firms were even more enticed to increase inventories to profit from lower relative marginal costs.

In essence,

If the marginal cost of acquiring and holding inventories is indeed lower in times of a monetary expansion (…) we should see this lower cost reflected not only in a slow response of prices to the monetary expansion, but also in an increase in firms’ inventory holdings.

Moreover, since the firm’s price reflects its shadow valuation of inventories, an increase in the stock of inventories is necessary for the firm to find it optimal keep its price low. (…) If the firm is unable to purchase more inventories, either because of quantity restrictions by suppliers, or because of other costs of adjusting the stock of inventories, the relatively lower factor prices do not translate into a lower shadow valuation of inventories, and the firm finds it optimal to change its price fully in response to the monetary shock.

As data shows, this is precisely what happened: 

Firms held prices lower because their relative marginal cost of inventories was also lower, as depressed interest rates erode the opportunity-cost and the cost of holding inventories.

Chairwoman Yellen announced a 2015 interest rate hike in May and confirmed this outlook in June while hiking in December, a clear drop in inventories as plotted in the chart 


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