DP16799 Corporate Legacy Debt, Inflation, and the Efficacy of Monetary Policy

Author(s): Charles A E Goodhart, M. Udara Peiris, Dimitrios P. Tsomocos, Xuan (Alex) Wang
Publication Date: December 2021
Date Revised: March 2022
Keyword(s): Corporate indebtedness, debt inflation, income effect, Monetary transmission Mechanism, Taylor principle, Working capital
JEL(s): E31, E44, E52, G33
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16799

The COVID-19 pandemic has coincided with a rapid increase in indebtedness. Although the rise in public debt and its policy implications have recently received much attention, the rise in corporate debt has received less so. We argue that high levels of corporate debt may impede the transmission mechanism of monetary policy and make it less effective in controlling inflation. In an environment with working capital financing requirements, when firms' indebtedness is sufficiently high, the income effect of higher nominal interest rates offsets or even dominates its usual negative substitution effect on aggregate demand and is quantitatively important. This mechanism is independent of standard financial and nominal frictions and aggravates the trade-off between inflation and output stabilisation.