Corporate Legacy Debt, Inflation and the Efficacy of Monetary Policy

Working Paper: CEPR ID: DP16799

Authors: Charles A. E. Goodhart; M. Udara Peiris; Dimitrios P. Tsomocos; Xuan Wang

Abstract: 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 onaggregate 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.

Keywords: corporate indebtedness; debt inflation; working capital; monetary transmission mechanism; income effect; Taylor principle

JEL Codes: E31; E44; E52; G33

Causal Claims

Cause	Effect
High levels of corporate debt (G33)	impede the transmission mechanism of monetary policy (E52)
High levels of corporate debt (G33)	less effective monetary policy in controlling inflation (E64)
Raising interest rates (E43)	smaller decrease in inflation when corporate debt exceeds a certain threshold (E31)
High corporate debt (G32)	income effect of higher nominal interest rates offsets negative substitution effect on aggregate demand (E43)
Raising interest rates (E43)	demand for more labor to spread fixed costs in high debt scenarios (J23)
High corporate debt (G32)	upward pressure on aggregate demand (E00)
High corporate debt (G32)	diminished effectiveness of monetary contractions in lowering inflation (E31)
Raising interest rates (E43)	increase inflation under high debt scenarios (E31)