PRICING STRATEGIES AND CREDIT DYNAMICS: UNDERSTANDING THE INTERCONNECTED WORLD OF INTEREST RATES, PRODUCT PRICES, AND TRADE CREDIT TERMS
Abstract
The growing interest in the effectiveness of monetary policy has prompted an exploration of the role of trade credit in shaping the credit channel of policy transmission. Despite increased attention, a comprehensive theoretical model elucidating the observed empirical phenomenon—wherein trade credit mitigates the impact of central bank actions—has been lacking. This paper addresses this gap by introducing a partial equilibrium model integrating third-degree price discrimination with menu costs. The key finding suggests that the incremental increase in net present value (NPV) resulting from the optimization of credit terms and product prices is insufficient to offset even negligible menu costs associated with short-term interest rate adjustments during low-inflation periods. As a consequence, credit terms and product prices exhibit remarkable stability over time. This outcome aligns coherently with the empirical evidence presented by Ng, Smith, and Smith (1999) and Mateut (2005), offering a theoretical foundation for the Meltzer (1960) hypothesis on the credit channel transmission of monetary policy. Specifically, our model implies that trade credit experiences less volatility than bank credit, rationalizing certain empirical phenomena related to the credit channel. In essence, firms strategically set trade credit terms to maximize NPV, taking into account the influence of menu costs. Additionally, we discuss the implications of our findings on broader economic phenomena, drawing parallels to exchange rate passthroughs and reflecting on the effectiveness of monetary easing in the context of a pandemic. By shedding light on the intricate interplay between trade credit, monetary policy, and menu costs, this research contributes to a deeper understanding of the mechanisms at play in the credit channel, thereby enriching the discourse on policy effectiveness in contemporary economic landscapes.
Keywords:
Trade Credit, Monetary Policy, Credit Channel, Net Present Value, Menu CostsDownloads
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Copyright (c) 2024 Prof. Mohammad A. Rashid, Dr. Sarah E. Watson
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