Inventories matter for the transmission of monetary policy: uncovering the cost-of-carry channel
By setting interest rates, monetary policy affects the cost of carrying inventories. We build
a model to capture the resulting cost-of-carry channel of monetary policy, finding it to yield
interesting non-linearities. We begin with a static model showing that higher inventory costs
drive firms, especially those with larger inventories, to reduce prices. Extending this to a
dynamic model where firms face distinct demand shocks, we first show in a tractable model
with only high and low demand shocks that firms with inventories reduce prices as carrying costs
rise, while others may increase them. In aggregate, higher inventory levels make prices more
responsive to tighter monetary policy. Finally, a quantitative model with firm heterogeneity
and idiosyncratic demand shocks reveals that prices should be more sensitive to the stance of
monetary policy when inventory levels are higher (effectively leaving sellers with less market
power). By drawing on data from the U.S. goods market, as well as from the housing and
oil markets, we are able to test this hypothesis, finding strong support for the cost-of-carry
channel. Central banks may therefore wish to pay close attention to inventory levels, as they
could matter for the strength of monetary policy transmission to inflation.
Terms of trade shocks, import dependency and debt distress
We study the relationship between terms-of-trade shocks and sovereign debt defaults
in import-dependent developing economies. While existing literature highlights a negative relationship
between terms-of-trade shocks and defaults for commodity exporters, we find the opposite for
commodity importers, where rising import prices can worsen debt distress and increase default
risks. We incorporate trade into a sovereign default model to explore this interaction, finding that
countries with a high import share are at risk of default when facing rising import prices and
deteriorating terms of trade. Additionally, heavily indebted nations risk default even with modest
price increases. Our empirical analysis focuses on food as a key terms-of-trade shock, given its limited
substitutability with domestic production. Using unexpected harvest shocks as an instrument to
isolate food price fluctuations, we focus on Ghana, which defaulted on its external debt in 2022.
We find that unexpected food price increases drive up import costs, inflation, trade imbalances, and
debt. These results underscore the importance of consumption composition in assessing trade shock
impacts.
