The Working Capital Channel

Firms relying on working capital raise prices following monetary tightening, and this paper demonstrates that the working capital channel plays a key role in partial and general equilibrium inflation dynamics. The working capital channel arises from firms’ need to pre-fund inputs, determined by their exposure (working capital shares) and price elasticity (working capital sensitivity) to interest rate changes. Using detailed firm-product-level price data, the analysis shows that the average firm holds working capital equal to 16% of sales. For a firm with this average share, a one percentage point policy rate hike leads to a 0.48–2.56% price increase over a 3–33 month horizon.