Business Cycles and Monetary Policy with Productivity Heterogeneity

Abstract

This chapter describes a new channel of the exogenous technology shock amplification mechanism induced by firm entry and exit. A new Keynesian model with endogenous net business formation and heterogeneous productivity is developed for this purpose. Economic expansion leads to higher entry rates and thus increasing competition, producing two outcomes. First, the cut-off productivity level that a firm must reach to achieve positive profits rises, and thus, average productivity within an economy also increases. Second, higher competition and average productivity lower the cost of market entry, which may amplify the first effect. With respect to second-moment conditions, the model outperforms standard real business cycle as well as other models that include endogenous firm entry. Moreover, monetary policy can influence the aforementioned channels, as it affects firms’ production and market entry costs. This new transmission mechanism of monetary policy may also affect the optimal policies pursued by a central bank.

I am gratefully indebted to Reto Föllmi, Johannes Fritz, Federico Ravenna and Carlo Strub for their helpful comments. Remaining errors are of course my own responsibility.