Book Description

We propose a supply-side channel for the transmission of monetary policy. We study an economy with heterogeneous firms, sticky prices, and endogenous markups. We show that if, as is consistent with the empirical evidence, bigger firms have higher markups and lower pass-throughs than smaller firms, then a monetary easing endogenously increases aggregate TFP and improves allocative efficiency. This endogenous positive "supply shock" amplifies the effects of the positive "demand shock" on output and employment. The result is a flattening of the Phillips curve. This effect is distinct from another mechanism discussed at length in the real rigidities literature: a monetary easing leads to a reduction in desired markups because of strategic complementarities in pricing. We calibrate the model to match firm-level pass-throughs and find that the misallocation channel of monetary policy is quantitatively important, flattening the Phillips curve by about 70% compared to a model with no supply-side effects. We derive a tractable four-equation dynamic model and show that monetary easing generates a procyclical hump-shaped response in aggregate TFP and countercyclical dispersion in firm-level TFPR. The improvements in allocative efficiency amplify both the impact and persistence of interest rate shocks on output.