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Risk-Taking, Capital Allocation and Optimal Monetary Policy

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Abstract

We study the role of firm heterogeneity in affecting business cycle dynamics and optimal stabilization policy. Firms differ in their degree of cyclicality, and hence, exposure to aggregate risk, leading to firm-specific risk premia that influence resource allocations. The heterogeneous firm economy can be recast in a representative firm formulation, but where total factor productivity (TFP) is endogenous and depends on the resource allocation. The model uncovers a novel tradeoff between the long-run level and volatility of TFP. Inefficiencies distort this tradeoff and result in either excessive volatility or depressed output, implying a role for corrective policy. Embedding this mechanism into a workhorse New Keynesian model, we show that allocational considerations can strengthen the incentives for leaning against the wind, i.e., optimal policy is more strongly countercyclical than in an observationally equivalent economy that abstracts from heterogeneity. A quantitative exercise suggests that the losses from ignoring heterogeneity can be substantial, which stem largely from a less productive allocation of resources and so depressed TFP and output.

Suggested Citation

  • Joel M. David & David Zeke, 2021. "Risk-Taking, Capital Allocation and Optimal Monetary Policy," Working Paper Series WP-2021-01, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:92157
    DOI: 10.21033/wp-2021-01
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    Cited by:

    1. Baqaee, David Rezza & Farhi, Emmanuel & Sangani, Kunal, 2021. "The Supply-Side Effects of Monetary Policy," CEPR Discussion Papers 15702, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    monetary policy; heterogeneous firms; misallocation; productivity;
    All these keywords.

    JEL classification:

    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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