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Optimal monetary policy and firm entry

  • Vivien Lewis


    (National Bank of Belgium, Research Department
    Ghent University, Department of Financial Economics)

This paper describes optimal monetary policy in an economy with monopolistic competition, endogenous firm entry, a cash-in-advance constraint and pre-set wages. Firms must make profits in order to cover entry costs; thus a mark-up on goods prices is necessary. Without this mark-up, profits would be zero and no firm would enter the market, resulting in zero production. Therefore, the mark-up should not be removed. In this economy with market entrants, goods are more expensive than in a competitive economy with marginal cost pricing. This leads to a misallocation of resources, because leisure is not sold at a mark-up. Goods and leisure are two sources of utility that households trade off against each other. Thus, they may buy too much leisure instead of consumption goods. The consequence is that labour supply and production are sub-optimally low. Due to the labour requirement at market entry stage, insufficient labour supply also implies too little entry and too few firms in equilibrium. In the absence of fiscal instruments such as labour income subsidies, the optimal monetary policy under sticky wages achieves higher welfare than under flexible wages. The policy-maker uses the money supply instrument to raise the real wage - the cost of leisure - above its flexible-wage level, in response to expansionary shocks. This induces a rise in labour supply, more production of goods and more new firms

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Paper provided by National Bank of Belgium in its series Working Paper Research with number 178.

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Length: 32 pages
Date of creation: Oct 2009
Date of revision:
Handle: RePEc:nbb:reswpp:200910-23
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  1. Lewis, Vivien & Poilly, Céline, 2012. "Firm entry, markups and the monetary transmission mechanism," Journal of Monetary Economics, Elsevier, vol. 59(7), pages 670-685.
  2. Florin Bilbiie & F. Ghironi & M. Melitz, 2007. "Monetary Policy and Business Cycles With Endogenous Entry and Product Variety," Working Papers hal-00515664, HAL.
  3. V. Lewis, 2010. "Product Diversity, Strategic Interactions and Optimal Taxation," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 10/661, Ghent University, Faculty of Economics and Business Administration.
  4. Bernardino Adao, 2000. "Gaps and Triangles," Econometric Society World Congress 2000 Contributed Papers 1904, Econometric Society.
  5. Bergin, Paul R. & Corsetti, Giancarlo, 2008. "The extensive margin and monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(7), pages 1222-1237, October.
  6. Bilbiie, Florin Ovidiu & Fujiwara, Ippei & Ghironi, Fabio, 2011. "Optimal Monetary Policy with Endogenous Entry and Product Variety," CEPR Discussion Papers 8565, C.E.P.R. Discussion Papers.
  7. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
  8. Aleksander Berentsen & Christopher J. Waller, 2009. "Optimal stabilization policy with endogenous firm entry," Working Papers 2009-032, Federal Reserve Bank of St. Louis.
  9. Kim, Jinill, 2004. "What determines aggregate returns to scale?," Journal of Economic Dynamics and Control, Elsevier, vol. 28(8), pages 1577-1594, June.
  10. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  11. Christian Broda & David E. Weinstein, 2007. "Product Creation and Destruction: Evidence and Price Implications," NBER Working Papers 13041, National Bureau of Economic Research, Inc.
  12. Lewis, Vivien, 2009. "Business Cycle Evidence On Firm Entry," Macroeconomic Dynamics, Cambridge University Press, vol. 13(05), pages 605-624, November.
  13. Isabel Correia & Juan Pablo Nicolini & Pedro Teles, 2008. "Optimal Fiscal and Monetary Policy: Equivalence Results," Journal of Political Economy, University of Chicago Press, vol. 116(1), pages 141-170, 02.
  14. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  15. Ireland, Peter N, 1996. "The Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 104(4), pages 704-23, August.
  16. Bernardino Adão & Isabel Correia & Pedro Teles, 2003. "Gaps and Triangles," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 699-713.
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