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Firm entry, inflation and the monetary transmission mechanism

  • Vivien Lewis

    ()

    (Postdoctoral Fellow of the Fund for Scientific Research - Flanders (FWO)
    Institute for Monetary and Financial Stability (Department of Money and Macroeconomics), Goethe University Frankfurt
    House of Finance, Frankfurt am Main, Germany)

  • Céline Poilly

    ()

    (Université catholique de Louvain, Department of Economics)

This paper estimates a business cycle model with endogenous firm entry by matching impulse responses to a monetary policy shock in US data. Our VAR includes net business formation, profits and markups. We evaluate two channels through which entry may influence the monetary transmission process. Through the competition effect, the arrival of new entrants makes the demand for existing goods more elastic, and thus lowers desired markups and prices. Through the variety effect, increased firm and product entry raises consumption utility and thereby lowers the cost of living. This implies higher markups and, through the New Keynesian Phillips Curve, lower inflation. While the proposed model does a good job at matching the observed dynamics, it generates insufficient volatility of markups and profits. Estimates of standard parameters are largely unaffected by the introduction of firm entry. Our results lend support to the variety effect; however, we find no evidence for the competition effect.

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Paper provided by National Bank of Belgium in its series Working Paper Research with number 211.

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Length: 46 pages
Date of creation: Feb 2011
Handle: RePEc:nbb:reswpp:201102-211
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