The Supply-Side Effects of Monetary Policy

We propose a supply-side channel for the transmission of monetary policy. We show that in an economy with heterogeneous firms and endogenous markups, demand shocks such as monetary shocks have a first-order effect on aggregate productivity. If high-markup firms have lower pass-throughs than low-markup firms, as is consistent with empirical evidence, then a monetary easing reallocates resources to high-markup firms and alleviates misallocation. Consequently, positive “demand shocks” are accompanied by endogenous positive “supply shocks” that raise output and productivity, lower inflation, and flatten the Phillips curve. We derive a tractable four-equation dynamic model and use it to show that monetary shocks generate a procyclical hump-shaped response in TFP and endogenous cost-push shocks in the New Keynesian Phillips curve. A calibration of our model suggests that the supply-side effect increases the half-life of a monetary shock’s effect on output by about 30% and amplifies the total impact on output by about 70%. Using identified monetary shocks, we provide empirical evidence for both the macro- and micro-level predictions of our model.