On the Role of Product Quality in Product Reallocation and Macroeconomic Dynamics

Recent empirical investigations by Argente et al. (2018) reveal that product reallocation, i.e. creation and destruction of products, happens through two leading margins: entry and exit of production modules within firms, the so-called "extensions", and changes in the characteristics of products within incumbent production modules, the so-called "improvements". This paper develops a DSGE model in which product reallocation involves these two margins and examines the impact on macroeconomic dynamics. I show that relative to the standard model that only accounts for extensions, the model augmented with product improvements does a better job at explaining the dynamics of production modules within firms and the firm-level TFP. A recession facilitates the production of low-quality/low-cost products, which allows the survival of low-productivity modules that would not survive in a fixed quality environment. As the recessionary shock dissipates, the share of high-quality products increases, eliminating low-productivity and low-quality modules and increasing the firm-level TFP. My results illustrate the importance of recognizing the dynamics of product characteristics within firms’ production lines in addition to the dynamics of production lines per se to understand business cycles.