Firm Dynamics, Inflation, and the Transmission of Monetary Policy

Abstract: I study how fluctuations in business formation and destruction affect inflation and the transmission of monetary policy. To do this analysis, I extend a New Keynesian model to include endogenous business formation and destruction and heterogeneous producers. A decline in the number of producers puts upward pressure on inflation, and I find that this mechanism can explain about half of the missing deflation following the Great Recession. I then study the transmission of monetary policy in this framework. I show that endogenous fluctuations in entry generate an intertemporal trade-off in monetary policy; a contractionary shock leads employment and inflation to decline on impact, but inflation later overshoots, as the shock also causes a decline in entry and an increase in exit.