Risk-Taking, Capital Allocation and Monetary Policy

Abstract

We study the implications of firm heterogeneity for business cycle dynamics and monetary policy. Firms differ in their exposure to aggregate risk, which leads to dispersion in costs of capital that influence micro-level resource allocations. The heterogeneous firm economy can be recast as a representative firm New Keynesian model, but where total factor productivity (TFP) endogenously depends on the micro-allocation. The monetary policy regime determines the nature of aggregate risk and hence shapes the allocation and long-run level/dynamics of TFP. Welfare losses from policies ignoring heterogeneity can be substantial, which stem largely from a less productive allocation of resources.

Keywords: monetary policy, heterogeneous firms, misallocation, productivity

JEL Classification: D24, E23, E32, E44, E52, E62