Risk-Taking, Capital Allocation and Optimal Monetary Policy

58 Pages Posted: 14 Jan 2021

See all articles by Joel Michael David

Joel Michael David

Federal Reserve Bank of Chicago

David Zeke

University of Southern California - Department of Economics

Date Written: January 13, 2021

Abstract

We study the role of firm heterogeneity in affecting business cycle dynamics and optimal stabilization policy. Firms differ in their degree of cyclicality, and hence, exposure to aggregate risk, leading to firm-specific risk premia that influence resource allocations. The heterogeneous firm economy can be recast in a representative firm formulation, but where total factor productivity (TFP) is endogenous and depends on the resource allocation. The model uncovers a novel tradeoff between the long-run level and volatility of TFP. Inefficiencies distort this tradeoff and result in either excessive volatility or depressed output, implying a role for corrective policy. Embedding this mechanism into a workhorse New Keynesian model, we show that allocational considerations can strengthen the incentives for leaning against the wind, i.e., optimal policy is more strongly countercyclical than in an observationally equivalent economy that abstracts from heterogeneity. A quantitative exercise suggests that the losses from ignoring heterogeneity can be substantial, which stem largely from a less productive allocation of resources and so depressed TFP and output.

Keywords: monetary policy, heterogeneous firms, misallocation, productivity

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

Suggested Citation

David, Joel Michael and Zeke, David, Risk-Taking, Capital Allocation and Optimal Monetary Policy (January 13, 2021). FRB of Chicago Working Paper No. 2021-01, Available at SSRN: https://ssrn.com/abstract=3765692

Joel Michael David (Contact Author)

Federal Reserve Bank of Chicago

230 South LaSalle Street
Chicago, IL 60604
United States

David Zeke

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall, 300
Los Angeles, CA 90089
United States

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