Firm Heterogeneity, Capital Misallocation and Optimal Monetary Policy

This paper analyzes the link between monetary policy and capital misallocation in a New Keynesian model with heterogeneous firms and financial frictions. In the model, firms with a high return to capital increase their investment more strongly in response to a monetary policy expansion, thus reducing misallocation. This feature creates a new time-inconsistent incentive for the central bank to engineer an unexpected monetary expansion to temporarily reduce misallocation. However, price stability is the optimal timeless response to demand, financial or TFP shocks. Finally, we present firm-level evidence supporting the theoretical mechanism.

Keywords: capital misallocation, financial frictions, firm heterogeneity, monetary policy

JEL Classification: E12, E22, E43, E52, L11

Suggested Citation: Suggested Citation

González, Beatriz and Nuño, Galo and Thaler, Dominik and Albrizio, Silvia, Firm Heterogeneity, Capital Misallocation and Optimal Monetary Policy (January, 2024). ECB Working Paper No. 2024/2890, Available at SSRN: https://ssrn.com/abstract=4697558 or http://dx.doi.org/10.2139/ssrn.4697558