The role of firm entry and firm heterogeneity for monetary and fiscal policy
Final Report Abstract
Our analysis shows that firm entry and firm heterogeneity matter for sectoral reallocation and business cycle fluctuations. In response to shocks to aggregate productivity, import-competing sectors contract by more than exporting sectors. Reallocation of firms across sectors through endogenous firm entry is an important adjustment mechanism contributing to the shifts in sectoral output. We have shown that firm entry and firm heterogeneity imply larger fluctuations in GDP and inequality, and a lower correlation of GDP across countries relative to a model without firm entry. The research in the DFG project also shows that accounting for firm entry, i.e., the extensive margin of adjustment, may lead policymakers to reconsider their policy targets. Ultimately, this happens because firm entry naturally leads to firm-level heterogeneity, and in a world with firm-level heterogeneity the dynamics in aggregate variables can differ substantially from the dynamics in disaggregated, or firm-level, variables. This difference is assumed away in models with a representative firm. However, this difference matters if what the factors that determine policy targets refer to firm-level variables rather than aggregate variables. This general idea is applied to a specific policy question, namely what is the role of firm entry for the central bank’s optimal inflation target. Indeed, the DFG research shows that what determines the inflation target are firm-level marginal costs, and not aggregate marginal costs. The optimal inflation target in a model with firm entry then differs from the optimal target in a model without firm entry, because the dynamics of firm-level marginal costs have a pronounced life-cycle component (in contrast to aggregate marginal costs). Finally, the DFG research has shown that firm dynamics have important spillover effects into worker flows and aggregate employment dynamics. In a model with search and matching unemployment and on-the-job search, heterogeneous development in firm-level productivity leads at the same time to some contracting and some expanding firms. This in turn leads to pro-cyclical quits and allows aggregate hires, quits, layoffs and vacancies to display a combination of “spiky” behavior during recessions and persistence during recoveries, as seen in the data.
