Towards a Micro-Founded Theory of Monetary Policy

• Applicant: Professor Lutz Weinke, Ph.D.
• Subject Area: Economic Theory
• Term: from 2018 to 2022
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 402884221

The lumpy nature of plant-level investment is generally not taken into account in the context of New Keynesian monetary theory (see, e.g., Christiano et al. 2005 and Woodford 2005). Our main result in Reiter et al. (2013) shows that if this theory is augmented by a standard model of lumpy investment, monetary policy shocks lead to large but very short-lived impacts on output and inflation, in a way that goes against empirical evidence and the consensus view in the literature. The microfoundations of standard monetary theory are therefore questionable. In fact, the perceived usefulness of that theory rests entirely on one of two assumptions. Capital accumulation is either abstracted from (see, e.g., Galí 2015, among many others) or taken into account in a way that is inconsistent with the microevidence on plant-level investment (see, e.g., Woodford 2003, 2005 or Christiano et al. 2005, among many others). The proposed project therefore aims at developing a theory of the monetary transmission mechanism that is consistent with the micro-level investment data. This is a ground-breaking step towards a micro-founded theory of monetary policy. Given the large extent to which current monetary theory is used at central banks and other policy institutions the proposed research clearly addresses important challenges. Specifically, the research projects will analyze the role of idiosyncratic productivity shocks in that context. We will also consider additional frictions originating in labor markets as well as in financial markets. Those frictions have the potential to imply a realistic monetary transmission mechanism in the presence of lumpy investment. The ultimate goal will be to use the resulting framework for an analysis of the desirability of alternative arrangements for the conduct of monetary policy. The key methodological challenge is the computation of large general equilibrium models with heterogeneous firms, which we solve by the methods developed in Reiter (2009, 2010a,b and 2017).

• DFG Programme: Research Grants
• International Connection: Austria
• Partner Organisation: Fonds zur Förderung der wissenschaftlichen Forschung (FWF)
• Co-Investigator: Dr. Michael Reiter