The Supply-Side Effects of Monetary Policy

Abstract

We propose a supply-side channel for the transmission of monetary policy. We show that in an economy with heterogeneous firms and endogenous markups, monetary shocks have first-order effects on aggregate productivity. If high-markup firms have lower pass-throughs than lowmarkup firms, as is consistent with the empirical evidence, then a monetary easing generates an endogenous positive "supply shock" that amplifies the positive "demand shock" on output. The result is a flattening of the Phillips curve. This effect is distinct from another mechanism discussed at length in the real rigidities literature: a monetary easing leads to a reduction in desired markups because of strategic complementarities in pricing. We derive a tractable fourequation dynamic model, disciplined by four sufficient statistics from the distribution of firms, and use it to show that a monetary easing generates a procyclical hump-shaped response in aggregate TFP and countercyclical dispersion in firm-level TFPR. In the data, in line with the model's predictions, we observe both procyclical aggregate productivity and reallocations to high-markup firms during expansions. A calibration using firm-level pass-throughs suggests that the supply-side channel is quantitatively as important as real rigidities, and amplifies both the impact and persistence of monetary shocks. Moreover, this channel becomes stronger, and the Phillips curve becomes flatter, with increases in industrial concentration.

Distribution of Market Power, Endogenous Growth, and Monetary Policy

“…To our knowledge, this mechanism is distinct from other complementary analyses of misallocation effects of monetary policy. Baqaee, Farhi and Sangani (2024) and Meier and Reinelt (2022) study allocative efficiency effects of monetary policy and are closely related to the theme of our paper. A key to the misallocation channel highlighted in these papers is the negative covariance between the level of markups and the pass-through of marginal costs into prices.…”

“…In Meier and Reinelt (2022), this negative covariance endogenously arises from heterogeneous price rigidity across firms in an environment with aggregate risk. Baqaee et al (2024) consider general settings when the negative covariance could arise from variable elasticity of demand faced by the firms or heterogeneous price rigidities. Relatedly, Baqaee and Farhi (2019) provide a general treatment of misallocation in general equilibrium models (see also Basu and Fernald, 2002).…”

“…Atkeson and Burstein (2008) and De Blas and Russ (2015) study models with heterogeneous firms and a distribution of markups that arises endogenously due to the strategic behavior of firms. As noted in Baqaee et al (2024), the covariance between the pass-through of marginal costs into prices and the level of markups is key in these models to generate time-varying misallocation.…”