The effects of firm entry and exit on macroeconomic fluctuations and monetary policy

Abstract

This paper studies how endogenous firm entry affects the responses of the economy to the monetary policy, cost-push and demand shocks. Opposite to the earlier literature we assume also that firm default rate is not constant but subject to exogenous shocks. We show that increased bankruptcies have long-standing negative effect on output and positive effect on inflation. This raises the question how monetary policy should react to the variability in business defaults. Based on our simulations we propose two alternative monetary policy rules, which give lower variance than the traditional Taylor rule which reacts to inflation and consumption.