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The Extensive Margin and Monetary Policy

Business cycles are characterized by sizeable investment dynamics of firm entry and exit. Just as real and monetary shocks may lead firms to adjust the scale of production, they also create opportunities to introduce new goods in the market, as lower costs or higher demand raise the profitability of new product lines. The first type of adjustment is commonly referred to as the intensive margin, whereas the second type of adjustment is referred to as an extensive margin.

A small but dynamic strand of literature has studied how the extensive margin of firm entry and product variety can contribute to our understanding of the business cycle in closed and open economies, e.g. Kim (2004), Ghironi and Melitz (2005), Bilbiie et al. (2005), Jaimovich (2006, 2007). These aim to provide a more complete model of imperfectly competitive markets in manufacturing where entry drives profits to zero. The question this paper investigates is their monetary policy dimension.

There is a clear need for studies on this subject, given that the tendency for firms to fail is among the most recognizable features of recession, and that new startup firms are likely to be among the most sensitive to interest rate changes by policy makers. This paper argues that the extensive margin is a dimension of monetary policy that has been under-appreciated. Firstly, studying the dynamics of firm entry and exit may be a good place for economists to look for mechanisms of monetary policy transmission.

It has been estimated that 25% of annual gross job destruction can be attributed to establishment deaths and 20% of annual gross job creation to new establishment births, as estimated by Davis and Haltiwanger (1990) on the basis of U.S. manufacturing data 1972-1986. Secondly, the extensive margin has welfare implications working through variety effects that are entirely distinct from the intensive margin. As a result, studying the extensive margin dimension of monetary policy may augment the welfare implications that motivate monetary policy.

The Extensive Margin and Monetary Policy