A widely held conventional view is that monetary policy should focus only on aggregate economic conditions because it cannot control or target the conditions of particular geographic regions. This paper examines the largely overlooked flip side of this conventional view. Regional economic conditions can (and do) significantly influence aggregate responses to monetary policy actions, for two simple and intuitive reasons.
First, economic sensitivity to monetary policy varies across regions, as shown recently by Carlino and DeFina , . Second, economic conditions prevailing at the time of monetary policy actions vary across regions, as we show later. For both reasons, aggregate dynamic responses to monetary policy actions are nonlinear so the magnitude and duration of the responses vary over time.
In other words, although monetary policy cannot target regional economic performance, regional heterogeneity may matter for the efficacy of monetary policy. For example, the extent to which the economy slows in response to a monetary tightening will depend on issues such as which regions are growing fastest, and whether the most rapidly expanding regions are the most interest sensitive.
More generally, the aggregate effects of monetary policy depend on the distribution of regional sensitivities to monetary policy and on the initial distribution of regional economic conditions at the time of monetary tightening. Both distributions vary over time, so small changes in the configuration of heterogeneity can produce economically significant changes in aggregate responses.