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Working Paper, No. 2021-01, January 2021 Crossref
Risk-Taking, Capital Allocation and Monetary Policy

(Revised February 22, 2022)

We study the implications of firm heterogeneity for business cycle dynamics and monetary policy. Firms differ in their exposure to aggregate risk, which leads to dispersion in costs of capital that influence micro-level resource allocations. The heterogeneous firm economy can be recast as a representative firm New Keynesian model, but where total factor productivity (TFP) endogenously depends on the micro-allocation. The monetary policy regime determines the nature of aggregate risk and hence shapes the allocation and long-run level/dynamics of TFP. Welfare losses from policies ignoring heterogeneity can be substantial, which stem largely from a less productive allocation of resources.

Working papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.


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