Working Paper: CEPR ID: DP12068
Authors: Florin Ovidiu Bilbiie
Abstract: Monetary policy is neutral even with fixed prices, if there is free entry and variety is determined optimally as in Dixit and Stiglitz (1977). When individual prices are sticky, entry substitutes for price flexibility in the welfare-based price index. In response to aggregate demand expansions, the intensive (quantity produced of each good) and extensive (number of goods being produced) margins move in offsetting ways, leaving aggregate production unchanged. Deviations from neutrality thus occur only when variety is not optimally determined (preferences are not Dixit-Stiglitz) or when entry is subject to frictions.
Keywords: Monetary Policy; Neutrality; Sticky Prices; Entry; Product Variety; Monopolistic Competition; Dixit-Stiglitz; Sunk Costs
JEL Codes: D42; E52; E58; L16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy neutrality (E49) | Aggregate production remains unchanged (E23) |
| Increase in aggregate demand (E00) | Firms increase labor demand (J23) |
| Firms increase labor demand (J23) | Marginal costs rise (D40) |
| Marginal costs rise (D40) | Aggregate production remains unchanged (E23) |
| Entry of new firms (L26) | Aggregate production remains unchanged (E23) |
| Deviations from Dixit-Stiglitz model (D43) | Neutrality of monetary policy may fail (E49) |
| Entry frictions (F12) | Neutrality of monetary policy may fail (E49) |