Academic journal article Economic Inquiry

Production Inflexibilities and the Cost Channel of Monetary Policy

Academic journal article Economic Inquiry

Production Inflexibilities and the Cost Channel of Monetary Policy

Article excerpt

This article shows how the existence of production inflexibilities in the form of capacity utilization constraints conditions the magnitude of the response of macroeconomic variables to a money supply stimulus. Capacity is modeled under explicit microfoundations, where the existence of idiosyncratic demand uncertainty generates variable utilization rates across firms. In this context, money has real effects due to non-Fisherian effects stemming from limitations in households' access to the financial market. Firms' capacity constraints generate a convex aggregate supply curve, which is a feature of the economy that has important implications for the conduct of monetary policy. (JEL E52, E42, E31, E13)

I. INTRODUCTION

Conventional wisdom is monetary analysis is that monetary policy generates persistent movements is short-term interest rates. The transmission of monetary policy through interest rate mechanisms has been a standard feature in macroeconomics literature, where the alleged inverse relationship is often referred to as the liquidity effect. The magnitude and persistence of such an effect is clearly an important issue, because it captures a key nonneutral outcome of monetary policy. This article shows that the existence of production inflexibilities in the form of capacity utilization constraints conditions the magnitude of the liquidity effect and, consequently, the short-run response of the economy to a money supply stimulus. These particularities are analyzed in a context where monetary policy operates through a cost-supply channel.

The literature offers several theoretical foundations for monetary policy acting as a cost shock. One line of research has considered agency problems in financial markets due to asymmetric information and costly enforcement of contracts. (1) Other approaches explicitly analyze the supply-side effects of monetary policy through its impact on working capital. Recently, Barth and Ramey (2001) present aggregate and industry-level evidence suggesting that these cost-side theories of monetary transmission deserve serious consideration. Moreover, the cost channel can potentially explain several important empirical puzzles in monetary macroeconomics. Ravenna and Walsh (2003), besides providing additional empirical evidence on the cost channel, show that the optimal monetary policy problem is altered. For example, they show that both the output gap and inflation are allowed to fluctuate in response to productivity and fiscal shocks under optimal policy.

Theoretical foundations of the cost channel include Blinder (1987), Christiano and Eichenbaum (1995), and Farmer (1984, 1988). These model all begin with the assumption that firms must pay their factors of production before they receive revenues from sales and must borrow to finance these payments. Additionally, some type of nominal rigidity is considered for money to be nonneutral. One way of introducing nominal frictions in these models is through a "limited participation" restriction. Originally proposed by Rotemberg (1984) and Grossman and Weiss (1983), and further developed by Lucas (1990) and Fuerst (1992), limited participation constraints imply that the ability of some agents in the economy to adjust their financial portfolios is restricted.

This article analyzes the implications for the transmission mechanism of monetary policy of production inflexibilities that result in variable capacity utilization rates across firms. The interaction between resource underutilization and monetary policy has been analyzed, for instance by cook (1999a), Dotsey and King (2001), and Christiano et al. (2001). However, their description of the underutilization phenomenon, which follows Burnside and Eichenbaum (1996) depreciation in use models, is highly stylized. By contrast, the issue of capacity utilization is modeled here under explicit microfoundations. In this respect, I follow Cooley et al. (1995), who probably were the first attempt to explicitly rationalize equipment idleness in modern quantitative macroeconomics. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.