Monetary Policy and Business Cycles with Endogenous Entry and Product Variety

This paper studies the role of endogenous producer entry and product creation for monetary policy
analysis and business cycle dynamics in a general equilibrium model with imperfect price adjustment.
Optimal monetary policy stabilizes product prices, but lets the consumer price index vary to accommodate
changes in the number of available products. The free entry condition links the price of equity (the
value of products) with marginal cost and markups, and hence with inflation dynamics. No-arbitrage
between bonds and equity links the expected return on shares, and thus the financing of product creation,
with the return on bonds, affected by monetary policy via interest rate setting. This new channel of
monetary policy transmission through asset prices restores the Taylor Principle in the presence of capital
accumulation (in the form of new production lines) and forward-looking interest rate setting, unlike
in models with traditional physical capital. We also study the implications of endogenous variety for
the New Keynesian Phillips curve and business cycle dynamics more generally, and we document
the effects of technology, deregulation, and monetary policy shocks, as well as the second moment
properties of our model, by means of numerical examples.