Monetary Policy Rules and the Extensive Margin

The number of producers and goods in a market is not constant but fluctuates with the business cycle. This empirically well-documented feature of markets has largely been ignored in the macroeconomic literature. Only very recently have some authors started to explicitly take producer entry into and exit out of markets into consideration and renounce the traditional approach in the monetary policy literature to assume a constant number of producers and goods. This paper studies optimal monetary policy and a range of simple monetary policy rules in a model with endogenous market entry and exit. To do that, a sticky-price general equilibrium model is used in which consumers display a “love for variety”. Monetary policy adjustments are motivated by the presence of productivity shocks. As opposed to traditional models monetary impulses now work through an effect on both the intensive margin (i.e. adjustments in the production of existing goods) and the extensive margin (i.e. the creation and elimination of goods). A policy of producer price index targeting is only able to generate welfare results similar to the optimal monetary policy for low degrees of the love for variety. Consumer price index targeting performs better after the love for variety passes a certain threshold. Monetary targeting and nominal income targeting are found to be inferior to the price targeting rules irrespective of the parameter combination.