Optimal Monetary Policy and Firm Entry

This paper characterises optimal monetary policy in an economy with endogenous …rm entry, a cash-in-advance constraint and preset wages. Firms must make pro…ts to cover entry costs; thus the markup on goods prices is e¢cient. However, because leisure is not priced at a markup, the consumption-leisure tradeo¤ is distorted. Consequently, the real wage, hours and production are suboptimally low. Due to the labour requirement in entry, insu¢cient labour supply also implies that entry is too low. The paper shows that in the absence of …scal instruments such as labour income subsidies, the optimal monetary policy under sticky wages achieves higher welfare than under ‡exible wages. The policy maker uses the money supply instrument to raise the real wage the cost of leisure above its ‡exible-wage level, in response to expansionary shocks to productivity and entry costs. This raises labour supply, expanding production and …rm entry. Keywords: entry; optimal monetary policy, sticky wages JEL classi…cation: E52, E63 Thanks to Florin Bilbiie, Martina Cecioni, Sanjay Chugh, Maarten Dossche, Pedro Teles, Alex Wolman, Raf Wouters and an anonymous referee for helpful comments. All errors are mine. Postdoctoral Fellow of the Fund for Scienti…c Research Flanders (FWO). Institute for Monetary and Financial Stability (Department of Money and Macroeconomics), Goethe University Frankfurt, House of Finance, Grüneburgplatz 1, 60629 Frankfurt am Main, Germany, [email protected], http://sites.google.com/site/vivienjlewis, tel.: +49 69 798 34034, fax: + 49 69 798 34502.