UC Davis

In this dissertation, I explore the relationship between firm market power and the conduct of monetary policy. The interaction of market power and monetary policy is at the heart of the New-Keynesian literature, yet there remain many unresolved puzzles that call for further investigation both empirically and theoretically. I work at the intersection of empirical research and theory, and I aim to answer policy-relevant questions using micro-data in light of theoretical models.

In Chapter I, I study the role of intangible inputs, such as software and marketing, and firm heterogeneity in productivity in determining how firms' price-cost markups respond to interest rate changes. In a standard sticky-price New-Keynesian (NK) model, conditionally counter-cyclical markups (i.e., markups fall conditional on a monetary easing) play a key role in the transmission of monetary policy to the real economy. Recent empirical evidence, however, finds that markups respond pro-cyclically to interest rate changes. This disconnect between theory and data casts doubt over the potency of this monetary transmission mechanism and raises the following questions: (1) What causes the pro-cyclical response of markups following a monetary policy shock? (2) What are the implications for the transmission of monetary policy to inflation?

To address these questions, I first examine the cyclical behaviors of firm-level markups with the goal to identify what characterizes the firms that drive the aggregate response. I find that firm-level markups are conditionally pro-cyclical to a monetary easing, consistent with earlier findings based on aggregate data. I find new evidence that firms that intensively use intangible inputs display more pro-cyclical markups. Motivated by the empirical evidence, I propose a novel mechanism through firms' adoption of intangible inputs to show that in a heterogeneous firms NK model, firms can reproduce pro-cyclical markups following a monetary easing. I test key predictions of the model and find empirical support for this mechanism. In the cross-section, as in the data, larger firms with higher market share adopt intangible inputs aggressively and become even larger and more profitable at the expense of smaller firms. These results run contrary to the conventional wisdom that a monetary easing leads to a strong labor market with shrinking profit margins and rising wages such that inflation is driven by rising costs, and a distributional consequence that benefits the workers. My findings suggest that a monetary easing could induce inflation driven by both rising costs and rising profits margins, and that it could lead to a redistribution of income from workers to firm profits.

Chapter II is part of joint work with Sanjay R. Singh. We study the business cycle interaction of monetary policy with TFP growth and product market power. We document a novel channel for monetary policy to affect the allocative efficiency of an economy, i.e., how resources are allocated across firms. The channel operates through the extensive margin of firm entry and incumbent innovation. In a textbook NK model, markup dispersion goes up irrespective of whether the shock is contractionary or expansionary. In our setting, markup dispersion can go down with expansionary monetary policy shocks. Our misallocation channel does not depend on heterogeneous pass-through of marginal costs into price. We show that even when the pass-through is the same for all firms, monetary policy could still have misallocation effects through it impacts on the cross-sectional distribution of market power across firms.

Specifically, we incorporate incumbent innovation into a endogenous growth model with nominal rigidities. In the model, firms accumulate market power through incumbent innovation over time. Successful innovation by entrants results in displacement of existing firms, and disrupts the accumulation of market power by the incumbents. A cross-sectional distribution of markups endogenously responds to business cycle shocks through variations in both entrant and incumbent innovation. Using this environment, we show that a monetary tightening causes an increase in markup dispersion across firms by discouraging entrant innovation relative to incumbent innovation. Using external instruments, we find empirical support for increased inter-sectoral dispersion in markups, lower aggregate TFP, and lower firm entry following contractionary monetary policy shocks in the US economy.

Lastly, chapter III is joint with Troy Matheson, in which we empirically investigate the extent to which Canada's road infrastructure gaps have held back productivity. We merge firm-level productivity estimated with detailed road network GIS data from Statistics Canada to estimate productivity improvement with respect to reductions in minimal travel time from marginal improvements in road network. We find that road network improvements increase firm-level productivity. A 1% increase in accessibility leads to a 0.3-0.5% increase in firm productivity.