UC Irvine

I study the interactions between liquidity constraints, monopolistic competition, and search frictions for product markets, labor markets, and credit markets. Monopolistic competition is especially important for three different reasons. First, there is an externality that links the demand of firms to the state of the economy. Second, under free entry, the product space is influenced by policy and interacts with liquidity constraints. Third, monopolistic competition generates markups, which can augment other wedges and thereby interact with liquidity constraints.

The first chapter considers the role played by endogenous variety and monopolistic competition in the long-run transmission of monetary policy. The combination of free entry and product variety gives rise to both an intensive margin (quantity of particular good) and extensive margin (extent of variety), and search frictions imply that firm entry involves a congestion externality. Inflation generally reduces variety. Under constant-elasticity-of-substitution (CES) preferences, firms are inefficiently small, with the inefficiency increasing in product differentiation and the extent of search frictions. The Friedman rule, which involves contracting the money supply at the rate of time preference, is the best policy under CES preferences. In contrast, with variable elasticity of demand, inflation can increase firm size, reduce markups, and raise welfare, even though output is lower. Under CES preferences, the welfare cost of inflation is high; moreover, it increases monotonically with the markup and is higher with endogenous variety than with a fixed variety alternative.

The second chapter departs from the dramatic growth of revolving credit since 1970 relative to both consumption and consumer credit. Importantly, revolving credit primarily determines short-run household liquidity and comoves positively with product variety. I augment the Mortensen-Pissarides model with an endogenous borrowing constraints and free entry of monopolistically competitive firms. Unemployment is amplified from a two-way feedback: higher debt limits encourage firm entry and raise product variety (the entry channel), and greater variety makes default more costly and thereby raises the equilibrium debt level (the consumption value channel). I compare the model to a counterfactual economy in which either channel is shut down and find that mean amplification exceeds 50%. Furthermore, only the model economy generates a procyclical response of the credit-to-consumption ratio, as observed in the data.

The third chapter examines the role of corporate finance and imperfect competition in the pass through of monetary policy to the real lending rate and its transmission into investment. Monopolistically competitive entrepreneurs can finance investment opportunities using bank-issued credit or money. They seek loans in an over-the-counter market where the terms of the contract (loan size, interest rate, and down payment) are negotiated subject to pledgeability constraints. I investigate pass through of the policy rate to the real lending rate and its transmission to output and investment, taking into account the interplay of (1) heterogeneous financial frictions from limited enforcement and (2) aggregate demand externalities from monopolistic competition. Whereas returns to scale or product diversity are not important for the pass through, the former substantially affect the transmission of policy to investment and output. Furthermore, financial frictions interact positively with demand complementarities from monopolistic competition. Greater dispersion of financial frictions reduces investment and output and also increases transmission unevenly across the range of nominal policy rates, having a maximal effect at about a policy rate of 9%.