Monetary policy with endogenous aggregate productivity and misallocation

Lauri Hannikainen

No 8/2026, Bank of Finland Research Discussion Papers from Bank of Finland

Abstract: Standard New Keynesian models treat aggregate total factor productivity as exogenous to monetary policy. This paper studies optimal monetary policy in the four-equation New Keynesian model of Baqaee, Farhi, and Sangani (2024), in which monetary expansions reallocate resources toward high-markup firms, reduce misallocation, and raise aggregate productivity. This endogenous productivity response flattens the Phillips curve and changes the optimal target criterion of a dual-mandate central bank. The resulting criterion is both forward- and backwardlooking. In my calibration, this criterion is closely approximated by a familiar New Keynesian target criterion adjusted only for the flatter Phillips curve. By contrast, applying a standard target criterion that ignores the effect of monetary policy on aggregate productivity leads the dual-mandate central bank to stabilize inflation too aggressively and generates excessive output fluctuations.

Keywords: monetary policy; Phillips curve; aggregate productivity; misallocation; target criteria; firm heterogeneity (search for similar items in EconPapers)
JEL-codes: D24 D43 D61 E31 E52 E61 (search for similar items in EconPapers)
Date: 2026
New Economics Papers: this item is included in nep-cba and nep-mon
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