DP15583 Aggregate-Demand Amplification of Supply Disruptions: The Entry-Exit Multiplier

Author(s): Florin Ovidiu Bilbiie, Marc J Melitz
Publication Date: December 2020
Keyword(s): Aggregate Demand and Supply, COVID-19, Entry-Exit, Recessions, sticky prices, Variety
JEL(s): E3, E4, E5, E6
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15583

The response of entry and exit to adverse supply shocks, such as COVID-19, is amplified by nominal rigidities. This leads to further amplification in the response of aggregate demand. Firms' inability to adjust their prices induces further changes in profitability that engender additional entry-exit dynamics. These changes in net entry, in turn, amplify the initial response to the shock by generating additional curvature in the relationship between the shock and aggregate demand. Even in our baseline model with efficient equilibrium entry, this entry-exit multiplier triggers a substantial magnification of the welfare losses due to a negative shock through these second-order effects. Nominal rigidities may also induce a first-order effect when entry is no longer efficient. Our model highlights how the addition of endogenous entry to a benchmark New Keynesian model radically changes the consequences of nominal rigidities. We focus on the amplification of aggregate demand to supply shocks, but also highlight other key divergences that can potentially resolve some empirical discrepancies associated with the workhorse New-Keynesian model.