Investment, Price Changes, and Monetary Policy: Models and Micro Data

The effects of monetary policy on the economy are shaped by two broad frictions: nominal frictions, such as price adjustment costs, determine the demand for output; and real frictions, such as capital adjustment costs, determine the supply of output. Although there are active literatures exploring each of these frictions in isolation, there is so far little work exploring their interaction. In this paper, we argue that ignoring these interactions is not innocuous. We show that in a quantitative model with endogenous state-dependent investment and pricing decisions, capital adjustment costs amplify price stickiness and thus the effects of monetary policy. However, the extent of these effects depends crucially on the size of the two key frictions at the micro level. We therefore estimate the model by combining confidential P.P.I. data on prices with Compustat data on investment, and use this estimated model to reassess the aggregate effects of monetary policy in models with realistic micro rigidities.