Reallocation, productivity, and monetary policy in an energy crisis

This paper presents a New Keynesian multi-sector model incorporating firm heterogeneity, entry-exit dynamics, and energy production from both fossil fuels and renewables. We investigate the effects of a sustained increase in fossil fuel prices on sectoral size, labor productivity, and inflation. A rise in fossil fuel prices leads to higher energy costs. Due to ex-ante heterogeneity in energy intensity, sectoral profitability is impacted asymmetrically. As production costs rise, new entrants must have higher idiosyncratic productivity to remain profitable, boosting average labor productivity but reducing firm entry and the number of active firms in each sector. When the price effects of the shock are persistent, a central bank with a strong anti-inflationary stance can mitigate the resulting inflation by curbing wage costs. This policy entails higher output costs and a milder response in average productivity, but enables a faster recovery in business dynamism. Our results thus reveal a novel trade-off for monetary policy between stabilizing aggregate activity and business dynamism.