Firm heterogeneity, capital misallocation and optimal monetary policy

BIS Working Papers  |  No 1148  | 
22 November 2023



An inefficient allocation of capital across firms may significantly reduce total factor productivity (TFP). Monetary policy is an important driver of individual firms' investment decisions. But, if firm investment responds in different ways to changes in monetary policy, then monetary policy can affect capital misallocation and TFP. Monetary policy design has traditionally taken aggregate productivity as given. In the workhorse model of monetary policy – the New Keynesian model – the central bank faces a trade-off between stabilising inflation and reducing the short-term deviations of output from its potential level. If monetary policy can affect misallocation and TFP, the central bank should also ponder how its decisions will impact the supply side of the economy in the medium term. Such considerations may be of relevance in phases of very active monetary policy, such as in the current inflationary environment.


This paper seeks to shed light on the interaction between monetary policy and capital misallocation and its implications for optimal monetary policy. To this end, we develop a model in which capital misallocation arises from financial frictions. We also present empirical evidence using granular data on Spanish firms.


Our model predicts that an expansionary monetary policy shock improves capital allocation and thus raises TFP. We call this effect "the capital misallocation channel of monetary policy". We present empirical evidence supporting this prediction: expansionary policy induces high-productivity firms to increase their investment more than it does for low-productivity firms. The central bank has an incentive to exploit the capital misallocation channel, by engineering a temporary economic expansion to increase TFP at the cost of some inflation. However, if the central bank can commit to a policy, we find that this optimal policy is price stability.


This paper analyzes the link between monetary policy and capital misallocation in a New Keynesian model with heterogeneous firms and financial frictions. In the model, firms with a high return to capital increase their investment more strongly in response to a monetary policy expansion, thus reducing misallocation. This feature creates a new time-inconsistent incentive for the central bank to engineer an unexpected monetary expansion to temporarily reduce misallocation. However, price stability is the optimal timeless response to demand, financial or TFP shocks. Finally, we present firm-level evidence supporting the theoretical mechanism.

JEL classification: E12, E22, E43, E52, L11

Keywords: monetary policy, firm heterogeneity, financial frictions, capital misallocation