Monetary Policy, Product Market Competition and Growth
GAICIL Insights
Central bankers rarely think of themselves as innovation policymakers.1 This paper suggests they should. Monetary Policy, Product Market Competition and Growth, by Philippe Aghion, Emmanuel Farhi and Enisse Kharroubi, looks past monetary policy's familiar effects on demand and inflation to its effects on long-run growth through firms' investment decisions. Monetary easing fosters growth more in credit-constrained environments, and more so the higher the degree of product market competition.
The model is simple and revealing. Firms can make growth-enhancing investments but face liquidity shocks forcing them to reinvest money in their projects. Anticipating this, firms may sacrifice part of their investment to secure reinvestment in case of a shock, behavior the authors call liquidity hoarding. Countercyclical interest rate policy is growth-enhancing because it reduces the need for liquidity hoarding. The effect is stronger when liquidity shocks are more likely and when competition is higher. With low competition, large rents let firms stay in the market and reinvest optimally regardless of funding conditions. Cash parked for emergencies is a project not built.
The empirical test uses the announcement of the European Central Bank's Outright Monetary Transactions (OMT) program, which produced an unexpected drop in long-term government bond yields. With euro area industry-level and firm-level data, the authors find that easing raised growth more in highly leveraged sectors and firms, and more where product market competition was higher, in countries and sectors with lower product market regulation or market concentration.
The interaction is the insight. Firms with monopoly power are insulated from cyclical fluctuations, while those facing tight competition depend more on favorable funding to sustain investment. Monetary policy matters more for growth in competitive economies. A monopolist barely notices the interest rate; a challenger lives by it.
Here is where the paper meets the present. AI investment fits the template. AI investment is growth-enhancing and requires sustained funding, and many firms investing in AI face credit constraints and liquidity risks. Countercyclical monetary policy can support such investment by reducing liquidity hoarding, especially in competitive markets. Stable funding conditions may help firms sustain AI investments through economic cycles. A recession that forces startups to hoard cash can quietly delay a generation of AI products.
The asymmetry has competitive consequences. In competitive AI markets, firms depend on funding access to keep investing, and easing during downturns helps them continue. In concentrated markets, dominant firms with large rents can invest regardless. Monetary policy may thus help level the playing field for competitive firms, supporting innovation by challengers. The central bank, without intending it, can be the challenger's ally.
The authors outline extensions: the relationship between structural reforms and monetary stimulus using bank-firm matched data, and the growth effect of quantitative easing through bank profitability. These would deepen understanding of how monetary policy affects firm-level investment, central to sustaining investment in new technologies.
Policy coordination emerges as the lesson. Structural reforms increasing product market competition may amplify the growth effects of monetary policy. Combining competition-enhancing reforms with supportive monetary policy could produce larger growth benefits than either alone. For economies promoting investment in AI and other innovations, coordinating the two is worth considering.
The paper challenges a piece of orthodoxy. Monetary policy is often seen as neutral in the long run. This research suggests countercyclical policy can affect long-run growth through investment by credit-constrained firms, broadening the potential impact of central bank decisions.
Distilled to one claim: monetary policy, competition and growth are linked. Countercyclical easing supports growth-enhancing investment by reducing liquidity hoarding, especially in competitive environments. As AI investment becomes central to growth, these links can help policymakers design macroeconomic and competition policies that sustain innovation through the cycle.
For central banks, the sting is this: in a competitive AI economy, the interest rate path through a downturn may shape the innovation frontier as much as any research grant. Competition authorities and monetary authorities may be working on the same problem without talking to each other.
Introduction
In this paper we argue that monetary easing fosters growth more in more credit-constrained environments, and the more so the higher the degree of product market competition. Indeed, when competition is low, large rents allow firms to stay on the market and reinvest optimally, no matter how funding conditions change with aggregate conditions. To test this prediction, we use industry-level and firm-level data from the euro area to look at the effects on sectoral growth and firm-level growth of the unexpected drop in long-term government bond yields following the announcement of the Outright Monetary Transactions programme (OMT) by the European Central Bank. We find that the monetary policy easing induced by OMT contributed to raising sectoral (firm-level) growth more in more highly leveraged sectors (firms), and the more so the higher the degree of product market competition in the country (sector).
Takeaway
In this paper we developed a simple model in which firms can make growth-enhancing investment but are subject to liquidity shocks that forces them to reinvest money in their project. Anticipating this, firms may have to sacrifice part of their investment in order to secure reinvestment in case of a liquidity shock (liquidity hoarding). A countercyclical interest rate policy is therefore growth-enhancing as it helps firms reduce the amount of liquidity hoarding. Moreover our model predicts that such a policy is more growth-enhancing when the probability to be hit by a liquidity shock is higher and when competition is higher: indeed when competition is low, large rents allow firms to stay on the market and reinvest optimally, no matter how funding conditions change. Cyclical fluctuations matter less for firms holding monopoly power than for those facing tight competition.1
We then confronted these predictions to the data. More precisely, we looked at the effect on sectoral growth and on firm growth of an unexpected drop in long-term government bonds following the announcement of OMT. We found that more highly leveraged sectors/ firms benefit more from this unexpected drop, and the more so in countries/sectors with lower product market regulation or market concentration. Our analysis can be extended in several directions. A first extension, which we are currently pursuing, is to investigate the relationship between structural reforms and monetary policy stimulus using bank-firm matched data. Here, we follow Chodorow-Reich (2014) to build a firm-specific measure of financial constraint using bank-firm existing credit relationships. We then want to investigate the growth effect of quantitative easing by the ECB, which raises banks’ profits through valuation gains on government bond holdings. Our conjecture is that firms borrowing heavily (little) from such banks benefit more (less) of a relaxation of their borrowing constraint. But this relaxation in financial constraints translated into an increase in employment and capital expenditures only in the most competitive sectors. A second extension would be to look at labor market regulation and see whether we find the same complementarity between a proactive monetary policy and labor market flexibility as the one we found in this paper between a proactive monetary policy and product market competition.
A third extension is to look at how product market competition interacts with fiscal policy, drawing the parallel with our analysis in this paper of how product market competition interacts with monetary policy. In particular we want to revisit the debate on the multiplier, introducing market structure as an interactor. But also we want to look at how fiscal policy can affect macroeconomic activity also through its potential induced effects on product market competition. More generally, we see the current paper as a first step towards introducing IO into standard macroeconomics.
Notes
- Philippe Aghion, Emmanuel Farhi & Enisse Kharroubi, Monetary Policy, Product Market Competition and Growth, 86 Economica 431 (2019), https://doi.org/10.1111/ecca.12311. Takeaway source: Conclusion, reproduced from a free author or repository copy (working-paper version). ↩
Cite as: Philippe Aghion, Emmanuel Farhi & Enisse Kharroubi, Monetary Policy, Product Market Competition and Growth, 86 Economica 431 (2019), https://doi.org/10.1111/ecca.12311
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