PEDRO PABLO ALVAREZ LOIS
output effects.6 Depending on the magnitude of these inflexibilities, the response
of the economy to a monetary shock will differ notably.7 These asymmetries are
quantified in the model presented here.
The outline of the paper is as follows. Section 2 presents a formal description
of the model’s behavioral aspects. Section 3 offers a characterization of the general
equilibrium of the economy and its qualitative properties. The implications for
short-run dynamics are analyzed at this stage. Section 4 studies the quantitative
dimension of the model, what involves the computation of impulse responses of
the main variables in the model to a monetary policy shock and other numerical
simulation exercises. Section 4 offers some concluding remarks and possible lines
for further research.
2. The Model Economy
The basic structure of the model is taken from Christiano, Eichenbaum and
Evans (1998) and Fagnart, Licandro and Portier (1999). I consider an economy
consisting of households, financial intermediaries, a central bank in charge of the
conduct of monetary policy and two productive sectors: a competitive sector pro-
ducing a final good and a monopolistic sector providing intermediate goods. These
intermediate goods are the only inputs necessary for the production of the final
good. The final good can be used either for consumption or for investment pur-
poses. Capital and labor are used in the production of intermediate goods by means
of a putty-clay technology.8 This specification of the production function allows for
the introduction of a simple, but realistic, concept of capacity. Each input firm
makes its investment, pricing and employment decisions under idiosyncratic de-
mand uncertainty, that is, before knowing the exact demand for its production.
This structure implies that intermediate goods firms can be either sales or capacity
constrained; it also allows different firms to face different capacity constraints. Con-
sequently, this source of uncertainty is what explains the presence of heterogeneity
between firms at equilibrium regarding the degree of utilization of their productive
capacities.
These production side particularities are embedded into an otherwise standard
limited participation model. Before proceeding to describe in more detail the dif-
ferent aspects that constitute the basis of the model economy, it is convenient to
define the information sets that appear in the model.
Ωo,t = economy-wide variables dated at time t - 1 and earlier
Ωx,t = includes Ω0.t and period t aggregate monetary shock
At this point, it is also useful to describe the elements that represent the state of
the economy in the model I am developing. These are the aggregate stock of capital
K, the capital-labor ratio X and the realization of the monetary policy shock, x.
6Christiano and Eichenbaum (1995) also analyses these margins.
7Finn (1996) and Cook (1999) analyze the role of capital underutilization in a monetary quan-
titative framework. The description of the underutilization phenomenon , which follows Burnside
and Eichenbaum (1996) depreciation in use models, is highly stylized, however.
8Capital and labor are substitutes ex ante, i.e., before investing, but complement ex post, i.e.,
when equipment is installed. This implies that each firm makes a capacity choice when investing.