Do Changes in Product Variety Matter for Business Cycles and Monetary Policy in Open Economies?

Firms constantly seek to develop and commercialize new goods to satisfy consumer needs. This process of creation and destruction of product varieties has important implications for competition in goods markets and consumer welfare. According to Bernard et al. (2009), product creation typically accounts for a large share of national output. Since it also crucially affects the dynamics of inflation through its effect on competition, taking this process into account may challenge traditional views on monetary policy design and transmission. In this paper, we find that changes in the range of products available to consumers matter for our understanding of business cycles and the conduct of monetary policy in open economies. Our evaluation of the welfare implications of alternative monetary policy rules shows the importance of product varieties in the design of monetary policy. Much theoretical literature has found that price stability should be the key objective of monetary policy. Considering product creation in an open economy changes this policy recommendation, since welfare is higher when central banks respond moderately to output fluctuations in addition to responding to inflation.