This study provides new insights on the allocative effect of monetary policy. It
shows that contractionary monetary policy exerts an important reallocation effect
by cleansing unproductive firms and enhancing aggregate productivity. At the same
time, however, reallocation involves a reduction in the number of product variety
that is central to consumer preferences and hurts welfare. A contractionary policy
prevents the entry of new firms and insulates incumbent firms from competition,
reducing aggregate productivity. We provide empirical evidence on U.S. data that
corroborates the relevance of monetary policy for product variety resulting from
firm entry and exit.
