whenever a new shop enters and diverts workers from old shops that were satisfying some
customers, because some of these workers' efforts will now be used up in defraying the fixed
cost of the new shop rather than producing goods that can be consumed by customers of
the old shop.
These events that reduce GDP are constantly being offset to some degree by the entry
of new shops that are able to satisfy customers in markets where there had previously been
no viable shop, and by the exit of shops that were using up fixed costs but not producing
enough to satisfy their customers. Thus, both entry and exit are critical to the system's
ability to approximate full-capacity utilization. However, although entry of new shops is
useful in markets where there are no incumbents, or where the incumbents are not hiring
all the potential workers because of layoffs or because of financial problems that prevent
them from meeting their payroll, entry can be harmful (to the level of real GDP) in cases
where incumbent shops were hiring most of the potential workers and satisfying most of the
potential customers. Likewise, although exit is important in cases where the shop has ceased
to play an active intermediation role, whether because of financial diculties, a surfeit of
inventories, or a too high markup, exit can also be very harmful in cases where the incumbent
was previously doing well, because it can cascade across markets causing a cumulative loss
of output (Howitt, 2006).
The effects of the shocks will tend to be larger when inflation is higher because inflation
introduces an extra source of dispersion in relative prices, given that individual prices are
changed at random times, and it does so by a larger percentage amount the higher is the
trend inflation rate.10 This dispersion in relative prices induces variability in each shop's sales
and, hence, in profitability, and the concomitant widening of the distribution of profitability
ends up putting more firms near the edge of failure, making it more likely for firms to fail due
to a random shock to innovation or a match breakup. The bigger is the fixed cost and the
smaller is the markup, the more likely is such a shock to trigger the failure of the shop. Thus,
a higher target rate of inflation intensifies the propagation of shocks through the failure of
trading enterprises. To explore this mechanism in more detail, however, we need first to
calibrate the model and then simulate it under different target inflation rates.