DOI: https://doi.org/10.71734/DP-2026‑4

How does supply-side turnover reshape inflation targeting? This study explores how firm turnover and product turnover – which are ubiquitous in modern economies – fundamentally alter the design of optimal monetary policy. By incorporating firm life cycles into a New Keynesian framework, the authors uncover new insights into inflation dynamics, optimal monetary policy responses, and the challenges of empirically distinguishing supply shocks from demand shocks.

The paper examines how supply-side turnover influences inflation targeting and optimal monetary policy. Conventional models assume a fixed set of firms, but, in modern economies, firms frequently enter and exit markets and new products replace older ones. This turnover affects productivity dynamics and, consequently, the optimal inflation target. The authors develop a theoretical framework for analysing these effects, showing that the optimal inflation target is positive on average, varies with productivity shocks, and challenges the conventional wisdom of steady-state price stability.

A fresh look at monetary policy design

The authors extend the standard New Keynesian model by introducing firm turnover, where firms face a risk of becoming unproductive and exiting the market. New firms replace exiting ones, entering with cohort-specific productivity levels that evolve over time. This setup accounts for three types of supply shocks: (i) common productivity growth affecting all firms, (ii) cohort-specific productivity growth affecting new entrants, and (iii) experience-based productivity growth affecting incumbent firms. These shocks influence relative productivity between new and existing firms, necessitating adjustments in relative prices.

The study derives a generalised New Keynesian Phillips curve and a welfare objective that depend on the gap between actual inflation and a time-varying optimal inflation target. Unlike in traditional models, the optimal inflation target fluctuates in response to cohort-specific and experience-based productivity growth shocks, while remaining unaffected by common productivity growth shocks. Inflation target dynamics reflect the need for efficient relative price adjustments between new and incumbent firms. The authors emphasise that these adjustments are critical for maintaining economic efficiency in the presence of sticky prices, where not all firms can adjust their prices simultaneously.

Insights on inflation targeting

Positive and time-varying inflation target: Under plausible calibrations, the optimal inflation target is positive in the steady state, reflecting the higher prices set by new firms compared with incumbents. The target also fluctuates with productivity shocks, increasing with experience-based productivity growth and decreasing with cohort-specific productivity growth. These fluctuations ensure efficient relative price adjustments in the presence of sticky prices. This finding challenges the traditional view that steady-state price stability is always desirable, suggesting instead that a dynamic inflation target would better align with economic realities.

“Looking through” supply shocks: The study finds that monetary policy should “look through” certain supply shocks, such as temporary or persistent cohort-specific productivity growth shocks. The optimal policy response to these shocks would keep interest rates unchanged, allowing inflation and output to adjust naturally. This approach contrasts with the conventional response to common productivity shocks, which typically require interest rate adjustments to stabilise inflation. By allowing inflation to follow its optimal target, central banks can avoid unnecessary disruptions to the economy.

Challenges in shock identification: Supply shocks, particularly those affecting experience-based productivity growth, can mimic demand shocks by simultaneously and temporarily increasing both output and inflation. This complicates the empirical identification of demand shocks using conventional approaches, such as sign-based restrictions or high-frequency monetary policy shock identification. As a result, some observed responses to monetary policy loosening, such as increases in aggregate productivity, may instead reflect misidentified supply shocks.

Implications for policy and research

The study underscores the need for improved methods for identifying demand shocks and supply shocks, given the potential for misidentification in the presence of supply-side turnover. The study also suggests that policymakers must distinguish between traditional mark-up shocks, which require trade-offs between output and inflation stabilisation, and certain supply shocks, which shift the optimal inflation target without such trade-offs. Policymakers should also be aware of the implications of structural change in the economy. For example, declining business dynamism can increase the persistence of inflation target fluctuations, while technological innovations, such as artificial intelligence, may affect the level of the inflation target depending on whether they benefit new or existing firms. Central banks should infrequently but regularly reassess their inflation targets against the backdrop of such developments.

Conclusion

This research provides an original perspective on inflation targeting by incorporating supply-side turnover into monetary policy analysis. The findings reveal that the optimal inflation target is not only positive, but also dynamic, responding to productivity shocks in ways that enhance economic efficiency. Inflation target dynamics ensure that monetary policy automatically “looks through” certain supply shocks. However, the challenges of proper shock identification highlight the need for more sophisticated empirical tools. As economies continue to evolve, this study offers a valuable framework for ensuring that inflation targeting remains effective in a world of constant economic change.

Adam, K., H. Weber (2026), Monetary policy and supply-side turnover, Bundesbank Discussion Paper, No 04/2026