Idiosyncratic Shocks and Macroeconomic Volatility: A Primer on Granular Analysis

This paper investigates how firm-level idiosyncratic shocks, when combined with fat-tailed firm size distributions, influence macroeconomic fluctuations and monetary policy. By developing a Calvo type granular DSGE model calibrated to the Chinese economy, we show both mathematically and numerically that idiosyncratic productivity shocks can significantly raise the volatility of output. Simulations reveal that economies with granular firm structures also require more aggressive monetary policies to stabilize the economy. By calibrating the model to the US economy, our model also exhibits superior power in explaining inflation, offering a potential solution to the reset price inflation puzzle. These findings underscore the macroeconomic relevance of firm-level heterogeneity and suggest that accounting for granularity is essential for accurate modeling and effective policy design, especially in economies with fat-tailed firm size distributions.