Circulated previously as "Endogenous TFP, business cycle persistence and the productivity slowdown in the euro area"; ECB Working Paper 2401, 2020; Bank of Finland Research Discussion Paper 21/2019
This paper analyses the role of endogenous total factor productivity dynamics in explaining business cycle persistence as well as the missing (dis-)inflation and productivity puzzles in the euro area. We show by means of an estimated medium-scale DSGE model in which TFP evolves endogenously as the result of costly investment in R&D and technology adoption that the endogenous slowdown in total factor productivity can explain the depth and persistence of the output drop and the weak recovery following the double-dip recession in the euro area. Our results suggest that a decrease in R&D efficiency and innovation is key in explaining the pre-crisis euro area productivity slowdown, while as of 2008 a crises-induced drop in technology adoption constitutes the most important factor. We document a flattening of the Phillips curve relationship under the endogenous TFP mechanism, resulting from the interaction between inflation and productivity dynamics. The endogenous reaction in TFP dampens the inflation response over the business cycle and can thus help explain both the moderate fall in euro area inflation during its crises and its sluggish increase in the subsequent recovery.
Most recent version; Recent slides (CEPR/ ESSIM); VoxEU article; Bank of Finland Research Discussion Paper 02/2024 ; previously circulated as "Price Stability and Debt Sustainability Under Endogenous Trend Growth".
Upcoming paper presentations: Stanford Institute for Theoretical Economics (SITE) on Fiscal Sustainability, CEBRA Annual Meeting
This paper studies price stability and debt sustainability when the real rate exceeds trend growth (r > g) in a New Keynesian model with endogenous growth through R&D. Fiscal deficits not backed by future surpluses are partly paid for through technology-led growth, which attenuates fiscal inflation. A dynamic r − g stability criterion characterizes feasible monetary-fiscal frameworks. If surpluses do not adjust to stabilize debt, the central bank must permit r−g to fall with inflation. Monetary policy which follows the Taylor principle can be consistent with a unique stable equilibrium under active fiscal policy, as growth creates fiscal capacity by expanding long-run aggregate supply.
This paper provides novel empirical evidence on the impact of monetary policy on innovation investment using unique firm-level data. First, we document the effect of a large, systematic monetary tightening (ECB rate increases from 0% to 4.5% during 2022-23), with average firm-level innovation cuts of 20%. These cuts are more pronounced in lower productivity firms and firms expecting high inflation and persist over the medium term, indicating a sustained innovation slowdown. Second, we use the survey to identify elasticities of innovation expenditure to exogenous policy rate changes. Responses to hikes and cuts are significant and largely symmetric at the baseline rate (4.5%), though we detect potential state-dependent asymmetry due to the extensive margin. The financing channel emerges as one of the transmission channels, with more pronounced effects in firms with higher shares of bank loans and variable-rate loans. Crucially, we show that monetary policy transmits via aggregate demand, with stronger responses in firms with pessimistic demand expectations. Forward guidance provides substantial additional stimulus by reducing uncertainty about future rates, suggesting long-term, supply-side effects of announcements. These results challenge monetary long-run neutrality and are suggestive of policy endogeneity of R∗ operating through innovation-driven technology growth.
This paper explores the sectoral reallocation effects of monetary policy shocks and their transmission to aggregate supply through sectoral interlinkages. First, using data for 65 industries for the period 1948-2014, we show by means of local projections that monetary policy shocks reallocate resources away from manufacturing. We study the implications of this phenomenon, considering differential sectoral contributions to aggregate total factor productivity (TFP) growth. Previous work on sectoral reallocation has not yet accounted for a key property: sectors have heterogeneous TFP growth rates with direct effects on macroeconomic dynamics and monetary policy. In particular, reallocation between sectors with heterogeneous growth affects endogenous growth of aggregate TFP and thus potential output and, moreover, inflationary pressures through marginal costs. To address this gap in the literature, we develop a multi-sector New Keynesian model with endogenous growth and heterogeneous sectoral contributions to long-run growth. Specifically, we contribute to the literature by (i) examining the role of nominal rigidities under frictional reallocation, (ii) investigating the heterogeneous monetary policy transmission to manufacturing versus services, and (iii) studying the long-run impact of monetary policy through sectoral reallocation. Our findings suggest that the reallocation-induced TFP response plays a critical role in the conduct of monetary policy, while monetary policy, in turn, shapes the reallocation process and underlying macroeconomic adjustment, as well as accelerates structural change.
Bank of Finland Research Discussion Paper 13/2022 .
This paper studies fiscal policy in a New Keynesian DSGE model with endogenous technology growth in which scarring can occur endogenously through hysteresis effects in TFP. Both demand- and supply-driven recessions can weaken investment in R&D and technology adoption, thus depressing the long-run trend. Fiscal policy has long-term effects under endogenous growth and the type of fiscal stimulus is decisive for the sign and magnitude of fiscal multipliers. Expansionary government spending boosts output transitorily but over time crowding out in technology-enhancing investment weakens the long-run trend. I introduce fiscal growth policies in this environment which in the short run raise aggregate demand and simultaneously support growth-enhancing investment and thus the long-run path of aggregate output, generating a positive trend multiplier. Multipliers of fiscal growth policies can be sizeable, above all when targeted to R&D, which is characterized by fiscal multipliers greater than unity. Fiscal growth policies are disinflationary and are thus effective stabilization tools in supply-driven recessions when monetary policy faces a trade-off between inflation and short- and long-run output stabilization.
Do recessions harm investment in technology and thus future aggregate supply? We provide novel evidence on this question using unique, granular data on innovation investment in R&D and diffusion from a representative survey of German firms. Our data allows to identify the crisis-induced innovation investment cuts with mean conditional reductions of -65% (R&D) and -70% (diffusion) relative to pre-crisis investment plans, concentrated in 20% and 25% of firms respectively. We estimate that a 1% cyclical output drop translates into a -0.3% fall in innovation investment. Firm-level financial constraints amplify the innovation reductions. Our findings suggest that short-term shocks affect aggregate supply over at least the medium term, challenging the exogenous technology assumption and the resulting dichotomy between business cycles and long-run growth in standard models of aggregate fluctuations. We show that demand shocks are among the main causes of the cyclical technology investment cuts, supporting the view that demand shocks can manifest as technology shocks. We formalize our micro-level results in a New Keynesian model with endogenous growth through investment in R&D and technological diffusion which determines cycle and trend jointly in general equilibrium.
This paper presents a two-country endogenous growth model with nominal wage rigidities for a currency union in which pessimistic expectations can generate permanent slumps with low growth and persistent unemployment. Stagnation evolves as a growth trap when nominal interest rates are constrained: Monetary policy cannot restore full employment as weak growth depresses aggregate demand which pushes its policy instrument against the constraint. Growth is low, in turn, as weak aggregate demand lowers firm profits and hence investment in R&D. The currency union can settle in a symmetric stagnation steady state in which weak aggregate demand in the currency union drives interest rates against the ZLB, generating persistent unemployment and low technology growth on the monetary union level. My results show that in addition an individual member state of sufficiently small size can enter a stagnation steady state asymmetrically, while the rest of the currency union maintains full employment and sound technology growth, as the central bank faces constraints given its responsibility for the currency union aggregate. I derive growth-promoting policies and show that bilaterally implemented R&D subsidies are effective in preventing stagnation in the currency union.
ECB Working Paper No 2714; Bank of Finland Research Discussion Paper 6/2022.
This paper studies monetary policy strategies under endogenous technology dynamics and low r* . Endogenous growth strengthens the gains from make-up strategies relative to inflation targeting, especially if policy space is reduced. This result is due to the long-run non-neutrality of money and the hysteresis effects in TFP through which ELB episodes generate permanent scars on long-run aggregate supply. Make-up strategies not only foster the alignment of inflation with target but also support productivity-improving investment in R&D and technology adoption and hence the long-run trend path, provided that the inherent make-up element is sufficiently pronounced. Inflation is less responsive to monetary policy due to the interaction with productivity dynamics. As a result, additional stimulus is required at the ELB and the degree of subsequent overshooting is alleviated. Endogenous growth also generates novel monetary policy trade-offs, most notably credibility challenges, which can be mitigated by confining make-up elements to ELB episodes.
Bank of Finland Research Discussion Paper.
I propose a two-sector endogenous growth model with heterogeneous sectoral productivity and sector-specific, nonlinear hiring costs to analyse the link between sectoral resource allocation, low productivity growth and stagnant real wages. My results suggest that an upward shift in the labor supply, triggered for instance by a labor market reform, is beneficial in the long-run as it raises growth of technology, labor productivity and real wages. I show, however, that in the immediate phase following the labor supply shock, labor productivity and real wages stagnate as employment gains are initially disproportionally allocated to low-productivity sectors, limiting the capacity for technology growth and depressing real wages and productivity. I demonstrate that due to the learning-by-doing growth externality in the high-productivity sector the competitive equilibrium is inefficient as firms fail to internalize the effect of their labor allocation on aggregate growth. Subsidies to high-productivity sector production can alleviate welfare losses along the transition path.