Business cycle implications of endogenous Schumpeterian growth in a new Keynesian DSGE model

Despite the development of modern endogenous growth models, commonly-used dynamic stochastic general equilibrium (DSGE) models are based on exogenous neoclassical long-term growth and focus only on the fluctuations around that trend growth. In contrast, we propose a model of economic fluctuations with New Keynesian (NK) nominal rigidities and common shocks that builds in the features of a Schumpeterian endogenous growth model (à la Aghion and Howitt, Econometrica, 1992) to capture the interactions between an economy's trend growth and its cyclical fluctuations. The innovation process is embedded in the intermediate production sector, as entrepreneurs/innovators invest final goods to increase their odds of pushing the technological frontier, so that an intermediate good producer implementing the new technology takes over the incumbent producer in his respective intermediate sector. This generates a dynamic not commonly seen in NK models, while conserving nominal wage and price stickiness (modeled through contracts à la Calvo) and studying the impact of productivity, spillover and monetary shocks.

We show that the inclusion and treatment of Schumpeterian growth features matter for several reasons. First, the endogenous choice of investing in research and development (R&D) has implications for the likelihood of advancing or not the technological boundary and to vary the entry and exit of firms. Therefore, the Schumpeterian dimension of our model, with Harrod-neutral technical progress in the production function for goods and a decreasing return-to-scale innovation production function, adds a relevant transmission channel for understanding economic fluctuations and the impact of both real and monetary disturbances. We consider its implications for the volatility, comovements and persistence of real variables, as well as inflation. Second, this dimension provides some support and microfoundations to monopolistic competition, mostly introduced de facto in NK models, as differing levels of technological advancement in the intermediate sector bring a justification for existing market power. Third, our hybrid model highlights and addresses new challenges at the modelling and simulation stages, when considering the implications of price rigidities on R&D investments. We show that sluggish price adjustments interact directly with the innovation process, as the discounted expected value of investing in R&D matters for the rate of innovation over the business cycles.