RDP 2024-01: Do Monetary Policy and Economic Conditions Impact Innovation? Evidence from Australian Administrative Data 2. Literature Review

Until recently, the prevailing wisdom was that current macroeconomic conditions and monetary policy have no effect on productivity over the medium term. For monetary policy, this assumption is reflected in the so called ‘neutrality’ of monetary policy. However, a growing number of papers and policymakers have begun to question this assumption, contributing to the broader literature on hysteresis. Much of this literature focuses on medium-run employment effects, stemming from labour market scarring for workers (e.g. Blanchard and Summers 1986; Ball 2009; Andrews et al 2020) or changes in the nature or number of startups (Ouyang 2009; Sedláček and Sterk 2017; Davis and Haltiwanger forthcoming).

More recently the scarring literature has begun to look at the medium-run implications for productivity, building on the existing evidence that economic and financial conditions can influence the amount of innovative activity undertaken (e.g. Brown, Fazzari and Petersen 2009; Jensen and Webster 2011; Ouyang 2011; Huber 2018). Early papers in this productivity hysteresis literature focused on economic downturns, and whether they could contribute to lower productivity in the medium run by weighing on the amount of innovation and technology adoption done during the downturn (Stadler 1990; Comin and Gertler 2006; Barlevy 2007; Anzoategui et al 2019; Bianchi et al 2019).^[2] Focusing mostly on R&D spending as their measure of innovation, these papers tend to find evidence that innovation declines during downturns and that this decline can have medium-run effects on productivity and output. Different papers propose different mechanisms for the decline in innovation, including reduced incentives due to lower demand (Comin and Gertler 2006; Barlevy 2007; Anzoategui et al 2019) or tighter credit market conditions (Bianchi et al 2019; Queralto 2020). Some papers have also argued that innovation will increase during downturns, as weaker economic activity can free up resources and make innovation cheaper (Aghion et al 2012).

Recent papers have begun to explore whether monetary policy can influence innovation and technology adoption and, through this, have medium-run effects on productivity and economic output. Jordà et al (2020), using a cross-country dataset, provide empirical evidence that contractionary monetary shocks lead to lower productivity growth over the medium term. They build a New Keynesian model with endogenous total factor productivity (TFP) growth to motivate their empirical findings.

Moran and Queralto (2018) provide more evidence on the mechanisms for the United States. Using a vector autoregression (VAR) model, they find that contractionary monetary policy lowers innovative activity, as measured by R&D spending. In turn, lower R&D spending tends to lead to slower productivity growth and therefore lower economic output. They build these mechanisms into a New Keynesian model where weaker economic conditions, including those due to contractionary monetary policy, lower the returns to innovation and adoption, and therefore lead to slower innovation as well as slower adoption of innovations. Monetary policy can thus influence productivity and economic output in the medium term. Their model indicates that the medium-run effects of policy and conditions on productivity and output can be sizeable, and therefore of first order importance to policymakers. They estimate that US output and productivity would have been permanently 2 per cent higher had monetary policy not been constrained by the effective zero lower bound following the global financial crisis. Similarly, US productivity and output would have been permanently 1 per cent higher if the tightening of monetary policy from 2016 had been more gradual (though this may have had implications for inflation and inflation expectations).

Ma (2023) focuses on patenting as a measure of innovative activity, again for the United States. He finds that the value and number of patents rise following an expansionary monetary policy shock, which in turn can contribute to higher productivity. He finds that firms with higher liquidity are more responsive than firms with lower liquidity, suggesting that financing constraints play an important role. In a heterogeneous firm model, he shows how this financing constraint mechanism can contribute to longer-lived impacts of monetary policy shocks on productivity and output.

Ma and Zimmerman (2023) focus on similar measures to the two previously mentioned papers, such as R&D spending and patenting, as well as venture capital funding, and find similar results to the above papers for the United States. Similar to our paper, they explore the channels through which monetary policy can affect innovative activity. They find that R&D and patenting are more responsive to monetary policy shocks in cyclical industries, suggesting monetary policy affects innovation by influencing demand conditions – the demand channel. They also find evidence that venture capital funding falls following a contractionary monetary policy shock, which in turn is likely to limit the amount of funds available for innovative activity – the financial channel. Applying standard multipliers from innovative activity to output, they suggest that a 100 basis point contractionary shock could lead to output that is 1 per cent lower five years after the shock.

Amador (2022) focuses on cross-country measures of the take-up of general-purpose technologies, like electrification. He finds that contractionary policy leads to slower diffusion of these technologies, which can weigh on output in the medium term.

Finally, our paper also touches on the large literature exploring global spillovers from US monetary policy. While this literature tends to focus on the effects of US policy on interest rates, investment or output in other countries (e.g. Georgiadis 2016; Arbatli-Saxegaard et al 2022; Kearns et al 2023), we extend this to consider firms' innovative activity.

Footnote

In a related literature, Sedláček and Ignaszak (2021) consider the role that firm-level demand can play in incentivising innovation, and in turn aggregate growth. [2]