Innovation and Endogenous Growth over the Business Cycle with Frictional Labor Markets

Abstract

This paper proposes a microfounded model featuring frictional labor markets
that generates procyclical R&D expenditures as a result of optimizing behavior
by heterogeneous monopolistically competitive firms. This allows to show
that business cycle fluctuations affect the aggregate endogenous growth rate
of the economy. Consequently, transitory shocks leave lasting level effects.
This mechanism is responsible for economically significant hysteresis effects that
significantly increase the welfare cost of business cycles relative to the exogenous
growth model. I show that this has serious policy implications and creates
ample space for policy intervention. I find that several static and countercyclical
subsidy schemes are welfare improving. Importantly, I find that due to labor
market frictions subsidizing incumbent firms generates large and positive welfare
effects.