Inflation and Growth: A Non-Monotonic Relationship in an Innovation-Driven Economy

Abstract

This paper investigates the effects of monetary policy on long-run economic growth via different cash-in-advance (CIA) constraints on R&D in a Schumpeterian growth model with vertical and horizontal innovations. The relationship between inflation and growth is contingent on the relative extents of CIA constraints and diminishing returns to two types of innovation. This model can generate a mixed (monotonic or non-monotonic) relationship between inflation and growth, given that the relative strength of monetary effects on growth between different CIA constraints and that of R&D-labor-reallocation effects between different diminishing returns vary with the nominal interest rate. In the empirically relevant case where horizontal R&D is subject to larger diminishing returns than vertical R&D, inflation and growth can exhibit an inverted-U relationship when the CIA constraint on horizontal R&D is sufficiently larger than that on vertical R&D. Finally, we calibrate the model to the US economy and find that the growth-maximizing rate of inflation is around 2.4%, which is consistent with the recent empirical estimates.

Inflation, endogenous quality increment, and economic growth

“…The discount rate ρ is set to a conventional value of 0.02. As for the strength of the CIA constraint on consumption (i.e., ξ), we follow Zheng et al (2019) to set it to 0.17, for matching the ratio of M1-consumption in the US. As for the strength of the CIA constraint on manufacturing, we follow Arawatari et al (2018) to set α = 1 as the benchmark.…”

“…A noticeable representative along this line of effort is the pioneering work of Marquis and Reffett (1994), which explores the effects of inflation on growth in the framework of Romer (1990). 2 A great number of studies have analyzed the effects of inflation in a Schumpeterian quality-ladder model, such as Chu and Lai (2013), Chu and Cozzi (2014), Chu et al (2015), Chu and Ji (2016), Huang et al (2017), Oikawa and Ueda (2018), Zheng et al (2019), Huang et al (2019), andGil andIglésias (2020). These models, however, all feature an identical step size of quality improvement.…”

Trade for catch-up: examining how global value chains participation affects productive efficiency

“…The inflation rate variability, black market premium, and interest rate variability are widely used proxies for macroeconomic conditions. Existing studies have shown that poor macroeconomic conditions, as measured by these indicators, disincentivize economic actors from engaging in productive economic activities or reaping the benefits thereof (Kandil 1992;Ćorić and Pugh 2010;Zheng et al 2021). It also prevents the economy from adjusting effectively to technological change.…”

Inflation, innovation, and growth: A survey

“…which is now decreasing in the nominal interest rate 𝑖 only via the CIA constraint on R&D investment (i.e., 𝛽 > 0). Huang et al (2021) and Zheng et al (2021) also consider the second-generation Schumpeterian growth model and confirm that an increase in the nominal interest rate has a negative effect on economic growth via the CIA constraint on quality-improving R&D. Interestingly, they find that an increase in the nominal interest rate has a positive effect on economic growth via a CIA constraint on variety-expanding R&D. The intuition of this result can be seen from ( 21), which shows that a smaller number of products 𝑁 gives rise to a higher growth rate 𝑔 = 𝜆 ln 𝑧 by increasing the amount of resources for the innovation of each product. 7…”