Monetary Policy in a Schumpeterian Growth Model with Two R&D Sectors

Abstract

We explore the growth and welfare effects of monetary policy in a two-sector Schumpeterian economy with cash-in-advance (CIA) constrained R&D investment in both sectors. We show that a nominal interest rate increase generates two effects on equilibrium labor allocation: a manufacturing-R&D-reallocation effect and a cross-R&D-sector effect. The former reduces economic growth by shifting labor from R&D to production, whereas the latter can enhance it by shifting labor from the less productive R&D sector to the more productive one. From the welfare perspective, we show that unless the high productivity R&D sector is severely more CIA-constrained than the low productivity one, aggregate R&D overinvestment is sufficient but not necessary for the Friedman rule of monetary policy to be suboptimal. Our benchmark parameterization suggests that a positive nominal interest rate is optimal despite that it exacerbates the aggregate R&D underinvestment problem.