Abstract
This paper investigates the effects of aggregate stock market liquidity on innovation at both aggregate and firm levels for publicly traded firms in the U.S. I show that both effects are significantly positive. Next, I provide two underlying mechanisms through which aggregate stock liquidity enhances innovation. First, high stock market liquidity reduces the cost of raising external capital, making it easier for firms, especially for small firms and those with R&D investments, to issue equity and finance their innovation. Second, high stock market liquidity generates high firm valuation and reduces transaction costs, motivating large firms to buy innovation from small firms through merger and acquisition activities. Overall, I document that, unlike Fang, Tian, and Tice (2013), who argue that stock liquidity impedes innovation at the firm level, aggregate stock market liquidity plays a very important and positive role in enhancing aggregate innovation.
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