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

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.