Monetary Policy, Financial Frictions, and Heterogeneous R&D Firms in an Endogenous Growth Model*

• Author: Takeo Hori
• DOI: http://doi.org/10.1111/sjoe.12387
• Published date: 01 October 2020
• Date: 01 October 2020

Scand. J. of Economics 122(4), 1343–1373, 2020

DOI: 10.1111/sjoe.12387

Monetary Policy, Financial Frictions, and

Heterogeneous R&D Firms in an

Endogenous Growth Model*

Takeo Hori

TokyoInstitute of Technology,Tokyo 152-8552, Japan

hori.t.ag@m.titech.ac.jp

Abstract

Motivated by empirical facts, I construct an endogenous growth model in whichheterogeneous

research and development (R&D) firms are financially constrained and use cash to finance R&D

investments. I also examine the optimal monetary policy. The effects of financial constraint

crucially depend on whether R&D firms are homogeneous or heterogeneous regarding R&D

productivity.If R&D firms are homogeneous, then the zero nominal interest rate (i.e., the Friedman

rule) is alwaysoptimal under severe financial constraint. Heterogeneity in R&D productivity leads

to the opposite result. With heterogeneity, severe financial constraint makes the strictly positive

nominal interest rate welfare-improving under a plausible condition.

Keywords: Cash-in-advance constraint; financial frictions; Friedman rule; heterogeneous firms;

R&D

JEL classification:E52; O30; O40

I. Introduction

Monetary policy affects corporate investment activities. If firms are

financially constrained, a high interest rate can depress their investments

by restricting access to external funds. It might be expected that the

interest rate should be as low as possible to stimulate investment.

However, when considering the presence of heterogeneity in productivity

among firms, a low interest rate can cause undesirable investment

consequences. A low interest rate could stimulate investments of low-

productive firms, increasing the resources allocated to them. Thus, a

low interest rate might end up causing inefficient resource allocation

among heterogeneous firms. In this study, I examine how the interaction

between firm heterogeneity and financial frictions affects firms’ investment

*I am grateful to Hiroki Arato, Ryoji Ohdoi, Hiroaki Ono, Naoki Takayama, Daichi Shirai, and

two anonymous referees for their comments. This research was financially supported by JSPS

KAKENHI Grant Nos 15K17025 and 18K01502. All remaining errors are mine.

C

The editors of The Scandinavian Journal of Economics 2019.

1344 Heterogeneous R&D firms

activities and the optimal monetary policy, especially the optimal interest

rate.1

For this purpose, I introduce firm heterogeneity into an endogenous

growth model based on research and development (R&D). As the effects on

investment activities are likely to be visible primarily in the long run, I use

an endogenous growth framework that focuses on long-run growth. Many

authors argue that external finance for R&D investments might be more

costly than other types of investments. In fact, empirical studies such as

Himmelberg and Petersen (1994) and Brown etal. (2009) provide evidence

that financial constraints matter for R&D investments more than for other

types of investments. Interestingly, Hajivassiliou and Savignac (2008) and

Hottenrott and Peters (2012) find that firms with high R&D abilities are

more likely to be financially constrained.2These facts, discussed in detail

in Section II, provide the motivation to build on an R&D-based growth

model. Moreover, some studies emphasize the fact that firms tend to rely

on cash to finance R&D (Berentsen et al., 2012; Chu and Cozzi, 2014; Chu

et al., 2015). Following these authors, I introduce a cash-in-advance (CIA)

constraint in the R&D sector.

Specifically, I extend the quality-ladder model proposed by Grossman

and Helpman (1991) as follows. R&D activities improve the productivity of

intermediate goods production. There is heterogeneity in R&D productivity

among R&D firms. At each moment in time, R&D firms decide whether to

conduct R&D activities; R&D firms with productivity higher (lower) than

a certain threshold can (cannot) operate. As in Grossman and Helpman

(1991), R&D firms need external funds to finance R&D investments. To

capture financial frictions, I depart from the standard setting as follows.

After completing R&D activities, R&D firms decide whether to repay

external funds. Defaulting firms can avoid a penalty with a positive

probability. Thus, R&D firms have an incentive to default. Because of this

1Recent studies mainly focus on the price stabilization properties of the monetary policy. The

effects of interest rates might not be a primary concern for monetary authorities. However, one

purpose of the zero-interest-rate policy after the 2008 crisis was to stimulate investments by

reducing borrowing costs. Thus, I believe that it is also important to examine the effects of

monetary policies on investments.

2This finding is somewhat counterintuitive. However, it can be interpreted as follows. Suppose

that each firm has an optimal amount of R&D investments. It is natural that this amount increases

with R&D productivity of the firm. Each firm tends to rely on external funds to finance R&D

investments. If R&D productivityof fir ms is unobservable,then lenders cannot distinguish high-

productivefirms from low-productive firms. Then, both high-productive and low-productivefirms

might obtain similar amounts of external funds. Because the optimal R&D investments of high-

productive firms are large, such firms tend to suffer from severe shortage of funds, and tend to

be financially constrained.

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The editors of The Scandinavian Journal of Economics 2019.