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

AuthorTakeo Hori
Publication Date01 Oct 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
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;
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.
The editors of The Scandinavian Journal of Economics 2019.
1344 Heterogeneous R&D firms
activities and the optimal monetary policy, especially the optimal interest
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.
The editors of The Scandinavian Journal of Economics 2019.

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