Innovation, FDI, and the long‐run effects of monetary policy

• Author: Hung‐Ju Chen
• DOI: http://doi.org/10.1111/roie.12351
• Published date: 01 November 2018
• Date: 01 November 2018

ORIGINAL ARTICLE

Innovation, FDI, and the long-run effects of

monetary policy

Hung-Ju Chen

National Taiwan University, Taipei,

Taiwan

Correspondence

Hung-Ju Chen, Department of

Economics, National Taiwan University,

No. 1, Sec. 4, Roosevelt Road, Taipei

10617, Taiwan.

Email: hjc@ntu.edu.tw

Funding information

Ministry of Science and Technology of

Taiwan

Abstract

This paper studies the long-run effects of monetary policy

on innovation and pattern of production in a North–South

product-cycle model with foreign direct investment (FDI)

and separate cash-in-advance (CIA) constraints on innova-

tive and adaptive R&D. If innovative R&D is subject to the

CIA constraint, then a decrease in the Northern nominal

interest rate raises the rate of Northern innovation, the rate

of FDI, and the North–South wage gap. Regarding the pro-

duction pattern, the extent of Northern production decreases

as the extent of FDI increases. If adaptive R&D is subject to

the CIA constraint, then a decrease in the Southern nominal

interest rate causes the same effects on the rates of innova-

tion and FDI as well as the extents of Northern production

and FDI as those in the case of a decrease in the Northern

nominal interest rate. However, such a monetary policy

change reduces the North–Southwagegap.Thisstudyalso

analyzes the stability of the long-run equilibrium and exam-

ines the responses of social welfare for Northern and

Southern consumers to monetary policy.

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INTRODUCTION

The effects of monetary policy on economic performance have long been a central issue in macroeco-

nomics.

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Based on a descriptive aggregate model, the pioneering paper of Tobin (1965) argues that a

higher-money growth rate reduces the real interest rate and raises the accumulation of physical capital.

Stockman (1981) and Abel (1985) develop a cash-in-advance (CIA) model where consumption/invest-

ment is subject to the CIA constraint. This has since become a popular model to study the impact of

monetary policy and subsequently has undergone various modifications in several studies assessing the

effects of monetary policy.

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Previous studies examining the effects of monetary policy tend to focus on a model in which

growth depends on the accumulation of physical and human capital and lean towards ignoring the

impact on innovation. However, Romer (1990), Grossman and Helpman (1991d), and Jones (1995)

Received: 25 May 2017

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Revised: 15 March 2018

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Accepted: 16 March 2018

DOI: 10.1111/roie.12351

Rev Int Econ. 2018;26:1101–1129. wileyonlinelibrary.com/journal/roie

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© 2018 John Wiley & Sons Ltd

demonstrate that innovation resulting from research and development (R&D) is also an important

engine for growth. Using the data of OECD countries, Aghion and Howitt (2009) show that total factor

productivity (TFP) growth accounts for about two-thirds of economic growth for these countries. Since

the empirical evidence suggests that there is a significant relationship between R&D expenditures and

cash flows (Hall, 1992; Opler, Pinkowitz, Stulz, & Williamson, 1999; Himmelberg & Petersen, 1994),

monetary policy would affect growth through the channel of innovative R&D. Chu and Cozzi (2012)

and Huang, Chang, and Ji (2014) introduce the CIA-constrained property into a closed-economy prod-

uct-cycle model to look at how monetary policy affects innovation and the market structure.

Empirical studies find that R&D expenditures are subject to a cash constraint for several reasons.

Hall and Lerner (2010) demonstrate that in practice 50 percent or more of R&D spending goes to the

wages and salaries of highly educated technology scientists and engineers. Projects often take a long

time between conception and commercialization, and the departure of these highly educated workers

will reduce a firm’s profits. In order to avoid the departure of these workers, firms tend to hold cash in

order to smooth their R&D spending over time. Moreover, Brown and Petersen (2009, 2011) provide

direct evidence that during the 1998 to 2002 boom and bust in stock market returns, U.S. firms relied

heavily on cash reserves to smooth R&D expenditures. This is because R&D has high adjustment costs

and it is very expensive for firms to adjust the flow of R&D in response to transitory finance shocks.

Brown, Fazzari, and Petersen (2009) develop and estimate a dynamic R&D model for high-tech firms

and find that cash holdings have a significant impact on R&D in young firms. Brown, Martinsson, and

Petersen (2012) argue that the lack of collateral value and information friction make R&D more sensi-

tive to financing frictions. Therefore, R&D-incentive firms tend to hold cash to avoid financing R&D

investment through debt or equity. Using a large sample of European firms, they find strong evidence

that the availability of finance matters for R&D once they control for a firm’s efforts to smooth R&D

with cash reserves and a firm’s use of external equity finance.

Technological progress has caused improvements in transportation and telecommunications, mak-

ing international production through foreign direct investment (FDI) quite common nowadays. The

availability of FDI allows firms to choose to produce goods domestically or abroad as a means of sav-

ing costs. Several studies use an R&D model with FDI to examine how a policy change in intellectual

property rights protection in developing countries affects innovation in developed countries (Glass &

Saggi, 2002; Parello, 2008; Dinopoulos & Segerstrom, 2010; Chen, 2015, 2018). Aside from the pol-

icy of intellectual property rights protection, international production also makes monetary policy in

one country exhibit cross-country influences owing to the adjustment of the production pattern for

firms in response to these policy changes. Chu, Cozzi, and Furukawa (2013) develop a two-country

model to analyze how monetary policy affects innovation and technology transfer via FDI.

This paper investigates the long-run macroeconomic effects of monetary policy in a two-country

(North and South) product-cycle model with FDI and quality improvements of goods. The product-

cycle model is originally introduced by Vernon (1966) and subsequently developed by Segerstrom,

Anant, and Dinopoulos (1990), and Grossman and Helpman (1991a,b,c). Our product-cycle model is

made up of a North country (a developed country) with innovative R&D and a South country (a devel-

oping country) with adaptive R&D through FDI. Innovation improves the quality of goods. Northern

workers can work either in the R&D sector or in the production sector. Northern firms choose either to

carry out the entire production of the goods in the North or allow the goods to be produced through

FDI in the South. There is a tradeoff for Northern firms when deciding to produce in the South through

FDI. Multinational firms produce products in the South through the use of state-of-the-art technologies

(adaptive R&D) so as to take advantage of the lower Southern wage rate, but they face the risk of imi-

tation by Southern firms. Once Southern firms succeed at imitation, they are able to use the state-of-

the-art technologies to produce the highest quality products.

CHEN

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