R&D policy in a volatile economy

The literature on R&D-based growth establishes that market equilibrium is inefficient and derives optimal R&D policy. Normative analyses of this type use the assumption of steady state, largely motivated by analytical convenience. This paper questions this steady-state approach by introducing endogenous cycles as long-run equilibria. We show that the government fails to maximize welfare if policy which is optimal in steady state is myopically applied in cyclical equilibria. More specifically, we demonstrate that (i) cycles arise in the (very) standard R&D-based model of Grossman and Helpman [1991. Innovation and Growth in the Global Economy. MIT Press, Cambridge, MA (Chapter 3)] once the model is framed in discrete time, (ii) these cycles are inefficient in the sense that they prevent welfare maximization, (iii) optimal steady-state R&D policy fails to eliminate cycles, and can even create inefficient cycles, (iv) the application of R&D subsidies leads to a trade-off between growth and macroeconomic stability, and (v) optimal R&D policy in a fluctuating economy is state-dependent, which generalizes optimal steady-state R&D policy.