The Aggregate Implications of Innovative Investment in the Garcia-Macia, Hsieh, and Klenow Model

We extend the model firm dynamics of Garcia-Macia, Hsieh, and Klenow (2016) to include a description of the costs of innovative investments as in the model of Klette and Kortum (2004). In this model, aggregate productivity (TFP) grows as a result of innovative investment by incumbent and entering firms in improving continuing products and acquiring new products to the firm. This model serves as a useful benchmark because it nests both Quality-Ladders based Neo-Shumpeterian models and Expanding Varieties models commonly used in the literature and, at the same time, it provides a rich model of firm dynamics as described in GHK. We show how data on firm dynamics and firm value can be used to infer the elasticities of aggregate productivity growth with respect to changes in incumbent firms' investments in improving their incumbent products, incumbent firms' investments in acquiring products new to the firm, and entering firms' investments in acquiring new products. As discussed in Atkeson and Burstein (2015), these elasticities are a crucial input in evaluating the extent to which it is possible to alter the medium term growth path of the macroeconomy through policies aimed at stimulating innovative investments by firms. We use these methods to provide quantitative estimates of these elasticities of aggregate TFP growth with respect to changes in each of the three categories of innovative investment in the model as well as of the rate of social depreciation of innovation expenditures.