Inflation and Innovation in a Schumpeterian Economy with North–South Technology Transfer

• Published date: 01 March 2019
• Author: ANGUS C. CHU,GUIDO COZZI,YUICHI FURUKAWA,CHIH‐HSING LIAO
• Date: 01 March 2019
• DOI: http://doi.org/10.1111/jmcb.12514

DOI: 10.1111/jmcb.12514

ANGUS C. CHU

GUIDO COZZI

YUICHI FURUKAWA

CHIH-HSING LIAO

Inflation and Innovation in a Schumpeterian

Economy with North–South Technology Transfer

This study analyzes how inflation affects innovationand international tech-

nology transfer via cash-in-advance constraints on R&D. We consider a

North–South quality-ladder model that features innovative Northern R&D

and adaptive Southern R&D. Wefind that higher Southern inflation causes

a permanent decrease in technology transfer, a permanent increase in the

North–South wage gap, and a temporary decrease in the Northern innovation

rate. Higher Northern inflation causes a temporary decrease in the Northern

innovation rate, a permanent decrease in the North–South wage gap, and

ambiguous effects on technology transfer.Finally, we calibrate the model to

China–U.S. data to perform a quantitative analysis.

JEL codes: E41, F43, O30, O40

Keywords: inflation, economic growth, R&D, North–South product

cycles, FDI.

THE RELATIONSHIP BETWEEN INFLATION AND economic growth

has been a fundamental question in macroeconomics ever since the seminal work

of Tobin (1965). Subsequent studies in this literature tend to focus on how inflation

affects economic growth via the accumulation of physical capital and/or human

The authors would like to thank Sanjay K. Chugh (the Editor) and two anonymous Referees for their

insightful comments and Xun Zhang for his helpful research assistance. Furukawagratefully acknowledges

a grant-in-aid from the Zengin Foundation for Studies on Economics and Finance.

ANGUS C. CHU is a professor of economics at China Center for Economic Studies, Schoolof Economics,

Fudan University and a research fellow at Shanghai Institute of International Finance and Economics

(E-mail: angusccc@gmail.com). GUIDO COZZI is a professor of macroeconomics at the Department of

Economics, University of St. Gallen, Switzerland (E-mail: guido.cozzi@unisg.ch). YUICHI FURUKAWA is a

professor at the School of Economics, Chukyo University,and Faculty Fellow at the Research Institute of

Economy, Tradeand Industry, (E-mail: you.furukawa@gmail.com). CHIH-HSING LIAOis an associate pro-

fessor at the Department of Economics, Chinese Culture University,(E-mail: chihhsingliao@gmail.com).

Received December 22, 2016; and accepted in revised form March 29, 2018.

Journal of Money, Credit and Banking, Vol.51, Nos. 2–3 (March–April 2019)

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2018 The Ohio State University

684 :MONEY,CREDIT AND BANKING

capital.1However,the seminal study by Solow (1956) shows that economic growth is

ultimately driven by technological progress, at least in the long run. Therefore, to fully

capture the effects of inflation on economic growth, it is important to explore how

inflation affects economic growth via endogenous technological progress. Studies in

this more recent branch of the literature2however have mostly focused on a closed-

economy analysis. Given the importance of cross-country spillover effects of R&D

as shown by Coe and Helpman (1995) and Coe, Helpman, and Hoffmaister (2009)

among others, this study analyzes how inflation affects innovation and international

technology transfer.

Specifically, we explore the cross-country effects of inflation on innovation and

international technology transfer via foreign direct investment (FDI) in a scale-

invariant North–South quality-ladder growth model that features innovative R&D in

the North and adaptive R&D in the South. Multinational firms investin adaptive R&D

in the South to transfer the production of the highest quality products from the North

to the South in order to take advantage of the lower Southern wage rate. To model

money demand, we impose cash-in-advance (CIA) constraints on R&D investment,

which is costly and subject to cash requirements in reality; see for example Chu et al.

(2015) for a discussion of empirical evidence.3We capture these cash requirements

on R&D by imposing CIA constraints on innovative R&D in the North and adaptive

R&D in the South. Within this monetary growth-theoretic framework, we derive the

following results.

Higher inflation in the South causes a permanent decrease in the rate of interna-

tional technology transfer via the Southern CIA constraint on adaptive R&D. Higher

inflation in the South also has the following general-equilibrium effects: a permanent

increase in the North–South wage gap, and a temporary decrease in the rate of inno-

vation in the North. Intuitively, higher inflation in the South raises the cost of adaptive

R&D, which in turn reduces the incentives for international technology transfer. As

a result, less products are manufactured by Southern firms and more products are

produced by Northern firms. The higher demand for production labor in the North

reduces R&D labor, which in turn decreases the rate of Northern innovation but

only temporarily due to the semi-endogenous-growth property of the model. Finally,

given that higher inflation in the South has a direct negative effecton the demand for

Southern R&D labor, it depresses the wage rate in the South relative to the North.

1. See, for example, Stockman (1981), Abel (1985), Dotsey and Ireland (1996) and Gillman and Kejak

(2005).

2. See, for example, Marquis and Reffett (1994), Chu and Lai (2013) and Chu and Cozzi (2014).

3. Early empirical studies, such as Hall (1992) and Opler et al. (1999), show a positive and significant

relationship between R&D expenditures and cash flows in U.S. firms. From 1980 to 2006, the average

cash-to-assets ratio in U.S. firms increased substantially, and Bates, Kahle, and Stulz (2009) argue that

this trend is partly driven by the firms’ increasing R&D expenditures. Brown and Petersen (2011) show

that firms smooth their R&D expenditures by maintaining a buffer stock of liquidity in the form of cash

reserves. Berentsen, Breu, and Shi (2012) argue that information frictions and limited collateral value of

R&D capital require firms to finance R&D projects with cash. Falato and Sim (2014) use firm-level data

in the United States to show that firms’ cash holdings increase (decrease) significantly in response to a

rise (cut) in R&D tax credits. These results suggest that due to financial frictions, firms need to use cash

to finance their R&D investment.

ANGUS C. CHU ET AL. :685

Higher inflation in the North causes a temporary decrease in the rate of Northern

innovation via the CIA constraint on innovativeR&D in the North. Higher inflation in

the North also has the following general-equilibrium effects: a permanent decrease in

the North–South wage gap, and an ambiguous effect on the rate of technology transfer

from the North to the South depending on the relative size of the two economies.

Specifically, we find that if the Southern population size is sufficiently large (small),

then an increase in the inflation rate in the North would cause a permanent decrease

(increase) in the rate of technology transfer from the North to the South. Intuitively,

higher inflation in the North raises the cost of innovative R&D, which in turn reduces

the incentives for innovation.As a result, the rate of innovation decreases temporarily.

Given that higher inflation in the North has a direct negative effecton the demand for

Northern R&D labor, it depresses the wage rate in the North relative to the South.

As for the effects on the rate of international technology transfer, there are two

opposing effects. On the one hand, it reduces the long-run level of aggregate quality,

which reduces the difficulty of adaptive R&D due to the property of increasing

R&D difficulty in the semi-endogenous growth model.4This is a positive effect on

international technology transfer. On the other hand, higher inflation in the North

also reduces the incentives for adaptive R&D because there are less benefits from

FDI due to the smaller North-South wage gap. This negative effect on international

technology transfer via adaptive R&D labor in the South is relatively strong when the

Southern labor force is large. Therefore, the overall effect of higher inflation in the

North on technology transfer would be negative (positive)if the Southern population

size is sufficiently large (small).

We calibrate the model to China–U.S. data in order to conduct a quantitative

investigation on the cross-country effects of inflation via the CIA constraints. We

find that permanently decreasing inflation to achieve the Friedman rule (i.e., a zero

nominal interest rate) in the United States would raise the wage gap between the

United States and China by 0.18% (percent change) and surprisingly decrease the

flow of technology transfer from the United States to China by 1.06% (percent

change). Decreasing inflation in the United States also leads to welfare gains that are

equivalent to a permanent increase in consumption of 4.93% in the United States and

5.02% in China. These significant welfare gains are due to a large increase in the

level of technology by 4.09%. Therefore, the cross-country welfare effect of inflation

is quantitatively significant from the North to the South.

On the other hand, permanently decreasing inflation to achieve the Friedman

rule in China would reduce the wage gap between the United States and China by

0.20% and increase the flow of technology transfer from the United States to China

by 1.21%. Also, it leads to relatively small welfare gains of 0.41% in China and

0.43% in the United States. These small welfare gains are partly due to the small

increase in the level of technology by 0.39%. In other words, reducing inflation in

China leads to a much smaller increase in the level of technology than reducing

4. See Venturini(2012) for empirical evidence based on U.S. manufacturing industry data that supports

the semi-endogenous growth model with increasing R&D difficulty.