Innovation and Growth with Financial, and other, Frictions

Jonathan Chiu, Cesaire Meh, and Randall Wright
CQER Working Paper 13-01
March 2013

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The generation and implementation of ideas, or knowledge, is crucial for economic performance. We study this process in a model of endogenous growth with frictions. Productivity increases with knowledge, which advances via innovation, and with the exchange of ideas from those who generate them to those best able to implement them (technology transfer). But frictions in this market—including search, bargaining, and commitment problems—impede exchange and thus slow growth. We characterize optimal policies to subsidize research and trade in ideas, given both knowledge and search externalities. We discuss the roles of liquidity and financial institutions, and show two ways in which intermediation can enhance efficiency and innovation. First, intermediation allows us to finance more transactions with fewer assets. Second, it ameliorates certain bargaining problems, by allowing entrepreneurs to undo otherwise sunk investments in liquidity. We also discuss some evidence suggesting that technology transfer is a significant source of innovation and showing how it is affected by credit considerations.

JEL classification: E4, G2, O3, O4

Key words: innovation, growth, ideas, technology transfer, liquidity, financial intermediation, search and bargaining

The authors thank many friends and colleagues for comments on earlier work on this and related projects. Randall Wright thanks the Bank of Canada for its hospitality, as well as the National Science Foundation and the Ray Zemon Chair in Liquid Assets at the Wisconsin School of Business for support. The views expressed here are the authors' and not necessarily those of the Bank of Canada, the Federal Reserve Banks of Atlanta or Minneapolis, or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Jonathan Chiu, Bank of Canada, 234 Wellington Street, Ottawa, Ontario K1A 0G9, Canada,; Cesaire Meh, Bank of Canada, 234 Wellington Street, Ottawa, Ontario K1A 0G9, Canada,; or Randall Wright, University of Wisconsin and Federal Reserve Bank of Minneapolis, 5262B Grainger Hall, 975 University Avenue, Madison, Wisconsin 53706,, 608-262-3656.

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