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Commonly used DSGE business cycle models focus on the cyclical fluctuations around a constant
exogenous trend of output. In this paper, we embed Schumpeterian innovation into the intermediate
production sector within a New Keynesian model with nominal wage and price stickiness and we
show that endogenous decisions to invest in R&D have implications for the likelihood of innovating
and pushing the technological frontier, while adding a relevant transmission channel for common
shocks that are consequential for business cycles. This raises important theoretical, methodological,
and empirical points, with both qualitative and quantitative dimensions.
Theoretically, new challenges at the modelling and simulation stages are addressed, in particular
with respect to the interaction between Schumpeterian innovation and price rigidities, as well as
between business cycle and growth. The introduction of Schumpeterian innovation makes it also
conceivable to consider the implications of knowledge-spillover shocks, as an additional dimension
not found in usual business cycle models.
Methodologically, the cyclical behaviour of the technological frontier's growth rate points out the importance
of explicitly applying the same treatment to both simulated and observed macroeconomic
variables. This has ramifications for the interpretation of the cyclical impulse response functions,
as well as for the cumulative impact on the levels of macroeconomic variables.
In a general equilibrium model that features jointly New Keynesian and real business cycles characteristics
with Schumpeterian growth, we show that the interplay of innovation with optimal pricesetting
in the intermediate sector both spells out how the technological frontier advances, but also
implies that more innovation leads to more price flexibility in a world with nominal rigidities.
We find that a reasonable calibration of the model makes it possible to get key moments and comovements
for important macroeconomic variables that are consistent with their observed counterparts.
It also reveals the cyclical impacts of various common shocks as well the knowledge-spillover
shocks on macroeconomic variables. In particular, the variables' dynamics are not invariant to the
parameter calibration of steady-state endogenous growth. Moreover, there are important welfare
implications of different combinations of steady-state innovation probability and extent of knowledge
spillovers, for the same steady-state growth rate of the economy. For instance, accounting for
dynamic interactions, a 23% quarterly probability of innovating consistent with an annual 1.95% of
the technological frontier raises welfare in consumption-equivalent terms by 4.7% higher level, by
comparison to a 15% quarterly innovation probability.
KEY WORDS: Schumpeterian endogenous growth; Innovation; Business cycles; New Keynesian
dynamic stochastic general equilibrium (DSGE) model; nominal price rigidity and flexibility.
JEL CODE: E32, E52, O31, O33, O42
