Fluctuations in R&D Investment and Long-run Growth: The Role of the Size Distribution of Innovating Firms

R&D investment drives productivity growth. Therefore, its fluctuations over the business cycle affect long-run dynamics. I show that taking into account the size distribution of innovating firms generates new insights on this link. I write an endogenous growth model with heterogeneous firms assuming, in line with empirical evidence, that small firms have a relatively higher innovation capacity than large firms. In addition, the model predicts that small firms reduce R&D more than large firms after negative aggregate shocks, especially financial ones. These differences between firms generate two novel predictions at the aggregate level. First, a financial shock leads to a rightward shift in the size distribution of innovating firms. This amplifies the shock's effect on productivity growth and makes it persistent over time. Second, there is a positive correlation between the share of an industry's innovations done by small firms, the industry's average productivity growth rate and the volatility of that growth rate. Firm-level empirical evidence supports the greater reaction of small firms ' R&D to negative aggregate shocks, and the model's aggregate predictions are consistent with a line of stylized facts