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Is employment higher in an economy that has a higher rate of innovation? In Hoonand Phelps (1997), we study this question in the small open, and closed, economy underthe assumption that the rate of technological progress is exogenous to the economic system.In this paper, we reexamine this question in the context of a model with endogenousproduct innovation (and thus endogenous technological progress) and endogenous laborsupply first in a small open economy taking the world interest rate as given and then ina closed economy that determines the whole term structure of the interest rate. In ourpresent model, creating a given flow of new ideas per unit time directly generates labordemand. Indirectly, as later innovations can benefit from a larger stock of ideas (“thestanding on the shoulders of giant” effect), thus requiring less R&D labor input to createa new idea, an economy that has been growing more rapidly in the past demands lesslabor input now to create a given flow of new ideas. Another source of labor demand inour model economy comes from the production of a variety of intermediate inputs whoseproduct designs have already been discovered through past R&D activity. We find thatin both the small open economy and the closed economy, a policy shock that leads to a higher rate of innovation also increases aggregate labor demand. When a shock leadsthe model economy to transit to a higher steady-growth path, the transition path ischaracterized unambiguously by rising stock market capitalization (taken as a ratio toGDP) in the closed economy. In the small open economy, there is the possibility thathigher growth is accompanied by declining stock market capitalization (taken as a ratioto GDP) as GDP races ahead of the stock market on the transition path. In both casesemployment is unambiguously rising with the possibility of overshooting in the smallopen economy. In terms of labor supply, the transition to a higher steady-growth pathleads agents to plan a rising path of employment until they reach the steady state whereemployment stays constant at a permanently higher level absent another shock. Whatinduces agents to keep postponing their leisure along such a transition path is the fallingconsumption-growth-adjusted real rate of interest and accelerating wage increases. Theprospect of a permanently higher debt-to-GDP ratio in the future requiring a higherpayroll tax rate to ensure fiscal solvency leads to a transient period of slower innovation,declining or rising stock market capitalization (taken as a ratio to GDP), and reducedemployment in the small open economy. In the closed economy, the same shock haspermanent effects as the economy settles on a lower steady-growth path with reducedemployment and lower stock market capitalization (taken as a ratio to GDP).


Innovation, employment, R&D subsidy, public debt


Labor Economics | Technology and Innovation

Research Areas

Economic Theory

Creative Commons License

Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License
This work is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 4.0 License.