Capital Replacement and Innovation Dynamics

Abstract:

We analyze the role of endogenous capital-embodied innovation for macroeconomic dynamics. We provide empirical evidence that new-product introduction by capital-goods producers is an engine of long-run technological progress, but drops during recessions, when investment demand is weak. We then develop a model of investment with heterogeneous firms and endogenous capital-embodied innovation. The model features two endogenous state variables: (i) the cross-sectional distribution of firms and (ii) the quality of new capital. The fraction of firms replacing their capital determines the incentives for capital-goods producers to innovate through a market-size effect. In turn, growth in new-capital quality induces final-good producers to replace their old capital. This feedback provides a propagation mechanism for macroeconomic shocks and generates fluctuations in productivity. We analyze efficiency in the model and show that capital-replacement subsidies have stronger stimulus effects than innovation subsidies in the short run, but are less desirable in the long run.