Finance, R&D Investment, and TFP Dynamics

Abstract

This paper investigates the role of R&D investment in shaping the relationship between financial constraints and aggregate total factor productivity (TFP). I study a dynamic model in which R&D investment, which affects productivity evolution endogenously, is subject to financial constraints. I parameterize the model with production, innovation, and balance sheet data. The estimated model implies sizeable static TFP losses caused by capital misallocation and dynamic TFP losses from distorting R&D investment. The accumulation of internal funds reduces the static TFP loss gradually. In contrast, because R&D has a persistent effect on productivity, the dynamic TFP loss rises initially and declines later. Compared to a model with exogenous productivity, innovation investment makes firms less able to use self-financing to reduce TFP losses, and prolongs the transition. Endogenous productivity growth amplifies the gains in TFP and output from financial reform, and leads to a longer-lasting consequence from a credit crunch. Improving the pledgeability of intangible assets in China to be the US level reduces the static TFP loss only 0.4%, but the dynamic TFP loss by 7.1%.