DP18869 Capital Replacement and Innovation Dynamics
We analyze the role of endogenous capital-embodied innovation in macroeconomic dynamics. We first leverage a newly assembled dataset to show that the quality of new capital goods is procyclical because new-product introduction by capital-goods producers drops during recessions. We then develop a model of lumpy investment with heterogeneous firms and endogenous technological progress embodied in new capital. The model features rich interactions between two state variables: (i) the cross-sectional distribution of firms and (ii) the level of technology embodied in the new vintage of capital. The fraction of firms replacing their capital stock affects the incentives for capital-goods producers to innovate through a market-size effect. In turn, the quality of new capital affects the incentives for final-good producers to scrap and replace their old capital. This equilibrium feedback accounts for the observed comovement between investment and innovation, provides a powerful propagation mechanism for macroeconomic shocks, and generates endogenous aggregate-productivity dynamics. Policies that stimulate capital replacement have stronger short-run expansionary effects than policies that stimulate innovation, but are less desirable in the long run.
