Donghai Zhang (National University of Singapore)

Lumpy R&D and the Great Twins: Great Moderation and Great Recession

Abstract: We document that firm-level R&D investments are lumpy, characterized by episodes of inaction and large increases in R&D expenses, suggesting the relevance of R&D decisions along the extensive margin.  Furthermore, the extensive margin, measured as the share of firms making spike adjustments in their R&D expenses, is pro-cyclical and explains 75% of the pro-cyclicality of aggregate R&D. Motivated by these empirical findings, we develop a medium-run business cycle model with heterogeneous innovative firms and fixed adjustment costs, featuring lumpy R&D. Within this framework, we identify a novel mechanism that gives rise to the `Great Twins’ hypothesis: the Great Moderation caused the observed severity of the Great Recession. We provide micro- and macro-level evidence supporting this hypothesis. Finally, we discuss the policy implications of our findings, including the novel tail-risk and variance tradeoff faced by central banks.