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For more than 50 years, most economists have agreed that actions taken by central banks to stabilize prices and output can have short-term—but not long-term—effects. The late Milton Friedman, a Nobel laureate who studied and worked at the University of Chicago, argued as much during a 1968 presidential address to the American Economic Association.
But monetary policy in the United States might not be so neutral in the longer term, especially related to its impact on innovation, according to research from Chicago Booth’s Yueran Ma and Frankfurt School of Finance and Management’s Kaspar Zimmermann. Their analysis suggests that high interest rates can discourage companies and industries from investing in technology, leading to a slower pace of innovation that can limit economic growth.
To understand the link between innovation funding and monetary-policy shocks, Ma and Zimmermann studied widely used innovation indicators, including aggregate US investment in intellectual property as well as venture-capital investment, public companies’ research and development spending, and patent filings. Their analysis covers monetary-policy shocks between 1969 and 2007 and focuses on the effects of conventional policy—namely adjusting interest rates—rather than unconventional moves such as quantitative easing.
For every 1 percentage point rise in interest rates, Ma and Zimmermann calculate, R&D spending fell by between 1 and 3 percent and VC investment fell by about 25 percent one to three years after the hike. Similarly, within four years of an interest-rate increase, patent filings and innovation each declined by 9 percent.
After five years, the researchers infer, these shifts can lower overall economic output by 1 percent and decrease total factor productivity, a measure of how many more goods and services are produced with the same resources, by 0.5 percent.
To analyze how innovation activities respond to monetary-policy tightening over time, the researchers traced the impact of an interest-rate shock across various measures using a tool called an impulse response function.
Why does monetary policy affect innovation? Increasing interest rates can reduce aggregate demand and make it less profitable to innovate, so companies have less incentive to develop new products. Monetary tightening can also sap investors’ appetite for risk-taking and reduce the availability of financing for innovation.
In the past decade, when interest rates were low, venture funding increased by about 20 percent annually, according to industry data. As interest rates rose substantially starting in early 2022, however, venture funding fell by about 30 percent annually, Ma and Zimmermann note. The decline in funding occurred in all major industries. Artificial intelligence has been one exception, thanks to the recent breakthroughs in generative AI.
When high interest rates decrease innovation, the reduction does not just come from having less bubble and froth. The number of new patents filed for important technologies—innovations such as mobile devices, machine learning, and cloud computing that were big topics in companies’ quarterly earnings calls—appear to be more affected by rising interest rates than patenting in general, the research suggests, potentially because the technologies are novel and riskier.
The research suggests that monetary policy could have a persistent influence on the US economy. But Ma and Zimmermann don’t recommend that central banks lower interest rates just to stimulate innovation and growth. “It is well recognized that efforts seeking to perennially stimulate the economy with monetary easing can be ineffective or counterproductive,” they write—but they think the evidence points to the need to conduct more research about optimal monetary policy that takes into account these longer-term effects.
Yueran Ma and Kaspar Zimmermann, “Monetary Policy and Innovation,” Working paper, September 2023.
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