Heterogeneous Innovations, Firm Creation and Destruction, and Asset Prices
54 Pages Posted: 12 Mar 2015 Last revised: 25 Sep 2015
Date Written: September 11, 2015
We study the implications of the creative destruction lifecycle of innovation for asset prices. We develop a general equilibrium model of endogenous firm creation and destruction where 'incremental' innovations by incumbents and 'radical' innovations by entrants drive productivity improvements. Micro-founded incentives of firms to innovate lead to the joint equilibrium determination of time-varying economic growth and countercyclical economic uncertainty. The model quantitatively matches key properties of consumption and asset prices, as well as novel stylized facts on the process of creative destruction in the U.S. economy obtained using a comprehensive sample of patents over the 1975-2013 period. We show that the interplay between incumbents' and entrants' innovations, which is at the core of creative destruction, is an important determinant of risks that are priced in financial markets.
Keywords: Economic uncertainty, Creative destruction, Innovation, Firm entry, Long-run risk
JEL Classification: E22, G12, O30, O41
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