Endogenous human capital and market structure in a monetary Schumpeterian model

Abstract

This study incorporates endogenous human capital into a monetary Schumpeterian model with endogenous market structure. We find that endogenous human capital leads to continuous entry of firms, sustaining horizontal innovation and making it a twin engine of long-run growth with vertical innovation. Moreover, an increase in the nominal interest rate has no immediate effect on growth, whereas it has a negative effect on long-run growth. This is because the return to vertical innovation (the incumbents) is proportional to firm size (i.e., human capital per firm), a state variable that adjusts slowly. A higher nominal interest rate decreases labor supply for human capital accumulation, reducing the growth rate of human capital and immediately lowering the return to entry. The relatively higher return to incumbents increases the growth rate of vertical innovation, thus offsetting the decrease in human capital growth rate. Firm size decreases in the long run, reducing the growth rate of vertical innovation and equilibrium total growth and welfare. We calibrate the model to the U.S. economy and find that the negative effects of nominal interest rate on growth and welfare are small and increasing during the transition due to endogenous human capital and market structure and substantial in the steady state.