Innovation and Growth with Frictions

Randall Wright, Consultant

November 2016 | Federal Reserve Bank of Minneapolis Economic Policy Paper 16-11

The generation and implementation of new ideas are major factors in economic performance and growth. If some people are better at research and others at development, there emerges a role for an “idea market,” where technology transfers reallocate knowledge to those best able to develop and apply it. Financial institutions can facilitate this reallocation by providing credit for these transfers.

However, the idea market is rife with frictions. These include so-called search-and-bargaining problems. Another obstacle is credit friction: If a debtor reneges, it is not always easy to repossess information or otherwise prevent its use.

These obstacles lead to several monetary policy implications. First, policymakers should strive for low inflation, since that encourages investment in liquidity, which is crucial for exchanging ideas when credit is imperfect. Second, policymakers should encourage financial intermediation, since that facilitates efficient reallocation of liquidity. Fiscal policy has a role, too, but in terms of lessons for central bank policy, sound money and sound banking are engines of economic growth.