Uncertainty and the Dynamics of R&D

Uncertainty about future productivity and demand conditions varies strongly over time, rising by 50 percent to 100 percent during recessions and by 100 percent to 200 percent after major political and economic shocks. These fluctuations in uncertainty appear to generate fluctuations in investment, hiring, and productivity, because higher uncertainty generates a temporary slowdown as firms postpone activity and wait for uncertainty to resolve (Bloom 2006). Research and development (R&D), which has become a focus of recent business cycle models (Diego Comin and Mark Gertler, 2006), is omitted from this analysis. R&D may respond differently to uncertainty because of different adjustment costs. Investment in the capital stock typically incurs stock adjustment costs from changing the capital stock, while investment in the knowledge stock typically incurs flow adjustment costs from changing the flow rate of new knowledge from R&D (see Section I). I show that these different adjustment costs lead to different predicted dynamics under uncertainty, including making R&D rates much less responsive to business conditions and more persistent over time at higher uncertainty. These adjustment costs and uncertainty effects can help explain the high persistence of R&D across time, which at the firm level is about three times more autocorrelated than investment. They may also help explain why, across business cycles, R&D is highly persistent and responds to recessions with a lag. The higher uncertainty