Innovation and Reallocation

This paper considers an improvement in capital embodied technology which only production units that adapt to new knowledge can utilize. This innovation is distinct from a decline in capital goods price which can be utilized by all production units. A simple firm dynamics model is used to show that such an innovation shock enhances reallocation, whereas a shock lowering capital goods price reduces reallocation. This implication is used in structural vector autoregressions to identify innovation shocks as one that explain most of the fluctuations in reallocation measures. By showing the innovation shock and the investmentspecific shock identified by a standard long-run restriction are closely related, the paper provides evidence supporting Schumpeterian creative destruction: technological breakthroughs resulting in an on-going reallocation is a major driver of economic growth and fluctuation. ∗Department of Economics, Emory University, 1602 Fishburne Drive, Atlanta, GA 30322. Email: [email protected]