Innovation, FDI, and the long-run effects of monetary policy

This paper studies the long-run effects of monetary policy on innovation and pattern of production in a North-South product-cycle model with foreign direct investment (FDI) and separate cash-in-advance (CIA) constraints on innovative and adaptive R&D. If innovative R&D is subject to the CIA constraint, then a decrease in the Northern nominal interest rate raises the rate of Northern innovation, the rate of FDI, and the North-South wage gap. Regarding the production pattern, the extent of Northern production decreases as the extent of FDI increases. If adaptive R&D is subject to the CIA constraint, then a decrease in the Southern nominal interest rate causes the same effects on the rates of innovation and FDI as well as the extents of Northern production and FDI as those in the case of a decrease in the Northern nominal interest rate. However, such a monetary policy change reduces the North-South wage gap. This study also analyzes the stability of the long-run equilibrium and examines the responses of social welfare for Northern and Southern consumers to monetary policy.