SUBSIDIES IN AN ECONOMY WITH ENDOGENOUS CYCLES OVER INVESTMENT AND INNOVATION REGIMES

We explore the roles of subsidies in the Matsuyama model [K. Matsuyama, Econometrica 67 (1999), 335-347] of growth through cycles with a Solow investment phase and a Romer innovation phase when innovation and intermediate goods production rely on existing capital. We show that subsidies to R&D investment or to the purchase of new intermediate goods can arbitrarily reduce the threshold level of capital per type of intermediate good beyond which the economy moves to the innovation phase. Sufficient subsidization can eventually eliminate cycles. For plausible parameterizations, optimal subsidies can achieve significant welfare gains equivalent to as much as 10% rises in consumption at all times.