International knowledge diffusion and productivity growth in a cash‐in‐advance economy

Abstract

This paper investigates how cash‐in‐advance (CIA) constraints on firm's production and innovation decisions affect the long‐run relationship between monetary policy and innovation‐based economic growth in an open economy. Firms produce differentiated goods and invest in process innovation to reduce production costs. With imperfect knowledge diffusion across countries, the country with the greater share of industry has relatively productive firms. When innovation has a stricter CIA requirement than production, higher nominal interest rates in the country with the larger (smaller) industrial share reduce (increase) productivity growth. We also examine how improved knowledge diffusion affects optimal nominal interest rate policy.