Deflation and Declining Business Dynamism in a Cash-in-Advance Economy

This study considers the relationship between deflation and declining business dynamism. We do this by incorporating the empirical evidence that inflationary factors essentially affect all stages of an R&D firm's life cycle―entry, exit, and survival―into an R&D-based growth model. Our model has a new feature; namely, the entry, exit, and survival of R&D firms are all endogenous and subject to a cash-in-advance constraint. The core finding is that deflation can significantly affect the nature of business dynamism. Specifically, a decrease in the inflation rate potentially encourages or discourages innovation and survival investments; however, it necessarily discourages both if the entry cost is sufficiently high. In this case, deflation stifles business dynamism, leading to lower entry and exit rates and a maturity bias in the firm age distribution. Calibrating the model to the U.S. economy, we show that deflation causes declining business dynamism under realistic values of entry, exit, and growth rates. Then, we show that deflation also causes welfare loss if the natural rate of firm exit is higher.