This paper proposes a microfounded model featuring frictional labor markets that generates procyclical R&D expenditures as a result of optimizing behavior by heterogeneous monopolistically competitive firms. This allows to show that business cycle fluctuations affect the aggregate endogenous growth rate of the economy. Consequently, transitory shocks leave lasting level effects.
This mechanism is responsible for economically significant hysteresis effects that increase the welfare cost of business cycles by two orders of magnitude relative to the exogenous growth model. I show that this has serious policy implications and creates ample space for policy intervention. I find that several static and countercyclical subsidy schemes are welfare improving.