Endogenous growth literature treats deliberate R&D effort as the main engine of long-run technology growth. It has been already recognized that R&D expenditures are procyclical. This paper builds a microfounded model that generates procyclical aggregate R&D investment as a result of optimizing behavior by heterogeneous monopolistically competitive firms.

I find that business cycle fluctuations indeed affect the aggregate endogenous growth rate of the economy so that transitory productivity shocks leave lasting level effects on the economy’s Balanced Growth Path. This result stems from both procyclical R&D expenditures of the incumbents and procyclical firm entry rates, and is in line with the empirical evidence on the negative impact of “missing generations” of firms on macroeconomic variables.

This mechanism generates economically significant hysteresis effects, increasing the welfare cost of business cycles by two orders of magnitude relative to the one typically found by the business cycles literature. High welfare costs of business cycles and potential to affect endogenous growth create ample space for welfare improving policy interventions. The paper evaluates the effects of several countercyclical subsidy schemes and finds some of them welfare improving.