The Effect of Innovation Capacity on the Relationship between Volatility and Growth

Schumpeter’s notion of creative destruction assumes that volatile growth leads to a more efficient reallocation of resources and the adoption of new technologies. However, this can only occur if such productivity-enhancing opportunities are available within society. This availability is represented by innovation capacity. I model and show empirically, that volatility affects growth differently depending on available innovation capacity. The model predicts that abundant innovation capacity can result in a positive effect of volatility on growth. I do not find empirical evidence for a positive effect. However, in line with the model, the results show that the adverse effect of volatility on growth is negated to a much higher degree when innovation capacity is high. This result emphasises the necessity to consider the current state of a society when analysing if volatility will be detrimental or harmless to growth