The Innovation Long-Run Risk Component

This paper provides empirical evidence that shocks to aggregate Research and Development (R&D) exert persistent effects on macroeconomic dynamics and represent a significant source of risk for investors, consistent with 'long-run risk' models. The analysis focuses on 'effective R&D', the unique scaling of R&D that, across a broad class of models, maintains a linear relationship with productivity growth. This measure theoretically captures the entire contribution of R&D to productivity, flexibly accounting for knowledge spillovers and product proliferation. Importantly, its deviations from equilibrium are empirically identifiable via the error correction term in the cointegration relationship among R&D, total factor productivity, and the labor force. Using U.S. data, structural R&D shocks, based on effective R&D, are shown to affect productivity and consumption growth rates beyond business cycle horizons, and to be associated with a significant risk premium (around 12% annually) in a cross section of stock and bond portfolios, with cash-flow risk a key determinant.