How does innovation lead to growth?

27 June 2017

Innovation is an essential driver of economic progress that benefits consumers, businesses and the economy as a whole. How does it play that role, how does it contribute to economic growth and what can be done to promote it?

What is innovation?

In economic terms, innovation describes the development and application of ideas and technologies that improve goods and services or make their production more efficient.

A classic example of innovation is the development of steam engine technology in the 18th century. Steam engines could be put to use in factories, enabling mass production, and they revolutionised transport with the railways. More recently, information technology transformed the way companies produce and sell their goods and services, while opening up new markets and new business models.

So why does the ECB care?

The ECB’s objective is to maintain price stability. By setting interest rates, the ECB influences financing conditions in the economy and, ultimately, overall demand for goods and services. However, the long-term growth potential of the economy, which depends on innovation, also affects the ECB’s ability to achieve its mandate.

As innovation has profound effects on the macroeconomic environment, the ECB monitors its development and researches the economic and social preconditions that enable and support innovation.

Why do we need innovation?

One of the major benefits of innovation is its contribution to economic growth. Simply put, innovation can lead to higher productivity, meaning that the same input generates a greater output. As productivity rises, more goods and services are produced – in other words, the economy grows.

How innovation leads to growth

Innovation

New ideas and technologies are developed and applied, generating greater output with the same input.

Productivity

Growth

More goods and services are produced, stimulating wages and business profitability.

Innovation and productivity growth bring vast benefits for consumers and businesses. As productivity rises, the wages of workers increase. They have more money in their pockets, and so can buy more goods and services. At the same time, businesses become more profitable, which enables them to invest and hire more employees.

How does innovation take full effect?

Innovation usually starts on a small scale, e.g. when a new technology is first applied in the company where it has been developed. However, for the full benefits of innovation to be realised, it is necessary for it to spread across the economy and equally benefit companies in different sectors and of different sizes. Experts call this process the diffusion of innovation.

Innovation in the euro area

While Europe is the birthplace of a great deal of innovation and continues to be an innovative region, there is clear potential to boost our innovative capacity further. Only three euro area countries are among the world’s top ten nations in the World Economic Forum’s Global Competitiveness Indicator. There has also been a persistent gap in spending on research and development (R&D) between the euro area and other major advanced economies.

In addition, the diffusion of innovation in the euro area appears to be slow. Recent ECB studies show a considerable difference in productivity between the most productive and least productive firms, for example. This means that while well-performing frontier firms are highly innovative, so-called laggard firms do not benefit much from innovation.

How can innovation be promoted?

Structural measures to promote innovation include increasing spending on research and development (R&D) and investing in education, as well as enabling entrepreneurs to start businesses more easily and for failed businesses to exit the market more quickly. In addition, companies can facilitate innovation by investing in their staff and conducting their own R&D.