We examine a perplexing phenomenon wherein technological innovations induce short-term contractions, using a two-sector New-Keynesian model. Pivotal to explaining the evidence are sticky prices, which alter the cyclicality of relative prices, impacting production during innovative phases. The model addresses key asset-pricing questions: Why is there a negative link between investment returns and stock returns? Why do valuations surge post adverse labor-market events? Why do both high book-to-market and high gross-profits forecast future returns positively, despite their divergent ties to technology? Why is the slope of the equity yield term structure procyclical? The mechanism of innovation-led contractions serves as a unifying thread, weaving together previously isolated puzzles, while offering a novel perspective.
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