This paper investigates the impact of monetary policy on firms' innovation investment using unique, representative firm-level data. We provide novel evidence on how systematic monetary tightening, exogenous policy rate changes and forward guidance affect innovation spending, challenging traditional assumptions about the transmission channels and persistence of monetary policy and its effects on longer-term aggregate supply.

First, we analyse the effects of the systematic monetary tightening in the euro area during 2022 – 2023, when policy rates increased from 0 % to 4.5 %. On average, firms reduced their innovation investment by 20 %, with 45 % of firms fully suspending it. These reductions are persistent, extending into the medium term, and are particularly pronounced among smaller firms and firms with greater reliance on bank loans and higher inflation expectations. 

Second, we use a survey-based experiment featuring hypothetical policy rate changes to identify how firms adjust their planned innovation investments in response to exogenous monetary policy shocks. Innovation investment reacts strongly to both rate hikes and cuts, with largely symmetric responses at the baseline rate of 4.5 %. However, state-dependent asymmetries emerge, driven by firms’ exit from innovation activities during high-rate periods. The financing channel plays an important role, with firms with higher shares of bank loans, and particularly those holding variable-rate loans, exhibiting stronger responses. Additionally, we provide evidence for the transmission of monetary policy to innovation through aggregate demand, as firms with pessimistic demand expectations are found to be particularly sensitive to rate cuts.

Finally, we explore the role of forward guidance in innovation investment. We find that forward guidance provides substantial additional stimulus beyond isolated rate cuts. This effect is particularly pronounced for firms reliant on bank financing, firms with variable-rate loans and firms with pessimistic demand expectations. Firms that face greater uncertainty about future policy rates respond more strongly to forward guidance announcements, highlighting the transmission of monetary policy communication to innovation through the reduction of uncertainty about the future path of policy rates.

Our findings challenge the traditional view that monetary policy is neutral in the long run. Instead, we show that monetary policy influences long-term supply dynamics through its impact on innovation and technology growth. Monetary policy may thus have more persistent effects than conventionally assumed, operating through longer-term aggregate supply. Moreover, our evidence suggests that the natural rate of interest (R*) is not only determined by exogenous factors, but also influenced by monetary policy.