Following EUís Lisbon strategy development of knowledge-based economy has become one of the headline objectives for the government of Latvia. In this paper we conceptualize driving forces and responses of governmentís commitment towards this objective. We investigate feedback loops that underlie dynamics of knowledge industry development. Increase in domestic Research and Development (R&D) activities is considered as a prerequisite for sustainable growth of knowledge economy. Dynamics of R&D supply and demand is further analysed and leverage points for different policy measures is identified. Scarce human resources is considered as the main impediment for building domestic R&D capability and impact from mix of policy options is assessed.