Countercyclical Elasticity of Substitution
44 Pages Posted: 5 Nov 2014 Last revised: 12 Jan 2017
Date Written: January 12, 2017
We empirically show that the short-run elasticity of substitution between capital and labor ($\sigma_t$) is countercyclical. In recessions, capital and labor are more substitutable than in expansions. We explore the effects of the countercyclicality of $\sigma_t$ on aggregate fluctuations in the context of an otherwise standard competitive-markets business cycle model. The countercyclical $\sigma_t$ contributes to resolve four main labor-market puzzles: Dunlop-Tarshis phenomenon, labor-productivity puzzle, hours-productivity puzzle, and labor share puzzle.
Keywords: elasticity of substitution, aggregate fluctuations, labor markets, Dunlop-Tarshis, labor productivity, labor share
JEL Classification: C63, E13, E32
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