What Does It Take to Explain Procyclical Productivity

Labor productivity comoves strongly with output, leads output and employment, and is only weakly correlated with employment at the businesscycle frequency. Procyclical productivity is observed in virtually all countries and industries, and it is observed at both the business-cycle frequency and the seasonal frequency. Such prominent features of economic °uctuations present a litmus test for business cycle theory. The conventional explanations for procyclical labor productivity are factor hoarding (labor hoarding and capacity utilization) or increasing returns to scale. Existing equilibrium-business cycle theory explain procyclical labor productivity by technology shocks. The sheer magnitude of excess volatilities in productivity relative to employment seems to defy explanations from increasing returns alone. The technology-shock explanation, on the other hand, comes perilously close to assuming the conclusion. Furthermore, even in periods of pure demand shocks, labor productivity remains procyclical. Applying general equilibrium theory, this paper shows that neither technology shocks nor increasing returns to scale are necessary for understanding procyclical productivity. Factor hoarding is su±cient for demand shocks to induce procyclical productivity at both aggregate and disaggregate levels despite constant or even diminishing returns to scale.