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What Prevents a Real Business Cycle Model from Matching the U.S. Data? Decomposing the Labor Wedge

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  • Dmitry Plotnikov

Abstract

I carry out a business cycle accounting exercise (Chari, Kehoe and McGrattan, 2007) on the U.S. data measured in wage units (Farmer (2010)) for the entire postwar period. In contrast to a conventional approach, this approach preserves common medium-term business cycle fluctuations in GDP, its components and the unemployment rate. Additionally, it facilitates decomposition of the labor wedge into the labor supply and the labor demand wedges. Using this business cycle accounting methodology, I find that in the transformed data, most movements in GDP are accounted for by the labor supply wedge. Therefore, I reverse a key finding of the real business cycle literature which asserts that 70% or more of economic fluctuations can be explained by TFP shocks. In other words, the real business cycle model fits the data badly because the assumption that households are on their labor supply equation is flawed. This failure is masked by data that has been filtered with a conventional approach that removes fluctuations at medium frequencies. My findings are consistent with the literature on incomplete labor markets.

Suggested Citation

  • Dmitry Plotnikov, 2017. "What Prevents a Real Business Cycle Model from Matching the U.S. Data? Decomposing the Labor Wedge," IMF Working Papers 2017/201, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:2017/201
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    Cited by:

    1. Oscar Iván Ávila-Montealegre & Anderson Grajales-Olarte & Juan J. Ospina-Tejeiro & Mario A. Ramos-Veloza, 2023. "Minimum Wage and Macroeconomic Adjustment: Insights from a Small Open, Emerging, Economy with Formal and Informal Labor," Borradores de Economia 1264, Banco de la Republica de Colombia.
    2. Daniel Fehrle & Johannes Huber, 2020. "Business cycle accounting for the German fiscal stimulus program during the Great Recession," Working Papers 197, Bavarian Graduate Program in Economics (BGPE).

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