INTRODUCTION

TO THE SERIES

The aim of the Handbooks in Economics series is to produce Handbooks for various
branches of economics, each of which is a definitive source, reference, and teaching
supplement for use by professional researchers and advanced graduate students. Each
Handbook provides self-contained surveys of the current state of a branch of economics
in the form of chapters prepared by leading specialists on various aspects of this
branch o f economics. These surveys summarize not only received results but also
newer developments, from recent journal articles and discussion papers. Some original
material is also included, but the main goal is to provide comprehensive and accessible
surveys. The Handbooks are intended to provide not only useful reference volumes for
professional collections but also possible supplementary readings for advanced courses
for graduate students in economics.
KENNETH J. ARROW and MICHAEL D. 1NTRILIGATOR

PUBLISHER'S

NOTE

For a complete overview of the Handbooks in Economics Series, please refer to the
listing at the end of this volume.

CONTENTS O F T H E HANDBOOK

VOLUME 1A
PART 1 - E M P I R I C A L A N D H I S T O R I C A L P E R F O R M A N C E

Chapter 1
Business Cycle Fluctuations in US Macroeconomic Time Series
JAMES H. STOCK and MARK W WATSON

Chapter 2
Monetary Policy Shocks: What Have we Learned and to What End?
LAWRENCE J. CHRISTIANO, MARTIN EICHENBAUM and CHARLES L. EVANS

Chapter 3
Monetary Policy Regimes and Economic Performance: The Historical Record
MICHAEL D. BORDO AND ANNA J. SCHWARTZ

Chapter 4
The New Empirics of Economic Growth
STEVEN N. DURLAUF and DANNY T. QUAH
PART 2 - M E T H O D S O F D Y N A M I C A N A L Y S I S

Chapter 5
Numerical Solution of Dynamic Economic Models
MANUEL S. SANTOS

Chapter 6
Indeterminacy and Sunspots in Macroeconomics
JESS BENHABIB and ROGER E.A. FARMER

Chapter 7
Learning Dynamics
GEORGE W. EVANS mad SEPPO HONKAPOHJA

Chapter 8
Micro Data and General Equilibrium Models
MARTIN BROWNING, LARS PETER HANSEN and JAMES J. HECKMAN

vii

Contents of the Handbook

viii
PART 3 - MODELS

OF ECONOMIC

GROWTH

Chapter 9
Neoclassical Growth Theory
ROBERT M. SOLOW

Chapter 10
Explaining Cross-Country Income Differences
ELLEN R. McGRATTAN and JAMES A. SCHMITZ, Jr.
VOLUME

1B

PART 4 - CONSUMPTION

AND INVESTMENT

Chapter 11
Consumption
ORAZIO E ATTANASIO

Chapter 12
Aggregate Investment
RICARDO J. CABALLERO

Chapter 13
Inventories
VALERIE A. RAMEY and KENNETH D. WEST
PART 5 - M O D E L S

OF ECONOMIC

FLUCTUATIONS

Chapter 14
Resuscitating Real Business Cycles
ROBERT G. KING AND SERGIO T. REBELO

Chapter 15
Staggered Price and Wage Setting in Macroeconomics
JOHN B. TAYLOR

Chapter 16
The Cyclical Behavior of Prices and Costs
JULIO J. ROTEMBERG and MICHAEL WOODFORD

Chapter 17
Labor-Market Frictions and Employment Fluctuations
ROBERT E. HALL

Chapter 18
Job Reallocation, Employment Fluctuations and Unemployment
DALE T. MORTENSEN and CHRISTOPHER A. PISSAR/DES

Contents of the Handbook

VOLUME 1C
PART 6 - F I N A N C I A L M A R K E T S A N D T H E M A C R O E C O N O M Y

Chapter 19
Asset Prices, Consumption, and the Business Cycle
JOHN Y. CAMPBELL

Chapter 20
Human Behavior and the Efficiency of the Financial System
ROBERT J. SHILLER

Chapter 21
The Financial Accelerator in a Quantitative Business Cycle Framework
BEN S. BERNANKE, MARK GERTLER and SIMON GILCHRIST
PART 7 - M O N E T A R Y A N D F I S C A L P O L I C Y

Chapter 22
Political Economics and Macroeconomic Policy
TORSTEN PERSSON and GUIDO TABELLINI

Chapter 23
Issues in the Design of Monetary Policy Rules
BENNETT T. McCALLUM

Chapter 24
Inflation Stabilization and BOP Crises in Developing Countries
GUILLERMO A. CALVO and CARLOS A. VI~GH

Chapter 25
Government Debt
DOUGLAS W. ELMENDORF AND N. GREGORY MANKIW

Chapter 26
Optimal Fiscal and Monetary Policy
V.V. CHAR/and PATRICK J. KEHOE

ix

PREFACE TO THE HANDBOOK

Purpose
The Handbook of Macroeconomics aims to provide a survey of the state of knowledge
in the broad area that includes the theories and facts of economic growth and economic
fluctuations, as well as the consequences of monetary and fiscal policies for general
economic conditions.

Progress in Macroeconomics
Macroeconomic issues are central concerns in economics. Hence it is surprising that
(with the exception of the subset of these topics addressed in the Handbook of
Monetary Economics) no review of this area has been undertaken in the Handbook
of Economics series until now.
Surprising or not, we find that now is an especially auspicious time to present such a
review of the field. Macroeconomics underwent a revolution in the 1970's and 1980's,
due to the introduction of the methods of rational expectations, dynamic optimization,
and general equilibrium analysis into macroeconomic models, to the development of
new theories of economic fluctuations, and to the introduction of sophisticated methods
for the analysis of economic time series. These developments were both important
and exciting. However, the rapid change in methods and theories led to considerable
disagreement, especially in the 1980's, as to whether there was any core of common
beliefs, even about the defining problems of the subject, that united macroeconomists
any longer.
The 1990's have also been exciting, but for a different reason. In our view, the
modern methods of analysis have progressed to the point where they are now much
better able to address practical or substantive macroeconomic questions - whether
traditional, new, empirical, or policy-related. Indeed, we find that it is no longer
necessary to choose between more powerful methods and practical policy concerns.
We believe that both the progress and the focus on substantive problems has led to
a situation in macroeconomics where the area of common ground is considerable,
though we cannot yet announce a "new synthesis" that could be endorsed by most
scholars working in the field. For this reason, we have organized this Handbook around
substantive macroeconomic problems, and not around alternative methodological
approaches or schools of thought.

xi

xii

Preface

The extent to which the field has changed over the past decade is considerable, and
we think that there is a great need for the survey of the current state ofmacroeconomics
that we and the other contributors to this book have attempted here. We hope that the
Handbook of Macroeconomics will be useful as a teaching supplement in graduate
courses in the field, and also as a reference that will assist researchers in one area of
macroeconomics to become better acquainted with developments in other branches of
the field.
Overview
The Handbook of Macroeconomics includes 26 chapters, arranged into seven parts.
Part 1 reviews evidence on the Empirical and Historical Performance of the
aggregate economy, to provide factual background for the modeling efforts and
policy discussion of the remaining chapters. It includes evidence on the character
of business fluctuations, on long-run economic growth and the persistence of crosscountry differences in income levels, and on economic performance under alternative
policy regimes.
Part 2 on Methods of Dynamic Analysis treats several technical issues that arise in
the study of economic models which are dynamic and in which agents' expectations
about the future are critical to equilibrium determination. These include methods for
the calibration and computation of models with intertemporal equilibria, the analysis
of the determinacy of equilibria, and the use of "learning" dynamics to consider the
stability of such equilibria. These topics are important for economic theory in general,
and some are also treated in the Handbook of Mathematical Economics, The Handbook
of Econometrics, and the Handbook of Computational Economics, for example, from
a somewhat different perspective. Here we emphasize results - such as the problems
associated with the calibration of general equilibrium models using microeconomic
studies - that have particular application to macroeconomic models.
The Handbook then tunas to a review of theoretical models of macroeconomic
phenomena. Part 3 reviews Models of Economic Growth, including both the
determinants of long-run levels of income per capita and the sources of cross-country
income differences. Both "neoclassical" and "endogenous" theories of growth are
discussed. Part 4 treats models of Consumption and Investment demand, from the
point o f view of intertemporal optimization. Part 5 covers Models of Economic
Fluctuations. In the chapters in this part we see a common approach to model
formulation and testing, emphasizing intertemporal optimization, quantitative general
equilibrium modeling, and the systematic comparison of model predictions with
economic time series. This common approach allows for consideration of a variety
of views about the ultimate sources of economic fluctuations and of the efficiency of
the market mechanisms that amplify and propagate them.
Part 6 treats Financial Markets and the Macroeconomy. The chapters in this part
consider the relation between financial market developments and aggregate economic

Preface

xiii

activity, both from the point of view of how business fluctuations affect financial
markets, and how financial market disturbances affect overall economic activity. These
chapters also delve into the question of whether financial market behavior can be
understood in terms of the postulates of rational expectations and intertemporal
optimization that are used so extensively in modern macroeconomics-an issue of
fundamental importance to our subject that can be, and has been, subject to special
scrutiny in the area of financial economics because of the unusual quality of available
data.
Finally, Part 7 reviews a number of Monetary and Fiscal Policy issues. Here we
consider both the positive theory (or political economics) of government policymaking
and the normative theory. Both the nature of ideal (or second-best) outcomes according
to economic theory and the choice of simple rules that may offer practical guidance
for policymakers are discussed. Lessons from economic theory and from experience
with alternative policy regimes are reviewed. None of the chapters in this part
focus entirely on international, or open economy, macroeconomic policies, because
many such issues are addressed in the Handbook of International Economics.
Nevertheless, open-economy issues cannot be separated from closed-economy issues
as the analysis of disinflation policies and currency crises in this part of the Handbook
of Maeroeconomics, or the analysis of policy regimes in the Part I of the Handbook
of Macroeconomics make clear.

Acknowledgements
Our use of the pronoun "we" in this preface should not, of course, be taken to
suggest that much, if any, of the credit for what is useful in these volumes is due
to the Handbook's editors. We wish to acknowledge the tremendous debt we owe to
the authors of the chapters in this Handbook, who not only prepared the individual
chapters, but also provided us with much useful advice about the organization of the
overall project. We are grateful for their efforts and for their patience with our slow
progress toward completion of the Handbook. We hope that they will find that the
final product justifies their efforts. We also wish to thank the Federal Reserve Bank of
New York, the Federal Reserve Bank of San Francisco, and the Center for Economic
Policy Research at Stanford University for financial support for two conferences on
"Recent Developments in Macroeconomics" at which drafts of the Handbook chapters
were presented and discussed, and especially to Jack Beebe and Rick Mishkin who
made these two useful conferences happen. The deadlines, feedback, and commentary
at these conferences were essential to the successful completion of the Handbook.
We also would like to thank Jean Koentop for managing the manuscript as it neared
completion.
Stanford, California
Princeton, New Jersey

John B. Taylor
Michael Woodford

Chapter 11

CONSUMPTION

ORAZIO P. ATTANASIO

University College London, Institute for Fiscal Studies and NBER

Contents

Abstract
Keywords
1. Introduction
2. Stylised facts

742
742
743
745
746

2.1. Aggregate time series data

2.2. Household consumption expenditure

750

2.2.1. Nature of the data sets and their comparability with the National Account data
2.2.2. Life cycle profiles

3. The life cycle model

3.1. The simple textbook model
3.2. Quadratic preferences, certainty equivalence and the permanent income model
3.3. The Euler equation approach
3.4. Precautionary motives for saving
3.5. Borrowing restrictions
3.6. Taking into account demographics, labour supply and unobserved heterogeneity
3.7. Bequest motives

4. Aggregation issues
4.1. Aggregation across consumers
4.2. Aggregation across commodities

5. Econometric issues and empirical evidence

5.1. Aggregate time series studies
5.2. Micro data: some econometric problems

751
752
760
761
762
765
770
772
777
780

781
781
782
783
784
785

5.2.1. Consistency of estimators derived from Euler equations

785

5.2.2. Average cohort techniques

787

* A preliminary draft of this chapter was presented at a conference at the New York Fed., February 27-28
1997, where I received useful comments from my discussant, Chris Carroll and several participants.
Tullio JappeUi provided many careful and insightful comments for which I am very grateful. I would
like to thank Margherita Borella for research assistance and James Sefton for providing me with the UK
National Accounts Data. Material from the FES made available by the ONS through the ESRC Data
Archive has been used by permission of the Controller of HMSO. Neither the ONS nor the ESRC Data
Archive bear any responsibility for the analysis or interpretation of the data reported here.

Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford

1999 Elsevier Science B.V. All rights reserved
741

742
5.2.3. Conditional second (and higher) moments
5.3. Micro data: some evidence
6. Where does the life cycle model stand?
7. Insurance and inequality
8. Intertemporal non-separability
8.1. Durables
8.2. Habit formation
9. Conclusions
References

O.P. Attanasio
788
789
791
795
798
799
802
804
805

Abstract
Consumption is the largest component of GDP. Since the 1950s, the life cycle and
the permanent income models have constituted the main analytical tools to the study
of consumption behaviour, both at the micro and at the aggregate level. Since the
late 1970s the literature has focused on versions of the model that incorporate the
hypothesis of Rational Expectations and a rigorous treatment of uncertainty. In this
chapter, 1 survey the most recent contribution and assess where the life cycle model
stands. My reading of the evidence and of recent developments leads me to stress two
points: (i) the model can only be tested and estimated using a flexible specification
of preferences and individual level data; (ii) it is possible to construct versions of the
model that are not rejected by the data. One of the main problems of the approach
used in the literature to estimate preferences is the lack of a 'consumption function'.
A challenge for future research is to use preference parameter estimates to construct
such functions.

Keywords
consumption, life cycle model, household behaviour
JEL classification: E2

Ch. 11:

Consumption

743

1. Introduction

In most developed economies, consumption accounts for about two thirds of GDP.
Moreover, it is from consumption that, in all likelihood, utility and welfare are in
large part determined. It is therefore natural that macroeconomists have devoted
a considerable amount of research effort to its study. In modern macroeconomics,
consumption is typically viewed as part of a dynamic decision problem. There is
therefore another sense in which an tmderstanding of consumption is central for
macroeconomics. Consumption decisions are also saving decisions from which the
funds available for capital accumulation and investment arise. Therefore, consumers
attitudes to saving, risk bearing and uncertainty are crucial to understand the behaviour
of capital markets, the process of investment and growth and development. It is
not by chance that modern consumption theory is also used to characterise asset
prices equilibrium conditions. The desire consumers might have to smooth fluctuations
over time determines the need for particular financial instruments or institutions.
Understanding recent trends in consumption and saving is crucial to the study, both
positive and normative, of the development of financial markets, of the institutions that
provide social safety nets, of the systems through which retirement income is provided
and so on.
One of the main themes of this chapter is that consumption decisions cannot be
studied in isolation. Exactly because consumption and saving decisions are part of a
dynamic optimisation problem, they are determined jointly with a number of other
choices, ranging from labour supply to household formation and fertility decisions,
to planned bequests. While modelling all aspects of human economic behaviour
simultaneously is probably impossible, it is important to recognise that choices are
taken simultaneously and to control for the effects that various aspects of the economic
environment in which consumers live might have on any particular choice. This is
particularly true if one wants to estimate the parameters that characterise individual
preferences.
Implicit in this argument is another of the main themes of this chapter: consumption
decisions should be modelled within a well specified and coherent optimisation model.
Such a model should be flexible and allow for a variety of factors. Indeed, I think it is
crucial that the model should be interpreted as an approximation of reality and should
allow for a component of behaviour that we are not able to explain. However, such a
model is crucial to organise our thinking and our understanding of the data. Without
a structural model it is not possible to make any statement about observed behaviour
or to evaluate the effect of any proposed change in economic policy.
This, however, is not a call for a blind faith in structural models. Inferences should
always be conditional on the particular identification restrictions used and on the
particular structural model used. Such models should also be as flexible as possible
and incorporate as much information about individual behaviour as is available. It
should be recognised, however, that without such models we cannot provide more than
a statistical description of the data.

744

0.17. Attanasio

The other main theme of the analysis in this chapter is that to understand aggregate
trends it is necessary to conduct, in most situations, a detailed analysis of individual
behaviour. In other words, aggregation problems are too important to be ignored. This
obviously does not mean that the analysis of aggregate time series data is not useful.
Indeed, I start the chapter with a brief summary of the main time series properties of
consumption. Estimation of structural models of economic behaviour, however, cannot
be performed using aggregate data only.
This chapter is not an exhaustive survey of the literature on consumption: such a
literature has grown so much that it would be hard even to list it, let alone summarise
all the contributions. What I offer, instead, is a discussion of the current status of our
knowledge, with an eye to what I think are the most interesting directions for future
research. In the process of doing so, however, I discuss several of the most important
and influential contributions. Omissions and exclusions are unavoidable and should
not be read as indicating a negative judgement on a particular contribution. At times,
I simply chose, among several contributions, those that most suited my arguments and
helped me the most to make a given point. Moreover, notwithstanding the length of the
chapter, not every sub-fields and interesting topic has been covered. But a line had to
be drawn at some point. There are four fields that I did not included in the chapter and
over which I have agonised considerably. The first is asset pricing: while much of the
theoretical material I present has direct implications for asset prices, I decided to omit a
discussion of these implications as there is an entire chapter of this Handbook devoted
to these issues. The second is the axiomatisations of behaviour under uncertainty
alternative to expected utility. There are several interesting developments, including
some that have been used in consumption and asset pricing theory, such as the KrepsPorteus axiomatisation used by Epstein and Zin (1989, 1991) in some fascinating
papers. The third is the consideration of within-household allocation of resources.
There is some exciting research being developed in this area, but I decided to draw the
line of 'macro' at the level of the individual household. Finally, I do not discuss theories
of consumption and saving behaviour that do not assume optimising and fully rational
behaviour. Again, there is some exciting work in the area of social norms, mental
accounting, time varying preferences, herd behaviour and so on. In the end, however,
I decided that it would not fit with the rest of the chapter and rather than giving just
a nod to this growing part of the literature I decided to leave it out completely.
The chapter is organised as follows. In Section 2, I start with a brief description
of some stylised facts about consumption. These include both facts derived from
aggregate time series data and from household level data. Throughout the section,
I use in parallel data from two countries: the USA and the UK.
In Section 3, I discuss at length what I think is the most important model of
consumption behaviour we have, the life cycle model. In that section, I take a wide
view of what I mean by the life cycle model: definitely not the simple textbook
version according to which the main motivation for saving is the accumulation of
resources to provide for retirement. Instead, I favour a flexible version of the model
where demographics, labour supply, uncertainty and precautionary saving and possibly

Ch. 11: Consumption

745

bequests play an important role. In other words, I consider the life cycle model
as a model in which consumption decisions are determined within an intertemporal
optimisation framework. What elements of this model turn out ot be more important
is largely an empirical matter. Indeed, even the presence of liquidity constraints, or
borrowing restrictions, can and should be incorporated within this framework.
In Section 4, I discuss aggregation problems. In particular, I focus on two different
kinds of aggregation: that across consumers and that across commodities. The aim of
this section is not just to give lip service to the aggregation issues and proceed to sweep
them under the carpet. With the development of computing and storage capability and
with the availability of increasing large number of micro data sets, it is important
to stress that scientific research on consumption behaviour cannot afford to ignore
aggregation issues.
In Section 5, I consider the empirical evidence on the life cycle model and discuss
both evidence from aggregate time series data and evidence from micro data. In this
section I also address a number of econometric problems with the analysis of Euler
equations for consumption. In Section 6, I take stock on what I think is the status of
the life cycle model, given the evidence presented in Section 5.
In Section 7, I address the issues of insurance and inequality. In particular, I present
some of the tests of the presence of perfect insurance and discuss the little evidence
there is on the evolution o f consumption inequality and its relationship to earning
inequality.
Most of the models considered up to this point assume time separability of
preferences. While such a hypothesis is greatly convenient from an analytical point
of view, it is easy to think of situations in which it is violated. In Section 8, I discuss
to forms of time dependence: that induced by the durability of commodities and habit
formation. Section 9 concludes the chapter.

2. Stylised facts
In this section, I document the main stylised facts about consumption behaviour
using both aggregate and individual data. I consider two components of consumption
expenditure: on non-durable and services and on durables. In addition I also consider
disposable income. While most of the facts presented here are quite well established,
the evidence in this section constitute the background against which one should set
the theoretical model considered in the rest of the chapter.
The data used come from two western countries: the United States and the United
Kingdom. I have deliberately excluded from the analysis developing or less developed
countries as they involve an additional set of issues which are not part of the present
discussion. Among the developed countries I have chosen the USA and the UK both
because data from these two countries have been among the most widely studied and
because the two countries have the best micro data on household consumption. For

O.P. Attanasio

746

4000

UK
USA - disposable income and consumption
~------150000
100000

2000

disposable income and consumption

50000

J
J

97.1

2319
55

6's

75

as

&

65

75

85

95

Fig. 1. Disposable income (top curve) consumption, divided into durables (bottom curve) and nondurables (middle curve).

the UK, in particular, the Family Expenditure Survey runs for 25 consecutive years,
giving the possibility of performing interesting exercises.
2.1. Aggregate time series data
In this section, I present some of the time series properties of consumption expenditure
and of disposable income. While the models considered in the following sections
refer to household behaviour, typically the consumption aggregates considered in the
National Account statistics include outlays of a sector that, together with households,
includes other entities, such as charities, whose behaviour is unlikely to be determined
by utility maximisation. While this issue is certainly important, especially for structural
tests of theoretical models of household behaviour, in the analysis that follows I ignore
it and, instead of isolating the part of total expenditure to be attributed to households,
I present the time series properties of National Account consumption. Seslnick (1994)
has recently stressed the importance of these issues.
In Figure 1, I plot household (log) disposable income along with consumption
divided into durables and non-durables and services for the UK and the USA. The
series have quarterly frequency and run from 1959:1 to 1996:3 for the USA and
from 1965:1 to 1996:2 for the UK. The data are at constant prices and are seasonally
adjusted. From the figure, it is evident that non-durable consumption is smoother than
disposable income. Durable consumption, on the other hand, which over the sample
accounts, on average, for 13% of total consumption in the USA and around 14% in
the UK, is by far the most volatile of the three time series. This is even more evident
in Figure 2 where I plot the annual rate of changes for the three variables. In Table 1,
I report the mean and standard deviation of the three variables. These figures confirm
and quantify the differences in the variability of the three variables considered.
In Tables 2 and 3, I consider two alternative ways of summarising the time series
properties of the three series I analyse for both countries. In Table 2, 1 report the
estimates of the coefficient of an MA(12) model for the same series. The advantage
of such an un-parsimonious model is that it avoids the sometimes difficult choice
among competing ARMA representations. Furthermore, its impulse response function

Ch. 11:

747

Consumption

USA- disposable income and consumption rates of growth

UK- disposable income and consumptionrates of growth

0.2

0.2

0.1

0.1

-0.1

-0.1

-0.2

-0.2

55

65

75

85

95

65

75

85

95

Fig. 2. Annual rates of change for the variables of Figure 1.

Table 1
Mean and standard deviations (annual rates of growth)
US

Disposable income
Nondurable consumption
Durable expenditure

UK

Mean

St. dev.

Mean

St. dev.

0.032
0.023
0.048

0.025
0.018
0.069

0.026
0.017
0.043

0.026
0.021
0.112

can be easily read from the estimated coefficients. I also purposely decided to be
agnostic about the presence o f random walks in the time series consumption or income,
even though this has implications for the so called 'excess smoothness' puzzle briefly
discussed below. In Table 3, instead, I report the M a x i m u m Likelihood estimates o f a
parsimonious A R M A m o d e l for the first differences o f the log o f the three variables.
While in some cases there were alternative specifications that fitted the data as well as
those reported in the table, the latter all pass several diagnostic tests. The Q-statistics
reported in the table indicates that the representations chosen capture adequately the
dynamic behaviour o f the series over the period considered.
The time series properties o f the rate o f growth o f the three variables are remarkably
different. Notice, in particular, the fact that both in the U K and in the USA, the sum o f
the M A coefficients for non-durable consumption is positive, while that for durables
is negative. The time series properties o f non-durable consumption differ remarkably:
in Table 2 the sum o f the first 12 M A coefficient is much larger in the U K than in the
USA. Furthermore, while the US data are well represented by an M A ( 3 ) (with the first
and third lag large and very strongly significant), the U K require an AR(2) model 1.

I The presence of an MA(3) effect in the non-durable series for the USA is evident even in the MA(12)
representation but it is not very robust. If one truncates the sample to 1990 or dummies out the few
quarters corresponding to the 1990-91 recession, 03 is estimated non-significantly different from zero

748

O.P Attanasio

Table 2
MA(12) representation a
US

0i

01
02
03
04
05
06
07
08
09
010
011
012

~ ) 2 I 0i

UK

Disposable
income

Non-durable
consumption

Durable
consumption

Disposable
income

Non-durable
consumption

Durable
consumption

-0.30
(0.091)
0.15
(0.094)
0.092
(0.094)
-0.092
(0.088)
-0.15
(0.087)
0.11
(0.088)
-0.13
(0.087)
-0.17
(0.088)
0.38
(0.088)
0.20
(0.095)
-0.06
(0.096)
-0.27
(0.091)
-0.25

0.41
(0.096)
0.18
(0.103)
0.43
(0.104)
0.12
(0.110)
-0.057
(0.108)
0.100
(0.108)
0.11
(0.107)
-0.20
(0.107)
0.05
(0.109)
-0.03
(0.100)
0.05
(0.099)
0.08
(0.092)
1.23

-0.092
(0.088)
-0.035
(0.089)
0.063
(0.089)
0.084
(0.086)
-0.16
(0.085)
0.15
(0.077)
-0.45
(0.077)
-0.021
(0.085)
-0.23
(0.085)
-0.03
(0.088)
0.005
(0.087)
-0.23
(0.086)
-0.95

-0.10
(0.094)
0.12
(0.095)
-0.06
(0.092)
-0.18
(0.088)
-0.19
(0.089)
0.22
(0.088)
0.21
(0.088)
0.14
(0.087)
-0.14
(0.086)
-0.20
(0.087)
0.05
(0.088)
-0.05
(0.086)
-0.18

0.005
(0.094)
0.20
(0.093)
0.004
(0.093)
0.28
(0.092)
0.19
(0.093)
0.19
(0.094)
0.09
(0.094)
0.22
(0.092)
-0.11
(0.090)
0.23
(0.091)
0.18
(0.091)
0.03
(0.093)
1.51

-0.29
(0.094)
-0.14
(0.096)
0.24
(0.097)
-0.45
(0.099)
0.15
(0.106)
0.05
(0.107)
-0.07
(0.106)
-0.18
(0.104)
-0.08
(0.098)
0.02
(0.095)
-0.20
(0.094)
-0.02
(0.089)
-0.97

a Standard errors are given in parentheses.

The sum o f the M A coefficients for disposable income in both countries is quite
small in absolute value, but is positive in the U S A and negative for the UK. As far as
a 'parsimonious' specification is concerned, in the U S A I chose an MA(1) for the first
differences, even though its coefficient is not very large and is statistically insignificant.
This model was almost indistinguishable from an AR(1) model. In the UK, the best
model for disposable income is an ARMA(1,1). The richer dynamics o f the U K series
is also evident in the pattern o f the M A coefficients in Table 2.

both in the MA(12) and in the MA(3) model. The same result is obtained if one excludes services from
this series.

Ch. 11:

749

Consumption

Table 3
ARMA representation a
Variable

US
Disposable
income

'[Pl

--

--

'10 2

--

01

-0.19
(0.088)

0 2

--

03

UK

Non-durable D u r a b l e Disposable Non-durable

Durable
consumption consumption income
consumption consumption
-0.103
(0.089)

-0.77
(0.293)
-

0.684
(0.339)

0.38
(0.083)
0.18

0.015
(0.087)
0.28
(0.087)
-

-1.09
(0.098)
-0.45
(0.082)
0.85
(0.077)

0.85
(0.077)
7.22
(0.30)

(0.088)

Q-stat
(p-value)

13.40
(0.10)

0.39
(0.082)
7.35
(0.28)

10.09
(0.26)

0.684
(0.339)
11.79
(0.11)

11.49
(0.12)

a Sample 1965:3-1996:3 (125 observations). Standard errors are given in brackets.

The properties of durable consumption are particularly interesting. The fact that the
time series properties are inconsistent with a simple model which adds durability to the
standard random walk property derived from some version o f the permanent income
has been noticed by Mankiw (1982). Such a model would imply an MA(1) model
for the changes in expenditure with a coefficient that would differ from minus one
by an amount equivalent to the depreciation rate. As can be seen from Table 2, the
US series' best representation is indeed an MA(1) with a negative coefficient; but that
coefficient is far from minus one 2. Caballero (1990b) has interpreted this and the fact
that, as reported in Table 3 :for b0th~eountries, the sum o f the 12 M A coeflici~fits is
negative and much larger in absolute value, as an indication o f the presence of inertial
behaviour that 'slows down' the process o f adjustment o f durables.
Having characterised the main time series properties o f consumption and income,
the next step would be the estimation of a multivariate time series model that would
stress the correlations among the variables considered at various leads and lags. Indeed,
some of the studies I cite below, such as Flavin (1981), do exactly this with the purpose
of testing some of the implications o f the life cycle-permanent income hypothesis. For
the sake of brevity, I omit the characterisation o f the multivariate time series process
o f consumption and other macro variables. One of the reasons for this omission is
the belief, discussed below, that aggregation problems make it very difficult to give

2 For durable consumption in the UK, the best model is an ARMA(2,1), by far the most complex model
I fitted to these data.

750

0.17 Attanasio

structural interpretation to this type of results. This does not mean, however, that
aggregate time series studies are not useful.
The careful specification of a flexible time series model for consumption and other
variables can be quite informative, especially if the dynamic specification allows for
the type of dynamic effects implied by the microeconomic behaviour. Several of the
studies by David Hendry and his collaborators are in this spirit; one of the most widely
cited examples of this literature is the paper by Davidson et al. (1978).
The approach taken in these papers, which received a further motivation by the
development of cointegration techniques, is to estimate a stable error correction
model which relates consumption to other variables. The statistical model then allows
to identify both short run and long run relationships between consumption and its
determinants. While the theory can be informative on the choice of the relevant
variables and even on the construction of the data series, it does not provide explicit
and tight restrictions on the parameters of the model. A good example of a creative
and informative use of this type of techniques is Blinder and Deaton (1985). While it
is difficult to relate this type of models to structural models and therefore they cannot
be directly used for evaluating economic policy, they constitute useful instruments for
summarising the main features of the data and, if used carefully, for forecasting. Often
the lack of micro economic data makes the use of aggregate time series data a necessity.
The only caveat is that these studies cannot be used to identify structural parameters.

2.2. Household consumption expenditure

In this section, I use two large microeconomic data set to document the main stylised
facts about consumption. The two data sets used are the US Consumption Expenditure
Survey (CEX) and the UK Family Expenditure Survey (FES). Both data sets are run
on a continuous basis to gather information for the construction of the weights for
the CPI (RPI in the UK). They have, however, been extensively used by researchers
and have now become an essential tool to study household consumption and saving
behaviour. The focus of the analysis is going to be the household. No attempt will be
made to attribute consumption to the single household members, even though some
(limited) information on this does exist 3.
Most of the descriptive analysis presented below attempts at describing the main
features of the life cycle profile for consumption expenditure and some other variables.

3 Both data sets containvery detailed information on the expenditure on individual commodities. Some
of this information can be used to attribute some items to some household members. For many items,
however, such attribution is difficult both in practice and conceptually. Browning (1987) has imputed
expenditure on alcoholand tobaccoto the adults to checkwhether predictedchangesin householdincome
and composition(such as the arrival of children with consequent- at least temporary- withdrawal from
the labour force of the wife) cause changes in consumption. Gokhale, Kotlikoffand Sabelhaus (1996) in
their study of saving behaviourhave attempted to impute all of consumptionto the individual household
members.

Ch. 11: Consumption

751

This approach reflects the fact that the theoretical discussion in the next sections will
be focused around the life cycle model.

2.2.1. Nature of the data sets and their comparability with the National Account
data
The FES is now available for 25 consecutive years. Each year around 7000 households
are interviewed and supply information on their consumption patterns as well as their
demographic characteristics and several other economic variables such as employment
status, income, education and so on. Each household stays in the sample for two weeks,
during which it fills a diary in which all expenditure items are reported. At the end o f
the two week period an interviewer collects the diaries and asks additional information
on durables acquired during the previous three months and on all major expenditure
items reported in the diary and periodic expenditures such as utilities.
The CEX is available on a continuous and roughly homogeneous basis since
1980. Each year about 7000 different households are interviewed for 4 subsequent
interviews, with quarterly frequency 4. Each month new households enter the survey to
replace those that have completed their cycle o f interviews. During each interview the
household is asked to report expenditure on about 500 consumption categories during
each o f the three months preceding the interview 5. The panel dimension of the CEX
is unfortunately very short: because each household is only interviewed four times,
seasonal variability is likely to dominate life cycle and business cycle movements. In
what follows, I do not exploit the panel dimension o f the survey.
There have been several discussions about the quality o f survey data and the
importance o f measurement error and about their ability to reproduce movements in
aggregate consumption. Several studies, both in the U S A and the UK, have addressed
the issue 6. It should be stressed that the aggregated individual data and the National
Account aggregate should be expected to differ for several reasons. First o f all, for
many consumption categories, the definitions used in the surveys and in the National
Accounts are quite different. Housing, for instance, includes imputed rents in the
National Accounts data but does not in the surveys. In the CEX, health expenditure

4 In total there are data for over 20000 interviews per year. Each household is in fact interviewed
five times. However, the Bureau for Labor Statistics does not release information on the first (contact
interview). The Bureau of Labor Statistics also rtms a separate survey based on diaries which collects
information on food consumption and 'frequently purchased items'.
s Unfortunately,the monthly decomposition of the quarterly expenditure is not very reliable. For several
commodities and for many households, the quarterly figure is simply divided by three. Given the rotating
nature of the sample, the 'quarters' of expenditure do not coincide perfectly. For instance, somebody
interviewed in December will report consumption in September, October and November, while somebody
interviewed in November will report consumption in August, September and October.
6 See, for instance, Seslnick (1992) and Paulin et al. (1990) for comparisons between the aggregate
Personal Consumption Expenditure and the CEX in the USA and the papers in Banks and Johnson
(1997) for comparisons on the FES and the UK National Accounts.

752

O.P. Attanasio

measures only out-of-pocket expenditures, while~ the National Accounts definition

includes all health expenditures regardless o f the payee. Furthermore, the populations
of reference are quite different. Surveys, for instance, do not include institutionalised
individuals, while the National Accounts do. Finally, National Account data arc not
exempt from measurement error that, for some items, can be quite substantial. Should
major difference emerge, it is not obvious that the National Account data should be
considered as being closer to the 'truth'.
The issues that arise are different for the two data sets. Overall, the degree o f
correspondence between the aggregated individual data and the National Account data
seems to be higher in the UK. For most consumption components, aggregating the FES
data, one obtains about 90% o f the corresponding National Accounts figure, while
the same ratio is about 65% for the CEX in the 1980s. This is probably due to the
use o f diaries rather than recall interviews. The latter, perhaps not surprisingly, tend
to underestimate consumption. In both surveys, however, because o f the consistent
methodology used over time, there is no major trend in the ratio o f the aggregated
individual data to the corresponding National Accounts aggregates 7. Furthermore, the
dynamics o f consumption and income growth and o f saving in both the aggregated
CEX and FES data do not track the corresponding macroeconomic aggregates badly.
The data are therefore not only useful to characterise individual behaviour and its shifts
over time, but also to make inferences, based on individual behaviour, about possible
explanations o f the observed macroeconomic trends.

2.2.2. Life cycle profiles

In the second part o f the chapter, in which I discuss the main theoretical model
o f consumption behaviour, a substantial amount o f attention is devoted to the life
cycle model in its several incarnations. In this section, I present life cycle profiles
for consumption, its components and various other variables in the USA and the UK.
In this sense, the life cycle model is the conceptual framework that I use to organise
the presentation of the microeconomic data.
As the data sets I use are not panels, to estimate age profiles, I am forced to use
grouping techniques. These techniques were first used within life cycle models by
Browning, Deaton and Irish (1985)8. The idea is quite simple. Rather than following
the same individual over time, one can follow tile average behaviour o f a group of

7 There are substantial differences in this ratio between the early CEX surveys (1960-61 and 1972-73)
and those of the 1980s, probably due to the differences in the methodology employed. In the FES the
one commodity for which a (downward) trend in the ratio is apparent is tobacco.
8 Ghez and Becker (1975) use observations on individual of different ages to study life cycle behaviour.
However, as they use a single cross section, they do not control for cohort effects as Browning et al.
(1985) do. Deaton (1985) and, more recently, Moffitt (1993) have studied some of the econometric
problems connected with the use of average cohort techniques. Heck~manand Robb (1987), MaCurdy
and Mroz (1989) and Attanasio (1994) discuss identification issues.

Ch. 11:

Consumption

753

individuals as they age. Groups can be defined in different ways, as long as the
membership o f the group is constant over time 9. Within the life cycle framework,
the natural group to consider is a 'cohort', that is individuals (household heads) born
in the same period. Therefore, to compute the life cycle profile o f a given variable, say
log consumption, one splits the households interviewed in each individual cross section
in groups defined on the basis o f the household head's year o f birth. This involves, for
instance, considering all the individuals aged between 20 and 24 in 1980, those aged
between 21 and 25 in 1981 and so on to form the first cohort; those aged between 25
and 29 in 1980, between 26 and 30 in 1981 and so on to form the second cohort, etc.
Having formed these groups in each year in which the survey is available, one can
average log consumption and therefore form pseudo panels: the resulting data will
have dimension Q x T, where Q is the number o f groups (cohorts) formed and T is
the number o f time periods m. Even if the individuals used to compute the means in
each year are not the same, they belong to the same group (however defined) and
one can therefore study the dynamic behaviour o f the average variables. Notice that
non-linear transformations o f the variables do not constitute a problem as they can be
computed before averaging.
The resulting age profiles will not cover the entire life cycle o f a given cohort, unless
the available sample period is longer than any o f the micro data set commonly used.
Each cohort will be observed over a (different) portion o f its life cycle.
These techniques can be and have been used both for descriptive analysis and
for estimating structural models. Their big advantage is that they allow to study
the dynamic behaviour o f the variables o f interest even in the absence o f panel
data. Indeed, in many respects, their use might be superior to that o f panel data ~1.
Furthermore, as non-linear transformations o f the data can be handled directly when
forming the group means, they allow one to solve various aggregation problems that
plague the study o f structural models with aggregate time series data.
In what follows, I define groups on the basis o f the year o f birth and educational
attainment o f the household head. The length o f the interval that defines a birth

9 Group membership should be fixed over time so that the sample is drawn from the same population
and the sample mean is a consistent estimator of the mean of the same population. Attanasio and Hoynes
(1995) discuss the implications of differential mortality for the use of average cohort techniques. Other
possible problems arise, at the beginning of the life cycle, from the possible endogeneity of household
formation and, more generally, from migration.
~0 Here I am implicitly assuming that the pseudo panel is a balanced one. This is not always the case
as each group might be observed for a different number of time periods. Suppose, for instance, to have
data from 1968 to 1994. One might want to follow the cohort born between 1965 and 1970 only from
the late 1980s or the early 1990. On the other hand, at some point during the 1980s one might want to
drop the cohort born between 1906 and 1910.
l~ Time series of cross sections are probably less affected by non-random attrition than panel data.
Furthermore, in many situation, averaging across the individuals belonging to a group can eliminate
measurement error and purely idiosyncratic factors which are not necessarily of interest. As most
grouping techniques, average cohort analysis has an Instrumental Variable interpretation.

O.P. Attanasio

754
Table 4
Cohort definition and cell size
Cohort

Year of birth

Cell size
US
Average size

Years in sample

Averagesize

UK
Years in sample

1895-1999

338

1968-1977

1900-1904

459

1968-1982

1905-1909

526

1968-1987

1910-1914

232

1980-1992

560

1968-1992

1915-1919

390

1980-1992

519

1968-1992

1920-1924

333

1980-1992

653

1968-1992

1925-1929

325

1980-1992

572

1968-1992

1930-1934

317

1980-1992

546

1968-1992

1935-1939

345

1980-1992

562

1968-1992

10

1940-1944

420

1980-1992

594

1968-1992

11

1945-1949

566

1980-1992

652

1968-1992

12

1950-1954

657

1980-1992

547

1971-1992

13

1955-1959

734

1980-1992

508

1976-1992

14

1960-1964

463

1981-1992

15

1965 1969

334

1986-1992

cohort is chosen taking into account the trade-off between cell size and within-cell
homogeneity. Table 4 contains the definition o f the cohorts and the average sample
size for both surveys.
We start, in Figures 3 and 4, with the life cycle profile of (log) consumption and
disposable income at constant prices for both countries. The units o f measurement
for income and consumption are chosen so that the two graphs would be roughly
in the same scale, enabling to stress the differences in the shape of the age profile.
In the figures, I plot the average cohort (log) consumption at each point in time,
against the median age o f the household head. Each connected segment represent the
behaviour o f a cohort, observed as it ages, at different points in time. As each cohort
is defined by a five year interval, and both surveys cover a period longer than five
years, at most ages we observe more than one cohort, obviously in different years.
It might be tempting to attribute the differences between adjacent cohorts observed
at the same age, to 'cohort effects'. It should be remembered, however, that these
observations refer to different time periods and might therefore be reflecting business
cycle effects. The plotted profiles reflect age, time and cohort effects 12 that, without

12 As well as measurement error and small sample variability.

755

Ch. 11." Consumption

USA - disposableincome

UK - disposable income

25000

~'250
200

20000
150
15000

lOO
8 50

10000
20

40

Age

60

70

20

40

Age

60

70

60

70

Fig. 3.
USA - total consumption
25000

20000

UK - total consumption
250

~2o0
"~150

~o

&loo

15000

05

10000

0
20

40

Age

60

70

50
20

40

Age

Fig. 4.
an arbitrary normalisation or additional information from a structural model, cannot
be disentangled.
Several considerations are in order. First of all, both consumption and income age
profiles present a characteristic 'hump'. They both peak in the mid 40s and decline
afterwards. The picture seems, at first glance, to contradict the implications of the life
cycle model as stressed in the typical textbook picture which draws a 'hump shaped'
income profile and a flat consumption profile. For total disposable income, the decline
around retirement age is faster in the UK than in the USA, but approximately of the
same magnitude. This probably reflects the more synehronised retirement of British
individuals. The consumption profiles, however, present some strong differences. The
most notable is the fact that UK consumption declines much more at retirement than
US consumption. Total consumption at age 70 is roughly 35% of the peak in the UK
and above 50% in the USA. I discuss the decline of consumption at retirement below.
In the UK consumption profile, the consumption boom of the late 1980s, followed
by the bust of the early 1990s, is quite apparent. Notice, in particular, the fact that the
aggregate consumption boom is accounted for mainly by the youngest cohorts. I have
discussed elsewhere how to interpret that episode. It is worth stressing, however, that
the analysis of the cross sectional variability of consumption can be useful to shed
some light on the nature of episodes that the analysis of the time series data cannot

0.17. Attanasio

756
Table 5
Variability of consumption and income
Standard error (%)

Variable

Total consumption
Total consumption per adult equivalent
Non-durable consumption
Non-durable consumption per adult equivalent
Durable consumption
Non-durable consumption (from levels)
Income

USA
(CEX)

UK (FES);
age < 81

UK (FES);
10 cohorts,
year < 86

2.94
2.39
2.60
1.95
15.79
2.58
3.68

2.46

2.65

2.62
2.30
2.49
9.54

2.64
1.88
2.05
8.54

2.31
3.05

1.86
3.60

explain. Information about which groups in the populations where mainly responsible
for a determinate episode can be informative about alternative hypotheses 13
It is not obvious how to assess the time series volatility o f (log) consumption and
income. The main reason for this is that a large part o f the variation o f consumption
over the life cycle is very predictable and can be explained by age and cohort effects.
Furthermore, given the limited size o f our samples, the year to year variation in the
average cohort data reflects both genuine time series variation and the measurement
error induced by sample variation. As Deaton (1985) has stressed, some information
about the size o f the measurement error can be gained using the within-cell variability
o f the variables used. Using this information, one might correct for that part o f
variability accounted for by sampling variation and attempt to isolate the genuine time
variation. In an attempt to isolate this component, I run a regression o f log consumption
and income on a fifth order polynomial in age and cohort dummies and consider
the deviations o f the observed profiles from such a profile. The standard deviation
o f the changes in these deviations, corrected for that part which can be attributed to
sampling error, is my measure o f time variability 54. These estimates o f volatility for
(log) income and consumption are reported in Table 5 along with those for the other
variables considered. The first column refers to the USA, while the second and third
columns are computed using the U K data. The former includes the whole sample,

i3 See Attanasio and Weber (1994). Groups do not need to be formed on the basis of age. In Attanasio
and Banks (1997) that analysis is extended considering not only the variability across cohorts but also
across regions.
14 The sample mean is distributed around the population mean as a random variable with variance
given by o2/N, where N is the cell size and cr is the within-cell variance. The latter can be estimated
from the available micro data. These estimates can be used to correct our estimates of volatility.

Ch. 11:

Consumption

757
UK - non-durable consumption
per household and per adult equivalent

USA - non-durable consumption

per household and per adult equivalent
~"

15000

200-

10000
100E

5000
20

40

Age

60

70

5020

40

Age

60

70

Fig. 5.

while the latter truncates it to 1986 to remove the effect of the consumption 'boom
and bust' of the last part of the sample.
As in the case of aggregate time series, total consumption appears less volatile than
disposable income, both in the UK and in the USA. In particular, the standard deviation
of changes in total disposable income at the cohort level is above 3% in both countries.
That of total consumption is between 0.6% and 0.95% less.
It may be argued that the differences in the consumption profiles for the two
countries are due to the differences in the definitions used in the two surveys. For this
reason, I next focus on a narrower definition of consumption which excludes a number
of items which might be recorded in different fashion in the two countries. In particular,
in Figure 5 I plot (log) expenditure on non-durables and services against age. This
definition excludes from total consumption durables, housing, health and education
expenditure. The other advantage of considering consumption of non-durables and
services, is that I avoid the issue of durability and the more complicated dynamics
that is linked to durables. The main features of the two profiles, however, including the
larger decline observed in the UK, are largely unaffected. In Table 5, the volatility of
non-durable consumption is considerably less than that of total consumption, especially
in the UK when data up to 1986 are used.
An important possible explanation for the life cycle variation of consumption over
the life cycle (and between the two countries considered), is the variation in needs
linked to changes in family size and composition. To control for this possibility,
I have deflated total household expenditure by the number of adult equivalents in the
household. For such a purpose, I use the OECD adult equivalence scale 15. The most
evident result is that the life cycle profile of consumption looks much flatter now. In
this sense, we can say that a large proportion of the variability of consumption over the
life cycle is accounted for by changes in needs. This result is perhaps not surprising

15 No adult equivalence scale is perfect. Different alternatives, however, do not make much difference
for the point I want to make here. The OECD scale gives weight 1 to the first adult, 0.67 to the following
adults and weight 0.43 to each child below 19.

O.P. Attanasio

758
USA - durables

UK - durables

5000-

4000-

looo-

30002000

1000-

~0

4o

6o

~0

Age

~0

40

6'o

8S

1;0

Age

Fig. 6.
if one considers that the life cycle profile of the number of adult equivalents (or of
family size) is also 'hump-shaped'. It may be argued that changes in needs are, to a
large extent, predictable. In terms o f the measure o f volatility in Table 5, it is greatly
reduced for the USA, while is slightly increased for the UK.
While the profile for non-durable consumption per adult equivalent is quite flat in
the first part of the life cycle, a marked decline is still noticeable in the last part.
It seems that the decline corresponds roughly to the time of retirement. In the UK,
where retirement is much more synchronised than in the USA, the decline is much
more rapid. The fact that per adult equivalent consumption declines with retirement
suggests that this might be due to a link between labour market status and consumption.
A possibility, for instance, is that some components of consumption are linked to
labour market participation. More generally, it is possible that consumption and leisure
are non-separable and, therefore, need to be analysed jointly. These issues have been
recently discussed by Banks et al. (1998).
Finally, it is of some interest to consider the life cycle profile of expenditure on
durables. The life cycle profiles for durables are plotted in Figure 6. Consistently with
the findings in aggregate time series data, the life cycle profiles for durable expenditure
are much more volatile than those for non-durables and services. The measure in
Table 5 for durables is 5 times as large as that o f total consumption for the USA
and almost 4 times as large for the U K 16.
Several variables are likely to be important determinants of, or determined jointly
with consumption. I have already stressed the important role which is likely to be
played by demographics and retirement behaviour in shaping the life cycle profiles
o f consumption. Similar considerations can be made for other labour supply variables

16 Because durable expenditure can be zero at the individual level I do not compute the average of
the log. Therefore, the deviations from the life cycle profiles are not percentage deviations, but are
measured in constant dollars. Because of this, in Table 5, in the row corresponding to durables I report
the coefficient of variation, rather than the standard deviation. For comparison, I adopt the same procedure
for non-durable consumption, in the following row.

Ch. 11:

Consumption

759

such as the participation rate of females to the labour market and the total number of
hours of work. A characterisation of the life cycle patterns of these variables and their
differences between the U K and the USA would go beyond the scope of this section 17.
However, it is important to stress that, as I argue in Section 5 and 6 below, one cannot
test any model of consumption without controlling for these factors, that, for the most
part, can only be analysed using household level data.
In Table 5, I only report the variability of the various components of consumption
and of disposable income. As with the aggregate time series data, it would be
interesting to characterise the autocorrelation properties of these variables and their
covariances. This analysis could be quite informative about the plausibility of
alternative structural models 18.
One of the implications of the textbook version of the life cycle model I discuss
in Section 3, is that consumption and current income should not be related. And yet,
comparing Figures 3 and 4, one cannot help noticing the similarity in the shape of
the two life cycle profiles. This similarity was interpreted as a failure of the life cycle
model by Thurow (1969) and reinterpreted in terms of non-separability of consumption
and leisure by Heckman (1974).
To pursue this issue, in Figure 7, I plot the life cycle profile of (log) disposable
income and non-durable consumption for four education groups in the USA defined
on the basis of the educational attainment of the household head: high school dropouts,
high school graduates, some college and college graduates. An interesting feature of
this figure is that the differences across groups in the shape of the income profiles
are mirrored in differences in the consumption profiles. In particular, notice that
both income and consumption profile of better educated individuals present a more
pronounced hump; not only are their income and consumption higher, but the profiles
are also much steeper in the first part of the life cycle. These differences where
interpreted within a life cycle model by Ghez and Becker (1975), but have interpreted
as a failure of the model by Carroll and Summers (1991) in an influential paper. An
interesting question, addressed below, is whether a version of the life cycle model
I discuss could generate these profile and account for the differences across education
groups.
In Table 6, I compute the variability of income, consumption and its components
as in Table 5, but splitting the sample by education. The most interesting feature of
this table is the fact that the only large difference in volatility among the groups is in
durable consumption. Expenditures on durables by high school dropouts is twice as
variable as that of college graduates, while the figure for high school graduates is in
the middle.
17 Interested readers can find the life cycle profiles for several variables in Attanasio (1994), Banks,
Blundell and Preston (1994) and Attanasio and Banks (1997).
a8 MaCurdy (1983) and Abowd and Card (1989) perform analyses of these kinds for earnings and hours
of work and use the results to assess the plausibility of different structural model. No similar analysis
exists for consumption and/or its components.

O.P. Attanasio

760
log i n c o m e a n d n o n d u r a b l e c o n s u m p t i o n
by e d u c a t i o n
high school graduates

high school dropouts

40000l
30000

20000

-l
10000

3--~

5459.04

some college

college graduates

30000

20000

10000

5459,04

20

910

410

50

age

Fig. 7.
Table 6
Variability of consumption and income by educational group
Variable

Standard error (%)

High school dropouts High school graduates Morethan high school

Total consumption
Non-durable consumption
Durable consumption
Income

2.88
2.40
22.85
5.98

2.74
2.93
16.58
6.53

2.88
2.25
9.66
5.17

3. The life cycle model

In this and in the next few sections, I will sketch what 1 think is the most important
model of intertemporal consumption behaviour: the life cycle-permanent income
model. In doing so, I take a fairly wide definition of the model: I consider a
very general framework in which consumption (and saving) decisions are taken as
a part of an intertemporal decision process. This general definition includes both
the initial formulations of the life cycle and permanent income models and more
recent and sophisticated developments, such as the precautionary saving model or
the bequest motive. While the emphasis given to various aspects of the problem is
different in the various incarnations of the general model I will consider, they have in
common the hypothesis that consumption decisions are taken by a decision unit that

Ch. 11: Consumption

761

maximises utility over time. The various versions of the model will then differ for their
assumptions about optimisation horizon, uncertainty, curvature of the utility function,
assumptions about separability and so on. Which of these various versions is the most
relevant is in part a matter of taste and, above all, an empirical matter.
3.1. The simple textbook model

The main attractiveness of the life cycle-permanent income model, developed during
the 1950s in a number o f seminal contributions 19, is the fact that consumption
decisions are treated as part of an intertemporal allocation problem. The allocation
of consumption over time is treated in a fashion similar to the allocation of total
expenditure among different commodities in demand analysis. The model recognises,
therefore, that intertemporal prices and the total amount of resources available to an
individual are bound to be important determinants of consumption. This approach
immediately gives the study of consumption solid microfoundations and constitutes
a discontinuous jump with respect to the Keynesian consumption function which
assumed consumption to be a simple function of current disposable income.
The main difference between the life cycle and the permanent income model in
their original formulation lies in the time horizon considered. The life cycle model is,
almost by definition, a finite horizon model, while in the permanent income model the
horizon is infinite. In both cases, however, consumers decide how much to consume
keeping in mind their future prospects. If no uncertainty is introduced in the model, its
predictions are quite straightforward: concavity of the utility function implies a desire
to smooth consumption over time; the main motivation for saving is to smooth out
fluctuations in income; consumption increases with current income only if that increase
is a permanent one. In the case of the life cycle model, the explicit consideration of
retirement, that is a period in which income declines considerably, generates the main
motivation for saving: households accumulate wealth to provide for their consumption
during retirement.
An interesting implication of the life cycle model in its simplest incarnation is the
way in which aggregate saving is generated. It is quite obvious that in a stationary
life cycle economy with no growth aggregate saving is zero: the younger generations
will be accumulating wealth, while the older ones will be decumulating it. Aggregate
saving, however, can be generated in the presence of growth. I f the amount of resources
available over the life cycle to younger generations is larger than that available to
older ones, it is possible that the amount accumulated at a point in time exceeds the
amount that is decumulated. This introduces a relationship between aggregate saving
and growth that Modigliani has stressed in several studies. It should be stressed,
however, that such a relationship depends on a number of factors including the life

19 Modiglianiand Brumberg(1954) contains the first formulation of the life cycle model. The permanent
income model was sketched in Milton Friedman's 1957 volume [Friedman (1957)].

762

O.P. Attanasio

cycle profile, the way in which growth is generated and who benefits from it and so
on.

The life cycle-permanent income models were developed to provide an answer to

several needs. First, by framing consumption decision within an intertemporal problem,
immediately introduces dynamics into the picture. This gives the possibility of fitting
some of the empirical facts that seemed at odd with the Keynesian consumption
function 20, such as the difference between average and marginal propensity to consume
in the short and long run. In addition, the introduction of dynamics is obtained
in a theoretically consistent fashion which is appealing to economists. The model
gives an obvious explanation of the smoothness of consumption relative to disposable
income linked to some well defined preference parameter (the concavity of the utility
function).
Obviously, the first empirical applications of the model were quite different from
the studies of the last 20 years, mainly for the much more sophisticated treatment of
uncertainty which I discuss below 21. The model, however, seemed to score a number
of empirical successes. I have already mentioned the fact that the model accounts
for differences between short run and long run responses of aggregate consumption to
disposable income (or other variables). More generally, it was clear that the model was
able to generate very rich dynamic patterns for aggregate consumption and its response
to disposable income. It could also explain the relationship between consumption and
wealth and provide a rationale for the relationship between wealth-income ratios and
growth. Indeed, as Modigliani has pointed out, the simplest version of the model is
capable to generate an aggregate wealth to income ratio of 5 which is close to what
this number is for the USA. Furthermore, the model also seemed able to explain some
of the regularities observed in cross sectional data. Just to mention one, Friedman
showed how the permanent income model can explain the fact that black households
seem to save, at each level of income, a larger fraction of their income than white
households 22.

3.2. Quadratic preferences, certainty equivalence and the permanent income model
One of the problems with the life cycle-permanent income model is that the
dynamic problems that consumers are assumed to solve can be quite complex. As a

20 Carroll and Kimball (1996) provide quotes from Keynes' General Theory in which he suggested a
concave consumptionfimction.
21 Friedman(1957) essentially approximatedpermanent income with a distributed lag of current income.
Modigliani and Ando (1963) stressed the role played by wealth (in addition to disposable income) in
aggregate consumptionequations. Both the Modigliani and Ando paper and Friedman's book contained
interesting discussions of the aggregationproblems that were absent, for a long time, from subsequent
empirical studies.
22 This fact is still true: data from the Consumer Expenditure Surveyfrom 1980 to 1992 confirm that
the saving rates of household headed by a black are systematicallyhigher, for any interval of income,
than those of household headed by a non-black.

Ch. 11:

Consumption

763

consequence, if one considers an uncertain environment, unless strong assumptions

about the nature of uncertainty and preferences are made it is not possible to
obtain a closed form solution for consumption. A popular parametrization of the
model which can yield an analytical solution is that of intertemporally separable and
quadratic preferences. Indeed, a large part of the profession has come to identify
the 'permanent income model' with such a parametrization of preferences with the
additional assumptions of infinite horizon, constant interest rates and stochastic labour
income.
The analysis of the model is greatly simplified by the linearity of the marginal utility
of consumption. This, and the fact that the only uncertainty comes from labour income,
allows the derivation of an analytical solution for consumption which depends only on
the first moment of future labour income. In particular, under the assumptions listed in
the previous paragraph, consumption at time t can be expressed as a simple fimction
of 'permanent income':
Ct = kY p,

(1)

where k= 1 if the (fixed) interest rate equals the subjective discount factor, and
permanent income YP is defined as

j=0 (1 +r)J
where r is the fixed interest rate, ;~=r/(1 +r), At is the value of current wealth, and
y is disposable labour income.
The main attraction of Equations (1) and (2) is that they provide a straightforward
relationship between the stochastic process that generates income and consumption.
These relationship give rise to a number of testable implications that have been studied
at length in the literature.
Flavin (1981) and Sargent (1978) were the first studies to exploit the fact that
Equations (1) and (2), together with the hypothesis that expectations about future
labour income are rational, imply cross equation restrictions on the bivariate VAR
representation of consumption and disposable income. Flavin (1981), in particular,
estimated such a system using US time series data and rejected the restrictions
implied by Equations (1) and (2). Flavin finds some evidence of excess sensitivity
of consumption to income.
Campbell (1987) proposes a slightly different interpretation of Flavin's results. From
Equations (1) and (2) it is possible to obtain the following expression for saving 23:
OO

st = )~ ~
j-0

EtYt+j -Yt
(1 + r)J

(3)

23 s on the left-hand side of Equation (9) coincideswith saving (i.e. income minus consumption),only
when k in Equation (7) is equal to 1. Otherwise,s = y - c/k.

764

0.17. Attanasio

The restrictions implied by Equation (3) are the same as those implied by Equations (1)
and (2). The nice thing about Equation (3), however, is its interpretation. The fact
that consumers smooth consumption over time is reflected in Equation (3) in the fact
that saving anticipates expected decline in disposable income. It is for this reason that
Equation (3) has been dubbed as the 'saving for a rainy day' equation. Formally, the
implication of Equation (3) can be written as saying that actual saving should equal the
best forecast of labour income declines. Consistently with Flavin's findings, Campbell
(1987) rejects the implications of the model. Campbell, however, finds that the time
series pattern of actual saving is not far from that implied by the model. He claims that
excess sensitivity of consumption to income within this framework "is more naturally
interpreted as insufficient variability of saving than as a correlation between changes
in consumption and lagged changes in income" (p. 1272).
Related to the tests of excess sensitivity discussed above, and using the same
framework, are those papers discussing the issue of 'excess smoothness' of consumption. Campbell and Deaton (1989) were the first to stress that, because Equations
(1) and (2) can be used to derive the relationship between changes in consumption and
innovations to the process generating income, the relationship between the volatility
of consumption (or permanent income) and that of current income depends on the
stochastic properties of the process generating the latter. In particular, if labour income
is difference stationary (rather than trend stationary), permanent income, and therefore
consumption, will be more volatile than current income. Intuitively, this result follows
the fact that if labour income is not stationary, current innovations are persistent
and will therefore imply a permanent revision to permanent income. Therefore the
observation that consumption growth is less volatile than current disposable income
growth contradicts the permanent income hypothesis 24. This result is ironic as one
of the original motivations for the development of the permanent income model
was, indeed, the observation that consumption is smoother than income. The most
problematic issue with this branch of the literature is the well known difficulty in
distinguishing between trend stationary and difference stationary models 25.
The version of the model with quadratic preferences has also been used to introduce
further refinements to the model. Goodfriend (1992) and Pischke (1995), for instance,
consider the implications of the lack of complete information on contemporaneous
aggregate variables. Pischke, in particular, explains the excess sensitivity results
typically obtained with aggregate data with this type of phenomena 26.
In a recent paper, Blundell and Preston (1998) use the assumption of quadratic
preferences to devise a clever way of decomposing transitory and permanent
components of income shocks. The idea is quite simple: under the permanent income

24 For a clear discussion of these issues see chapters 3 and 4 in Deaton (1992).
25 See, for instance, Christiano and Eichenbaum(1990)
26 Deaton(1992) also discusses the possibilitythat the informationset used by individual agents differs
from that available to the econometrician.

Ch. 11:

Consumption

765

model, consumption should react to innovations to permanent income and not to

transitory income. Consumption variability can therefore be used to isolate that part
of the observed volatility of income which is to be attributed to permanent shocks.

3.3. The Euler equation approach

Without the assumption of quadratic utility (and of uncertainty confined to the
exogenous income process), one is left with the problem that it is not possible to derive
an analytical solution for the level of consumption.
The most important theoretical development since the development of the life cyclepermanent income model is the rigorous treatment o f uncertainty introduced in the
late 1970s, after the rational expectations revolution in macroeconomics. In a famous
paper, Hall (1978) used what is the main implication of the intertemporal optimisation
problem faced by a generic consumer to derive empirically testable restrictions that
have been at the centre of much of the empirical analysis in the last 20 years. The idea
is simple and elegant: in a situation in which consumers maximise expected utility
under uncertainty, they act so to keep the expected (discounted) marginal utility of
consumption constant.
This condition is equivalent to the equalisation of the marginal rate of substitution
to relative prices in consumer demand. The beauty of the approach lies in the way in
which the difficulties associated with the presence of uncertainty are circumvented.
The effect of future variables on consumption at a given point in time is summarised
by the multiplier associated to the budget constraint: the marginal utility of wealth.
This object is eliminated by considering the equations for two different periods and
considering the optimal pattern for the evolution of the multipliers.
It is now time to introduce a bit of notation and formalise what said so far.
Suppose a consumer maximises expected life time utility subject to an intertemporal
budget constraint. She consumes a homogeneous consumption good C, receives labour
income y and has the possibility of investing in N different assets A i that pay a rate of
return R I at the end of period t. Both rates of returns and labour income are uncertain.
This setup is formalised in the following equation:
T-t

max Et ~

fiJ U(Ct~j, zt+j, vt+j)

j-0

(4)
N

subject to Z
i-1

A~+j+, = Z AI+J(1 + RJ+t)+Yt+i-Ct+J '

i=l

where I allow the instantaneous utility function U to depend on a vector of observable

variables z, and an unobservable variable v. The operator Et denotes expectations
conditional on the information available at time t. I omit an index for the individual for
notational simplicity. Implicit in Equation (4) are a number of simplifying assumptions
of various nature that will be relaxed in the following sections. It is useful to list some
of them along with ways in which they can be rationalised.

766

o.P. Attanasio

(i)

Equation (4) assumes that utility is separable over time. This is a strong
assumption and rules out at least two important phenomena: habit formation
and durable commodities. The marginal utility o f consumption in any given time
period does not depend on consumption expenditure in any other period. We also
assume that expenditure coincides with consumption. One obvious possibility to
rationalise this model without excluding the existence o f durables is to assume that
the instantaneous utility function is additively separable in non-durables and in
the services provided by durables. In this case, a term for expenditure on durables
should be added to the intertemporal budget constraint.
(ii) Utility is derived from an homogeneous consumption good. The conditions under
which intertemporal choices can be summarised by a single price index are seldom
discussed. The two situations that are treatable are the absence o f changes in
relative prices, so that one can construct a Hicks composite commodity, or that
preferences take the Gorman polar form. These issues are discussed below.
(iii) Labour income is exogenous. No labour supply choices are considered. One
can reconcile a situation in which labour supply is endogenous with the model
discussed above, assuming that the instantaneous utility function is additively
separable in leisure and consumption. In this case, one should modify only the
budget constraint o f the problem (4) above.
(iv) The duration o f life is certain. This assumption is easily relaxed to assume an
uncertain life time. Davies (1981) has shown that this equivalent to assuming a
discount factor fi that varies with age as a consequence of a varying probability
o f survival. Utility at future ages is discounted not only because it accrues in
the future but also because its accrual is uncertain. I will not discuss this issue
any further, except when I discuss some o f the issues relevant for the analysis of
consumption based on numerical methods.
(v) The rate o f return on assets does not depend on the net position on that asset or
on the total level o f wealth held by the consumer. The model, however, can easily
accommodate a situation in which several assets are subject to various kinds of
constraints, as long as there is at least one asset in which is possible to borrow
and lend at the same rate 27
(vi) For simplicity, I have not considered explicitly the presence o f inflation. Obviously
the presence of (uncertain) absolute price changes is simply accommodated in the
model above by changing appropriately the budget constraint and the definition
o f interest rates.
Under these assumptions it is possible to derive an extremely useful first-order
condition for the intertemporal maximisation problem described above. I f we denote

27 This is the condition under which the first-order condition derived below holds. If the rate of return
on a given asset changes with the net position in that asset in a continuous and differentiable fashion, that
is if the intertemporal budget constraint is concave and does not present kinks, the first-order condition
derived below can be easily modified. More complicated is the situation in which there are discontinuities
and kinks for all assets at some level of net worth (for instance zero).

Ch. 11: Consumption

767

with )~t the multiplier associated to the intertemporal budget constraint at time t, it can
be shown that two of the first-order conditions for the problem in Equation (4) are

OU(Ct, zt, 03
OCt

(5)

-- i~t,

)~t = Et D~t+x/3(1 +R~+,)] ,

i= l,...,m.

(6)

Equation (6) holds for the m (m ~<N) assets for which is possible to borrow and lend
at the same rate and for which the consumer is not at a corner.
Equation (5) states that the marginal utility of consumption is equal to the marginal
utility of wealth at time t. The latter term summarises all the information about
the future. Equation (6) is the Euler equation that corresponds to the problem in
Equation (4) and states that the intertemporal maximisation problem (4) implies that
the discounted value of the marginal utility of wealth is kept constant over time. In
other words, the marginal utility of wealth is a martingale 28.
If we substitute Equation (5) into Equation (6) we obtain
Uct = E t [U~,~/3(1 +R~+l) ] ,

i = 1,...,m,

(7)

where Uc is the derivative of the instantaneous utility function with respect to

consumption. It is Equation (7) that Hall (1978) used to derive his famous 'random
walk' property of consumption. These can be derived for the level of consumption if
utility is assumed to be quadratic, or, under some distributional assumptions, for its
log if utility is isoelastic.
Notice that I have allowed instantaneous utility to depend on a number of
observable variables (the vector z) for which I have not specified any property. Such
variables could in principle be choice variables determined in the same intertemporal
maximisation problem. Indeed, the variables z constitute the vehicle through which
I introduce a number of factors such as the effect of demographics or of labour supply.
As long as we control for their effect on the marginal utility of consumption (and treat
them as endogenous at the estimation level), I do not need to model them explicitly.
It should be stressed that Equation (7) is not a consumption function, but only an
equilibrium relationship that can be used (and has been used) to estimate structural
(behavioural) parameters and/or to test some of the implications of the model. The big
advantage of Equation (7) is the elimination of the term that represents the marginal
utility of wealth and therefore the necessity of explicitly modelling the way in which
the distribution of future variables influences consumption choices. The price of this
simplification, however, is not a small one: we lose the ability to say anything about the
levels of consumption. While it is true that given the level of current consumption, we
can use Equation (7) to forecast the expected level of future consumption, we do not

28 MaCurdy (1981) uses this frameworkto construct his 'A-constant' labour supply function.

0.17. Attanasio

768

know how consumption reacts to unexpected changes in the economic environment.

These include changes to taxes or any other policy instruments that might affect
consumption decisions. The elimination of the tmobservable marginal utility of wealth
is similar to the elimination by quasi differencing of fixed effects in econometrics.
The problem here is that the 'fixed effect' that is differenced out is one of great
importance.
Hall (1978) used quadratic utility to derive his famous 'random walk' result.
After his paper, several studies developed and used the Euler equation approach with
different assumptions about preferences. Hansen and Singleton (1982), for example,
used isoelastic preferences to derive an expression whose parameters they estimated
by GMM on aggregate time series data for consumption and several rates of return.
In particular, Equation (7) with isoelastic preferences (and neglecting the z and v
variables) implies
c t-Y+l

The assumption of rational expectations and the fact that expectations in Equation (8)
are conditional to the information available at time t can be used to find valid
instruments to identify the structural parameters of Equation (8), which, once again,
can be considered for several rates of returns. If we denote with q the dimension
of the vector of parameters [in Equation (8), q = 2], with m the assets for which (8)
holds and with k the number of instruments considered, Equation (8) yields m k - q
overidentifying restrictions that can be used to test the model. The results obtained by
Hansen and Singleton on aggregate data indicate that the model is strongly rejected
whenever several returns are considered simultaneously. On the other hand, when one
asset is considered in isolation, the overidentifying restrictions are not violated, but
the preference parameters are estimated at somewhat implausible values.
Hansen and Singleton (1983) considered a log-linear version of Equation (8). If one
assumes that the rate of returns and consumption growth are joint log-normal, from
Equation (8) one can derive the following expression:
Alog(Ct+l) = 1 [log/3 + g2vart(Alog(Ct+l )) + vart (log(1 + Rit+l))
(9)
+2Cov(Alog(Ct+l), log(1 +R)+I))] +

log(1 +Rt+l) ) + et+l,

where et+l is an expectational error uncorrelated with all the information available
at time t. The advantages of Equation (9) are that it is (log) linear and some of its
coefficients, as the one on the interest rate, have a natural and interesting interpretation.
When the utility function in Equation (4) is isoelastic, its curvature parameter y
plays a double rote. On the one hand it is equal to the coefficient of relative risk
aversion and therefore summarises consumer's attitude towards risk. On the other,

Ch. 11:

Consumption

769

its reciprocal is equal to the elasticity o f intertemporal substitution and therefore

measures as consumption growth changes when the relative price o f present and future
consumption changes 29.
The linearity of Equation (9) allowed a number o f researchers to estimate it
by linear instrumental variables methods. Valid instruments include, as before, any
information available to consumers at time t - 1. Hall (1988), however, noted that if the
frequency with which consumption decisions are taken is higher than the frequency o f
observations, the residuals o f equations will not be uncorrelated over time, as implied
by the assumption o f rational expectations, but have, under certain assumptions, an
MA(1) structure with a positive coefficient. If this is the case, valid instruments will be
any variable dated t - 2 or earlier. The choice of lagged two instruments has become the
common practice for the studies who estimate versions o f Equation (9) using aggregate
time series data 3.
Most empirical applications that used a version o f Equation (9), including Hansen
and Singleton (1983), typically assume that the conditional second moments that
appear on its right hand side are constant over time so that they can be estimated as
an intercept term. I discuss the role o f the conditional variances in Section 5. For the
time being it will suffice to notice that assumption o f constant second moments can be
relaxed to the weaker one that the innovations to the second moments in Equation (9)
are uncorrelated with the instruments used in estimating the equation.
Having found the instruments that allow the (over) identification o f the parameters o f
Equation (9), it is possible to estimate its parameters and test the model. Alternatively,
it is possible to test for the significance of additional variables that might be o f
particular interest and that, according to the simplest versions o f the model, should not
appear in the equation. A test which has received considerable attention is the addition
o f the expected value o f current labour income growth. One o f the main examples o f
this approach, is a series o f papers by Campbell and Mankiw (1989, 1991) who have
estimated on aggregate time series data an equation like the following:
Alog(Ct+l) = a + ort+l + )~Alog(yt+l) + et+l,

(10)

where y is labour income and r an interest rate. Both o f the variables on the right hand
side are instrumented. According to the model the parameter )~ should be zero and the
residual term should be orthogonal to the information available at time t.
Equations (8) and (9) illustrate one of the main advantages o f the Euler equation
approach. Even if it is not possible to obtain a closed form solution for consumption, it

29 For a discussion of the interpretation of such a parameter and the links between intertemporal
substitution and risk aversion see Hall (1988), Attanasio and Weber (1989) and Epstein and Zin (1989,
1991).
3o Carroll et al. (1994) argue for the explicit consideration of the MA(1) process that would allow
the use of the orthogonality conditions with instruments dated t - 1 and therefore yield more precise
estimates and more powerful tests.

770

O.P.Attanasio

is possible to consider equilibrium relationships that can be used to estimate structural

parameters. While these, as I discuss below, are not sufficient to answer many important
policy questions, they constitute a basic ingredient of any answer. Furthermore, the
orthogonality restrictions implied by the equations (and the assumption of rational
expectations) can be used to test the validity of the model. Finally, the model can
encompass a number of features that make it quite realistic without loosing its
empirical tractability. In particular, it is possible to consider the effects that variables
such as durables, labour supply, children and so on have on the marginal utility of
non-durable consumption without having to model explicitly these variables. Having
said this, however, one should also stress that the empirical implementation of the
Euler equation is not without problems. First of all, data requirements can be quite
formidable. Furthermore, a number of subtle econometric problems needs to be
considered. I discuss these problems and some o f the available empirical evidence
in Section 5.

3.4. Precautionary motives for saoing

The assumption of quadratic preferences, which makes it possible to derive a
closed form solution for consumption, is not very appealing. In addition to various
shortcomings of quadratic preferences, many would find certainty equivalence, i.e.
what makes the model easy to handle, questionable. It is therefore not surprising that
a large literature has developed in the attempt to go beyond quadratic preferences.
The first paper to consider explicitly the effects of non-linear marginal utility is
Dreze and Modigliani (1972). While the Dreze and Modigliani contribution focuses
on a two period problem, it contains many of the insights of the precautionary saving
literature, such as the fact that the importance of the precautionary motive for saving
depends on the third derivative of the utility function.
Kimball (1990) discusses within a rigorous framework the conditions under which
one can expect to observe precautionary savings. In particular, he proves that
precautionary saving will occur when the utility function exhibits 'prudence', that
is when the 3rd derivative of the utility function is positive. Under a CRRA utility
function this will always be the case. To see this it is sufficient to consider Equation (6)
above, that is the log-linearization of the Euler equation under the assumption of lognormally distributed random variables 31.
Notice that, keeping the other variables constant, an increase in the conditional
variance of consumption increases, at time t, the expected rate of growth of
consumption between t and t + 1. This can be achieved by decreasing consumption at t,
that is increasing saving at t. It is this that is usually referred to as precautionary

31 Alternatively, an equation similar to Equation (6) can be obtained by a Taylor expansion of the
marginal rate of substitution, as in Dynan (1993). Banks, Blundell and Brugiavini (1997) use an
approximation of the Euler equation developedby Blundell and Stoker (1999).

Ch. 11:

Consumption

771

motive for saving. As Browning and Lusardi (1996) stress, the fact that the effect that
the conditional variance has on the rate of growth of consumption is scaled by the
coefficient of relative risk aversion is an artefact of the CRRA utility function in which
a single parameter controls both risk aversion and prudence (as well as the elasticity of
intertemporal substitution). More generally, Carroll and Kimball (1996) have proved
the concavity of the consumption function under precautionary saving.
It should be noticed that the variance of consumption is not an exogenous variable.
While it is likely to depend on the overall uncertainty facing the consumer, it is
not obvious how it reacts to the arrival of new information or how it is related to
uncertainty in income and interest rates. To evaluate this relationship it would be
necessary to solve for the level of consumption and establish how consumption at
t+l reacts to changes in the economic environment which, under CRRA preferences,
is not possible.
Caballero (1990a,b, 1991) using the exponential utility function as a parametrization
of within-period utility obtains, with some additional assumptions, a closed form
solution for consumption. In an interesting example, he expresses consumption as a
function of permanent income (as in the case of certainty equivalence), minus a term
which summarises the effect of the precautionary motive. He then goes on to evaluate
the effect that precautionary saving is likely to have in reality.
While the results obtained with the exponential utility give useful insights about
the potential importance of the precautionary motive, such a parametrization of the
utility function is not exempt from criticism. It is therefore important to evaluate
the importance of precautionary saving using more general functional forms for
the utility function. Unfortunately, when one uses different utility functions is not
possible to obtain a closed form solution for consumption. It is therefore necessary
to use numerical methods to obtain solutions and additional assumptions about
the nature of the problem faced by consumers. This is the approach taken in a
number of studies, such as those of Skinner (1988), Zeldes (1989b), Deaton (1991),
Carroll (1994) and Hubbard, Skinner and Zeldes (1994, 1995). A disturbing feature
of these studies is that the quantitative importance of the precautionary motive
depends crucially on the properties of the distribution of the income process in the
left tail. Bounding away the income process from zero (or from arbitrarily small
realisations) greatly reduces the precautionary motive. While the reason for this
is clear (consumers will want to insure themselves against disastrous events), the
realism of such a mechanism is questionable. It might be worth investigating how the
precautionary motive would change in the presence of insurance mechanisms other
than self insurance (such as a safety net supplied either by society or by family and
relations).
Carroll (1994, 1997a) has strongly advocated the precautionary saving motive (or
'buffer stock saving') as an explanation of most empirical puzzles in consumption,
including the tracking of expected consumption and income. I discuss the empirical
findings on the precautionary motive and more generally on the Euler equation in
Section 5. From a theoretical point of view, however, it should be stressed that while the

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O.P Attanasio

precautionary motive is likely to be important for impatient consumers and especially

in the early part of the life cycle, it is also clear that if retirement savings become,
at some point during the life cycle, important, they can be used to buffer unexpected
fluctuations to income. This effect, however, can be limited if most retirement wealth
is held in the form of claims to future benefit or in other illiquid assets (such as special
retirement accounts, housing, social security etc.). The relevance of the precautionary
saving motive is ultimately an empirical matter, as it depends on preference parameters,
on the features of the individual income process and on the availability of safety nets
and insurance mechanisms.
An attractive possibility to test the relevance of the precautionary motive for saving
is to relate observed saving behaviour to perceived uncertainty. Guiso, Jappelli and
Terlizzese (1992) is the only paper that uses direct observations on the perceived
variance of the income process to assess the importance of precautionary savings.
They use a unique data set (the Bank of Italy Survey of Household Income and
Wealth) in which individuals are asked not only about their income expectations,
but about the complete probability distribution of future income 32. This allows the
authors to compute individual variances, which they then relate to individual savings,
finding some mild evidence of precautionary savings. One obvious problem with this
approach is the possibility that the individuals who have selected themselves into
riskier occupation are less risk averse and, maybe, less 'prudent'. A similar argument
was used by Skinner (1988) to justify his finding that self-employed individuals seem
to save less than the average.
More recently, Guiso, Jappelti and Terlizzese (1996) have studied the implications
of the precautionary motive for portfolio composition. They show that, in the presence
of different and unrelated sources of risk, individuals with higher and undiversifiable
earning uncertainty will tend to invest in relatively 'safer' portfolios.
3.5. Borrowing restrictions

Related to the issue of precautionary saving is that of the presence of borrowing

constraints. The standard model sketched above assumes that individuals can borrow
against future labour income to finance current consumption at the same rate at
which they can lend. Of course, if this is not the case, the basic model has
to be amended in that the maximisation problem in Equation (4) has to take
into account the additional constraint. It has now become customary to interpret
evidence of 'excess sensitivity' of consumption growth to labour income as an
indication of 'liquidity constraints', by which it is usually meant the presence
of some imperfection in financial markets that prevents people from borrowing.
However, there is no reason to believe that liquidity constrained individuals consume
their disposable income. Only when the constraints are actually binding will this

32 Individuals are asked to divide 100 probabilitypoints over several intervals of income growth.

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occur. Therefore, excess sensitivity tests and, more generally, Euler equations are
not the best way to identify the presence o f liquidity constraints. Furthermore,
as we discuss below, there are several reasons why predicted income and consmnption might be related that have nothing to do with the presence of liquidity
constraints.
With these considerations, I do not want to dismiss the possibility of liquidity
constraints as unimportant or unrealistic 33. Especially for some groups in the
populations, they might be quite relevant and have an important effect on aggregate
consumption. Early contributions to the literature on the policy implications of the
permanent income-life cycle models, such as the papers by Flemming (1973) and
Tobin and Dolde (1971), were quite aware of the importance o f liquidity constraints.
It is crucial, however, that the presence o f liquidity constraints is incorporated in the
optimising framework sketched above.
The definition o f liquidity constraints I use in what follows appeal to partial
equilibrium considerations: the interest rate schedule is taken as given. General
equilibrium considerations, however, even though they are rarely made, can be quite
important. In a world o f identical consumers, the possibility o f smoothing consumption
over time will be constrained by the technology available to transfer resources over
time. In equilibrium, interest rates and asset prices will adjust depending on the
demand for borrowing (saving) and on the available technology. In such a situation,
nobody is liquidity constrained at the current interest rates. With heterogeneous
consumers, it is possible that some will want to borrow and others will be saving.
The equilibrium interest rates will then reflect these factors. While the focus o f most
o f the considerations in this section is on the partial equilibrium effects, it is worth
keeping in mind that aggregate fluctuations, for instance a recession, might have effects
on asset prices that reduce the demand for loans relative to what would be observed
under constant interest rates.
The first step in the integration of borrowing restrictions in the model above must
be their exact definition. There are several possibilities. The first and most general
alternative is to allow the interest rate paid on assets to depend on the net asset position.
As a simple example o f this alternative, consider the possibility o f a difference between
borrowing and lending rate. Such a wedge induces a kink in the intertemporal budget
constraint. One can then consider Euler equations for individuals who are net borrower
and net savers: the interest rate relevant for the two groups will be different, but the
Euler equation still holds as an equality. For the individuals that will cluster at zero net
assets, however, the Euler equation (with either interest rate) holds as an inequality.

33 As Hayashi (1996) stresses, most specifications of preference implicitly imply a form of borrowing
restrictions. If the marginal utility of consumption is infinite a zero consumption, consumers will not
want to borrow more than the present discounted value of the minimum realisation of income, even
though the probability of this event is very low. This is because they want to avoid the possibility of
zero consumption even with a very small probability.

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774

It is also possible that the interest rate varies continuously with the quantity borrowed
or saved. I f that is the case, at any point in which the function is differentiable, it is
still possible to write down an Euler equation which, relative to Equation (8), contains
an additional term referring to the derivative of the interest rate with respect to the
asset position 34:

OAf ,'/3

(l +

Et

= 1

(al)

At those points of the intertemporal budget constraint where the interest rate changes
discontinuously (such as zero), Equation (11) will be replaced by an inequality.
An alternative to the consideration of interest rates varying with the amount
borrowed (or saved) is the assumption that individuals face a limit to the amount they
can borrow (which can be zero). Obviously this can be interpreted as a case o f the
previous situation, with the borrowing rate being infinite at the limit. Even in this
case, however, there are several alternatives. It is possible, for instance, that the limit
an individual can borrow is not fixed but a function of some variables which, in turn,
can be endogenous 35. Finally, it is possible to consider the existence of collateralizable
loans.
When liquidity constraints take the form of a limit to borrowing, it is still possible
to write the Euler equation for consumption, as long as the constraint is not binding.
When it is binding, instead, the Euler equation will hold as an inequality, or as an
equality with the addition of a slack variable (a Kuhn-Tucker multiplier). Equation (8)
becomes
E,

[ C'+Yl(1

= 1 +~tt,

(12)

where #t is an unobservable Kuhn-Tucker multiplier associated to the borrowing

restriction.
If instead of considering a homogeneous consumption good, one considers several
commodities explicitly, assuming that none of them is durable or can be used as a
collateral, for each of these commodities it is possible to obtain an equation of the
following form:
OU( ) _ ,~,p~ + ~,,

where At is the marginal utility of wealth and Pl is the relative price of commodity i.
Notice that gt appears in the first-order conditions for all commodities, so that any

34 A paper which contains this type of analysis is Pissarides (1978).

35 Alessie et al, (1989) and Weber (1993) consider the possibility that the limit to borrowing is a function
of earnings.

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two of these equations can be used to eliminate it. This implies that the intratemporal
first-order conditions hold regardless of the presence of liquidity. Meghir and Weber
(1996) used this intuition to distinguish between liquidity constraints and intertemporal
dependence in preferences. They consider three different non-durable commodities and
stress that the presence of dynamic effects in the Euler equation can be rationalised
with intertemporal non-separabilities only if the same dynamic effects are found in the
intratemporal first-order conditions. On the contrary, if one finds that the intratemporal
conditions do not show any sign of dynamic effects while these appear in the Euler
equations, one should interpret this evidence as a sign of binding liquidity constraints.
Some studies have explored the possibility that some commodities, such as durables,
can be used as collateral to relax the severity of borrowing restrictions. Because
durables can be used as collateral, when liquidity constraints are binding, they become
relatively more attractive than non-durables. This fact has implications for the withinperiod allocation of resources between durables and non-durable consumption. In the
absence of liquidity constraints, this would depend only on the relative price and
on their marginal rate of substitution (where the relevant price for durables would
be their user cost). In the presence of liquidity constraints, however, an additional
term has to be added to the first-order condition to reflect the fact that it is possible
to use durables to borrow against future resources. Therefore, as Chah, Ramey and
Starr (1995), Brugiavini and Weber (1994) and Alessie, Devereux and Weber (1997)
have noted, the possibility of using durables as collateral and the presence of liquidity
constraints distorts the intratemporal allocation of resources between durables and nondurables.
At several points in the discussion so far ! have stressed that even when liquidity
constraints are present, if they are not binding, the Euler Equation (8) will hold.
Therefore, such an equation and the mis-specification tests conducted on it (such as
tests of 'excess sensitivity') are likely to be a poor tool to identify the presence of
borrowing restrictions. In addition to the power considerations just made, in what
follows I also stress that evidence on excess sensitivity can often be interpreted as
evidence of non-separability between consumption and leisure.
The fact that the Euler Equation (8) holds whenever the borrowing restrictions
are not binding does not mean that these constraints have no effect on the level of
consumption. Indeed, as discussed clearly by Hayashi (1987), the presence of potential
liquidity constraints has the same effect as that of a shortening of the horizon relevant
for current choices. Alternatively, one can interpret the presence of liquidity constraints
(when they are not binding) as an increase in the discount factor.
From a policy perspective, liquidity constraints are important because of their
effect on the level of consumption, rather than on its changes. In other words, what
matters is how consumption reacts to unexpected changes in the economic environment
(including policy changes). Euler equations are not informative about this.
Deaton (1991) provides one of the first analysis of the effect of liquidity constraints
on the level of consumption. By solving the Euler equation numerically, he shows
that the behaviour induced by the presence of liquidity constraints is similar to that

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O.R Attanasio

associated with a precautionary motive for saving. As in the precautionary motive

for saving, people will accumulate a buffer stock to avoid the possibility of needing a
loan that they cannot obtain. Furthermore, the liquidity constraint will be binding only
occasionally as during most periods, individuals avoid, by their optimal behaviour, to
find themselves constrained.
For liquidity constraints (or precautionary saving) to be relevant for individual
behaviour, it is necessary that the households concerned want to borrow, that is they
face an increasing income path and are impatient enough to -want to bring resources
from the future to the present. Even in such a situation, however, it is not necessary
that the Euler equation restrictions are violated. If one rules out the possibility of dying
in debt and considers finite lives and a marginal utility of consumption that goes to
infinity when consumption goes to zero, it is possible that 'liquidity constraints' are
generated endogenously by the model. In particular, to avoid the possibility of having
zero resources (and therefore zero consumption) in the last period of life, individuals
will not want to borrow any amount in excess of what they can repay with probability
one. Notice that in such a situation, consumption in any two periods satisfies the Euler

equation 36.
From a theoretical point of view, the considerations above indicate that a profitable
research strategy is one which aims at characterising the response of consumption to
various news when liquidity constraints are relevant (regardless of whether they are
binding). Deaton (1991) constitutes a first important step in this direction. On a more
specific level, the analysis in Hubbard, Skinner and Zeldes (1994, 1995) constitutes
another good example of how a consistent theoretical model incorporating borrowing
restrictions can be used and be informative about important policy issues 37
Several other interesting problems remain to be modelled and understood. If labour
supply choices are endogenous, the presence of liquidity constraints might induce
female labour force participation. These effects might be strengthened if the ability
to borrow is linked to earnings 38. All these issues are examples of the need to be able
to use the model to make statements about consumption levels that I discuss again
below.
Identifying the presence and the relevance of borrowing restrictions is not easy. One
possibility is to use direct questions on the matter. Jappelli (1990) used this strategy and
analysed the answers to some questions contained in the Survey of Consumer Finances
in the USA. The households interviewed in 1983 were asked whether they were denied
credit or whether they did not applied because they felt they would be denied. The
main problem with this research strategy is that very few household surveys contain
questions similar to those analysed by Jappelli.

36 This point was also noted in Hayashi (1987).

37 Jappelli and Pagano (1994) eharaeterisethe link between liquidityconstraints, saving and growth.
38 See O'Brien and Hawley(1986).

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777

The presence of (binding) liquidity constraints has some direct implications for
the demand for loans. Its analysis constitute therefore an interesting possibility for
the identification of borrowing restriction and for evaluating their importance. If
consumers are subject to binding borrowing restrictions they will be at a kink (or in a
relatively steep section) of an intertemporal budget constraint. Their demand for loans,
therefore, will not be much affected by changes in the interest rate. On the contrary, if
consulners are not at a corner (or in a relatively fiat part of the budget constraint) their
demand for loans will be elastic to the interest rate. The effects of maturity, however,
should be opposite. A consumer who is not affected by borrowing restrictions will
be indifferent to changes in maturity. On the other hand, a constrained consumer, for
whom an increase in maturity will effectively increase his ability to borrow by reducing
the size of the payments to maturity, will increase its demand for loan. Juster and
Shay (1964) were the first to use this intuition using semi-experimental data. They
asked a sample of consumers whether they would finance the hypothetical purchase
of an automobile when faced with different packages of interest rates and maturity.
The packages of interest rate and maturity were randomised to the individuals in the
sample so to enable the estimation of the interest rate and maturity elasticity of the
demand for loans. In a recent paper, Attanasio and Goldberg (1997) develop the work
of Attanasio (1995b) and perform a similar exercise but on a sample of households who
actually purchased (and occasionally financed) automobiles. The main advantage of the
Attanasio and Goldberg exercise is that their data refer to actual choices. The main
disadvantage relative to the work of Juster and Shay (1964) is that for the households
that decided not to finance their car purchases neither interest rates nor maturity are
observed. This poses a number of econometric problems that are similar to those that
labour economists deal with when analysing participation choices and labour supply.

3.6. Taking into account demographics, labour supply and unobseroed

heterogeneity
In the previous sections, for the sake of expositional simplicity, I have neglected the
vector of observable variables z and the unobserved component v in Equation (4).
Their exclusion, however, especially if one wants to estimate or test the model, would
be unrealistic. It is quite obvious, for instance, that family size and composition affect
the marginal utility of a given amount of consumption expenditure. It is also likely
that labour supply behaviour, and in particular female labour supply, will also affect
the utility derived from expenditure. Working often implies bearing a certain number
of costs that range from transport, to eating out, to clothing. Furthermore, if both
spouses work, a number of services that would be produced at home by the partner
not participating in the labour force would have to be purchased on the market and
would be counted as consumption. More generally, it is plausible that consumption
and leisure are not separable in the utility function and that consumption, saving and
labour supply choices are taken simultaneously.

o.P. Attanasio

778

Given these considerations, it is important, especially if one wants to bring the model
to the data, to consider a specification that allows for these factors. While it is true, as
shown in Section 2, that consumption life cycle profiles often mirror income profiles, it
is not obvious that one should interpret this as evidence of the empirical failure of the
model without considering explicitly the possibility of important demographic effects
and that consumption and leisure are not separable. These are not new arguments and
I discuss them at length in Section 5, where I interpret the available evidence. The
point of this section, however, is to stress that the consideration of these factor is not
only important, but also relatively simple. If one does not want to model explicitly
these variables, controlling for them does not jeopardise the empirical tractability of
the model illustrated by Equations (8) and (9).
I re-write a slight modification of Equation (4) for convenience:
T-t

max Et Z [3J U(Ct+j,

nd zt+j, vt+j),
j=o

(4')

where the superscript nd indicates that I am now modelling explicitly only non-durable
consumption. As before, the vector of observable variables z indicates variables that are
relevant for the intertemporal optimisation problem. The variable u is unobservable to
the econometrician. The latter variable is sometimes referred to as 'taste shift'. More
generally, it represents all the unobservable factors that affect consumption choices
and that we do not model or control for. The variables included in the vector z may
range from demographic variables, to labour supply variable, to other components of
consumption (such as services from durables). Notice that these variables may be either
exogenous to the choice problem (age is a good example), or chosen simultaneously
with non-durable consumption (such as labour supply). Even if one does not wish
to model these latter variables explicitly, it is possible to identify, using Equation (4I),
conditional preferences and the associated parameters under very mild conditions 39.
If the z variables in Equation (4 ~) enter the utility function in an additive separable
fashion there is no need to consider them. If, on the other hand, they affect the marginal
utility of non-durable consumption, they will enter the corresponding Euler equation.
As an example, let us consider the following parametrization:
U ( C t d, zt, ot) -

(cpd)l-7 exp(O'zt +
1-y

ut).

(13)

A possible interpretation of Equation (13) is that the discount factor varies with
variables z and v. Such an interpretation is particularly attractive for demographic
variables. In this case, the vector of parameters 0 implicitly represents an equivalence
scale.

39 See the discussion in Browningand Meghir (1991) on demand systemsconditionalon labour supply.

Ch. 11:

779

Consumption

Under the parametrization used in Equation (13), the Euler equation for non-durable
consumption will be

E, [ \ ~ - j

[(,q,+a)

(1 + R ~ + , ) / 3 e x p [ O ' ( z t + l - z , ) +

v t + x - vt]

= 1.

(14)

It should be stressed that Equation (14) holds even if some of the variables included in z
are endogenous choice variable, regardless of the way in which they are determined.
Modelling labour supply or durable consumption, for example, can be quite difficult
because of corner solutions, intertemporal (non)-separability and transaction costs.
These problems do not need to be tackled explicitly and Equation (14) can be
considered as an equilibrium relationship that holds at the optimal values of the
endogenous z, regardless of how these are obtained.
Equation (14) can be linearised in the same fashion as Equation (8) to obtain a
log-linear expression similar to Equation (9). Neglecting the second moments, that
I incorporate into the constant of the equation, we have:
Alog(C~dl) = const. + oR~+1 + OtAZt+ 1 + Avt+l + et+l.

(15)

Notice that because of the presence of the term representing unobserved heterogeneity
and taste shocks, the residual of equation has now two components, one which
represents an expectational error and, by the assumption of rational expectations, is
likely to be uncorrelated over time, and another that has an MA(1) structure if taste
shocks are i.i.d, over time.
If the unobserved heterogeneity term v has a time invariant component which is
individual specific, it will be eliminated in the first differences. On the other hand, it
is possible that such a term is persistent (rather than white noise) but not fixed and/or
that the 'pure' discount factor/3 is individual specific. In the former case the term Av
in Equation (15) would have a structure more complex than a simple MA(1), while
in the latter, Equation (15) would have a fixed effect. In Section 5, I discuss these
econometric problems.
The particular parametrization considered in Equation (13) is just an example. More
complex structures may be and have been considered. It is possible, for instance,
to allow some of the variables in the vector z to affect the curvature of the utility
function as well as the rate at which utility is discounted. Blundell, Browning and
Meghir (1994) and Attanasio and Browning (1995) have used this approach and found
significant deviations of estimated differences from the simple isoelastic case. The
issue is particularly important in that preferences of this kind can allow for systematic
differences in the elasticity of intertemporal substitution across consumers.
Attanasio and Browning (1995) also stress the fact that to estimate an Euler equation
and its parameters, it is not necessary to specify explicitly the within-period utility
function. It is possible and analytically convenient to start from a flexible specification

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0.17. Attanasio

for the marginal utility of consumption and, if needed, obtain the corresponding utility
function by integration 4.

3.7. Bequest motives

According to the simplest version of the life cycle model sketched at the beginning of
the section, the main motivation for individual saving is to provide resources during
the last part of the life cycle, when, following retirement, income is low. In such
a situation aggregate wealth can be generated by and associated with productivity
growth, if the generations that save (the young) are relatively wealthier than those
that dis-save (the old). I f the bequest motive is operative, on the other hand, the
mechanism through which aggregate wealth is accumulated is quite different. A lively
exchange on whether a large or small proportion of aggregate wealth in the USA is
accounted for by bequeathed wealth or retirement saving wealth developed in the 1980s
between Kotlikoff and Summers [Kotlikoff and Summers (1981), Kotlikoff (1988)]
on one side and Modigliani (1988) on the other. The result of that debate remained
somewhat ambiguous, as the answer seems to depend mainly on whether one considers
the interests earned on bequeathed wealth as originating from bequests or not.
A bequest motive can be simply added to the basic model (1) by considering a term
which is a function of the bequest left. As it is obvious such a term does not affect
the Euler equation for consumption in subsequent periods. It will, however, affect the
level of consumption (and saving).
One of the implications of the simplest version of the life cycle model is that
wealth is decumulated in the last part of the life cycle. While the rate at which
wealth is decumulated depends on the parameters of the model and in particular about
beliefs about longevity, the result that wealth should decline seems to be robust. The
evidence on this point is mixed, in that several studies do not find strong evidence of
decumulation of wealth by the elderly 41.
When bequests motives are operative, from a theoretical point of view, the wealth
age profile can take different shapes in the last part of the life cycle. In an important
paper Hurd (1989) has characterised several of these profiles. Hurd also showed that
for several realistic sets of parameters, the wealth age profile under bequests is also
declining in the last part of the life cycle. From an empirical point of view, Hurd (1989)
stresses the importance of conditioning on the labour force status of the individuals
in the sample. In particular, whether individuals are retired or not seems to be crucial
for the decumulation of their wealth.

40 If one follows such a procedure, one should check the integrability conditions.
41 JappeUiand Modigliani (1997) have forcefully argued that pension benefits should be considered as
decumulation of pension wealth.

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4. Aggregation issues
The models considered in Section 3 refer to the dynamic optimisation problem faced
by an individual consumer (or household). The early contributors to the life cyclepermanent income model were quite aware of the aggregation issues involved with
the empirical implementation of the theory of intertemporal optimisation. These issues,
however, were largely ignored by the literature of the late seventies and early eighties
which focused mainly on the rigorous introduction of uncertainty in the model.
Aggregation problems, however, cannot be ignored when the model is tested and when
is estimated to evaluate structural parameters. In this section, I consider briefly two
problems: the aggregation across consumers and that across commodities.
4.1. Aggregation across consumers

The Euler equations for (non-durable) consumption that can be derived from the
problem in Equation (1) are, for most specifications of preferences, non-linear. As they
refer to individual households, their aggregation is problematic. A number of papers
have shown that the dynamics of aggregate consumption implied by the Euler equation
for individual consumption cannot be described simply by the first moments of the
cross-sectional distribution of consumption. Attanasio and Weber (1993), Blnndell,
Pashardes and Weber (1993b) and Blundell, Browning and Meghir (1994) have shown
that higher order moments can play an important role. Attanasio and Weber (1993), in
particular, have stressed that the use of aggregate data to estimate an Euler equation is
equivalent to omit high moments of the cross sectional distribution of consumption and
might cause systematic biases in the estimation of structural parameters and lead to
rejections of the over-identifying restrictions 42. These contributions will be discussed
when I evaluate the empirical evidence, at this point I only wanted to stress that
exact aggregation is in general impossible when considering the Euler equation for
consumption. This implies that aggregate data cannot be used to estimate structural
preference parameters and/or to test the model.
Individual panel data on consumption might be very difficult to obtain. Partly
because of this, many of the papers I discuss in Section 5 use the average cohort data
that I have used in Section 2 to describe the individual data. The use of grouped data
allows one to use time series of repeated cross section to study dynamic models. In
this sense, average (or synthetic) cohort data are particularly useful to study life cycle
models. It is important to stress, however, that synthetic cohort data are aggregate
data; the difference relative to National Accounts data is that the aggregation process
is controlled directly. As a cohort ages, the researcher can follow the evolution of
the variables of interest, that range from consumption to income, to family size and

42 Blundell, Pashardes and Weber (1993b) make a similar point for a demand system. Similar results
were obtained in an asset pricing frameworkby Constantinides and Duffle (1996).

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O.P. Attanasio

composition, to labour supply behaviour. The presence ofnon-linearities in the relevant

equations (as long as they are linear in the parameters) does not constitute a problem,
as one can compute the relevant non-linear transformations before averaging the data.
Unlike in the aggregate data, therefore, time series of the average of any non-linear
transformations of the variables of interest is readily available.
In addition to the standard aggregation problems caused by the non-linearity of
the Euler equations, there is another sense in which aggregation across consumers
can be problematic. As discussed above, it is likely that demographic variables are
likely to be important for the determination of consumption. If one does not want to
make arbitrary assumptions about the effects that these demographic variables have on
the utility function, it might be necessary to consider individual data explicitly 43. In
the aggregate, demographic variables move quite slowly so that, even neglecting nonlinearities, their effect cannot be estimated precisely from those data. On the contrary,
differences across cohorts, observed over different parts of their life cycle, can be
profitably be exploited to identify these effects.
Finally, because repeated cross sections are much more common than long panels,
one can estimate the structural parameters using a relatively long time period. The
importance of a 'large T' in getting consistent estimates is discussed in section 5.
The use of average cohort data is not without problems. Probably the most important
is that of the presence of measurement error and sample variation. Particular care has to
be devoted to evaluating the quality of the data and to use the appropriate econometric
techniques.
4.2. Aggregation across commodities

Another important aspect which is often neglected in the literature on the Euler
equation is the aggregation of expenditure on different commodities. In principle, one
should consider simultaneously the allocation of total expenditure across time periods
and the allocation within each period across different commodities. I f one had detailed
enough data on expenditure on individual commodities and was willing to specify the
form of the direct utility function, the problem could be addressed in a straightforward
manner. One could consider the Euler equation defined in terms of the marginal utility
of each individual commodity.
The issue, however, is to determine under what conditions one can consider the
within-period utility function defined in terms of total consumption and assume that
the allocation of expenditure over time can be determined with the help of a single
price index. One obvious and not particularly interesting answer is when relative
prices do not change so that it is possible to construct a Hicks composite commodity.
Gorman (1959) was the first to provide a more interesting answer in that he derived

43 Estimation of the effects of demographic variables can be interpreted as the estimation of adult
equivalent scales and is therefore important for a variety of reasons.

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783

the conditions that the utility function has to satisfy so that it is possible to consider a
single commodity 44. In particular, it is necessary that preferences take the generalised
Gorman Polar form, that is, i f X is the K x 1 vector of commodities andp the vector
of corresponding prices, the indirect utility function has to take the form

V(X, p) = F(X/b(p), a(p)),

(16)

where b(p) and a(p) are functions homogeneous of degree 1 and degree 0 respectively
and depend on within-period preferences.
From the specification in Equation (16) one can derive an Euler equation for
total consumption expenditure: two-stage budgeting can be used to separate the
intertemporal from the within-period allocation. To implement Equation (16) it is
necessary, however, to estimate the price functions a(p) and b(p), which requires
the specification and estimation of a within-period demand system. In an important
paper, Blundell, Browning and Meghir (1994) estimate a demand system and use
the resulting price indexes to estimate the Euler equation for total consumption
expenditure. A remarkable result they obtain is that a Stone price index (which does not
require the knowledge of preference parameters) constitutes a good approximation to
the price indexes in Equation (16). This result is important because points to a simple
way to implement Euler equations for non-durable consumption without estimating the
entire demand system. The results in Blundell, Browning and Meghir are generalised to
a demand system with quadratic Engel curves by Banks, Blundell and Preston (1994).
Attanasio and Weber (1995) with a different parametrization of the indirect utility
function find a statistically significant role for the zero-homogeneous price index a(p)
on US data.
If one is willing to specify a utility function defined over several commodities, one
can derive an Euler equation for each of these commodities. Under the assumption
of additive separability, each of these Euler equation depends only on expenditure on
that commodity, nominal interest rates, changes in the commodity-specific price index
and on the relevant controls. On the other hand, when additive separability does not
hold, the individual commodity Euler equation depends also on the consumption of
other commodities. This is an important point in that creates problems for the use of
data sources which contain information only on some components of total expenditure,
such as the US PSID which gives only information on food consumption. Attanasio
and Weber (1995) show that the consideration of food consumption in isolation can
yield very misleading results.
5. Econometric issues and empirical evidence

I now move to consider the empirical evidence on the life cycle-permanent income
model. In the process of doing so, I also discuss some of the econometric problems
44 See Deaton and Muellbauer (1980) for a clear discussion of these issues.

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O.P. Attanasio

relevant for theanalysis. As I want to have a rigorous treatment of uncertainty, I only

consider the contributions that followed the Hall (1978) paper. I start with a discussion
of studies based on aggregate data and then discuss some based on individual data.
As ! focus mainly on studies based on Euler equations, I do not discuss a large
empirical literature, which has estimated flexible error correction models for aggregate
consumption that I have mentioned in Section 2.
5.1. Aggregate time series studies

Because of the aggregation problems discussed in Section 4.1, it is my opinion that

aggregate time series data cannot be used to estimate structural preference parameters
and test the life-cycle model. Indeed, some papers, such as Attanasio and Weber (1993,
1995), have shown that aggregation issues can easily explain some of the rejections
of the model found in the literature. Nonetheless, the papers that have tested the life
cycle-permanent income model using aggregate time series data are many and almost
impossible to list. Many of the most influential papers in the literature on consumption,
such as those by Hall (1978, 1988), Hansen and Singleton (1982, 1983) and Flavin
(1981), have been useful conceptual exercises that have brought to the attention of the
profession many important issues.
Among the most influential and most widely cited studies of aggregate time series
papers are those of Campbell and Mankiw (1989, 1991). In these papers the authors
consider a simple version of the Euler Equation (5) and estimate it on aggregate
data with the addition of income growth on the right hand side. The justification
they use for such a specification is that there is a fraction )~ of consumers behaving
according to the permanent income-life cycle model while the remaining follow a 'ruleof-thumb' which consists in setting their consumption equal to their disposable income.
Several scholars have since interpreted the coefficient ( 1 - ) 0 estimated by Campbell
and Mankiw as the fraction of consumers that are 'liquidity constrained'. Campbell and
Mankiw estimate their equation by instrumental variables 45 and obtain a coefficient
( 1 - ) 0 of 0.4.
There is no reason to believe that the 'excess sensitivity' of consumption to income,
as summarised in such a coefficient, represents the fraction of consumers that behave
according to Campbell and Mankiw's rule of thumb. First of all, one would have
to assume that, if the consumers behaving according to such a rule were the same,
the fraction of income (and consumption) accruing to them was constant over time.
Second, one would have to believe that the non-linearities in the Euler equation have
no effect and could not generate such a result. Finally, to exclude that income and
consumption are unrelated under the life cycle model, one would have to believe that
consumption and leisure are separable in the utility function.

45 Because they worry about time aggregation, Campbell and Mankiw use instruments dated t - 2 and
earlier.

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785

More recently, in the spirit of the Campbell and Mankiw studies, several papers have
studied the time series properties of aggregate consumption and have tried to interpret
its relation to a number of other variables in terms of the life cycle-permanent income
model or as alternative deviations from it. Carroll et al. (1994), for instance, relate
consumption to the index of consumer confidence and provide some interpretation of
the high predictive power that such a variable has. Ludvigson (1997), on the other
hand, relates consumption to consumer credit and finds that 'excess sensitivity' of
consumption to such a variable is even more marked than that to labour income.
In the past, some of the papers that used aggregate time series data have also tried to
incorporate in the model the possibility that consumption and leisure are not separable
in the utility function. Bean (1986), Eichenbaum and Hansen (1988) and Mankiw,
Rotemberg and Summers (1985) are examples of these attempts. The presence of
corner solutions in labour supply, such as those observed in the case a spouse does
not participate to the labour force or in the case of retirement, make the aggregation
issues even more complicated.

5.2. Micro data: some econometric problems

The analysis of household data on consumption presents a variety of problems that
range from the availability and reliability of individual consumption data, to some
subtle econometric problems. Of the many problems that is worth stressing three in
particular are relevant for the discussion at hand. The first relates to the way in which
consistent estimates are achieved from the orthogonality conditions implied by an Euler
equation for consumption. The second concerns instead estimation and inference with
average cohort data instead of genuine panels. The last point is about the presence of
conditional second moments in the (log) linearised Euler equation.

5.2.1. Consistency of estimators derived from EuIer equations

The first issue was pointed out by Chamberlain (1984) and subsequently discussed by
Itayashi (1987), Altug and Miller (1990) and Deaton (1992) among others. The Euler
equation for consumption for a generic individual i can be written as follows:
i
i
Et [h(xt+l,x
t, 0)] = 0,

(17)

where 0 is a vector of parameters and x a vector of observable and unobservable

variables. Equation (17) states that a function of parameters and variables is orthogonal
to information available at time t. If the unobservables are i.i.d, innovations to
stationary processes, we can, without loss of generality, restrict the vector x to be made
of observable variables. In such a situation one can identify a vector of instruments wt
that, if its size is greater than the dimension of the parameter vector, can be used to
identify it.
The problem arises if one tries to exploit the cross sectional dimension rather than
the time dimension to construct the sample equivalent of Equation (17). Equation (17)

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o.P. Attanasio

implicitly defines expectational errors, which by rational expectations are orthogonal

with lagged information, o f which, typically, the instruments are part. There is no
reason to believe, however, that expectational errors average to zero in a cross section,
at a given point in time. Analogously, there is no reason to believe that the cross
sectional covariance o f h in Equation (17) with the vector o f instruments w equals zero.
The addition o f time dummies, therefore, is not a solution for the problem at hand:
each orthogonality condition one considers would imply the inclusion o f a vector of
dummy variables.
The only condition under which one can use the cross sectional equivalent of
Equation (17) under which introducing a vector o f time dummies can solve the problem
is when the expectational errors at a point in time are known to be exactly the same
across individuals. But this is equivalent to assume complete markets. This is the option
chosen, for instance, by Altug and Miller (1990) and by Atkeson and Ogaki (1996).
If one is not willing to assume complete markets, the only alternative is to have
a sample covering a long time horizon. This is necessary so that expectation errors
average out to zero. Notice that the 'large T' refers to the total length o f the sample
period over which individuals (or groups of individuals) are observed and not to the
length over which a single individual is observed 46.
The necessity of a 'large T' to obtain consistent estimates of the parameters o f an
Euler equation follows from the nature o f the residuals of such an equation which
incorporate expectational errors. The same argument does not apply to the residuals
o f intratemporal (within-period) first-order conditions. Indeed, if expectational errors
are the only component o f the residuals, such equations should have a perfect fit. It
is for this reason that the consideration o f unobserved heterogeneity is crucial in the
specification o f preferences [see Equation (13) above].
As mentioned in Section 3.6, the presence o f unobserved heterogeneity has
implications on the nature o f the residuals of the Euler equation. The specification of
preferences in Equation (13) implies that in Equation (9 ~) unobserved heterogeneity
enters in first differences, so that, depending on the time series properties o f v~,
the properties of the Euler equation residuals will be different. If the unobserved
heterogeneity term v I has a time invariant component which is individual specific,
it is differenced. If v I has a unit root, its differences would be white noise. I f the
deviation o f v~ from a constant component are white noise, the residuals of the Euler
equation are an MA(1) process. This has implications for the choice o f instruments
and the computation o f the standard errors.
The situation is more complicated if the deviations o f v I from its fixed component
are persistent (rather than white noise) and/or if the 'pure' discount factor /3 is

46 A problem similar to the one just discussed is the issue of the presence of individual fixed effects in
the Euler equation for consumption. These could arise, for instance, if the discount factors contain an
individual specific component. In this case, the use of weakly exogenous instrument would be invalid.
For a discussion of the issues related to this problem see Keane and Runkle (1992) and the comments
to that paper in the Journal of Business and Economic Statistics.

Ch. 11: Consumption

787

individual specific. In the former case the term Ao in Equation (9 ~) would have a
structure more complex than a simple MA(1), while in the latter, Equation (9 ~) would
have a fixed effect. In such a situation the choice of instruments is not trivial, in that
lagged individual variables are, in principle, correlated with the residuals of the Euler
equation.
The problem might be less severe if one uses average cohort data: grouping the
individuals belonging to a given cohort averages out the individual fixed effects and
leaves only the cohort specific ones. Here the availability of a long time period is once
again crucial: it is possible to estimate cohort specific fixed effects (say in discount
factors) by introducing cohort dummies in the Euler equation.
The necessity of a 'large T' to obtain consistent estimates of the parameters of an
Euler equation follows from the nature of the residuals of such an equation which
incorporate expectational errors. The same argument does not apply to the residuals
of intratemporal (within-period) first-order conditions. Indeed, if expectational errors
are the only component of the residuals, such equations should have a perfect fit. It
is for this reason that the consideration of unobserved heterogeneity is crucial in the
specification of preferences (see Equation 13 above).

5.2.2. Average cohort techniques

The lack of true panel data has often forced researchers to use the synthetic cohort data,
which I have used in Section 2 for descriptive purposes, to estimate and test dynamic
models, such as the Euler equation for consumption. The use of these techniques,
pioneered by Browning, Deaton and Irish (1985) and discussed by Deaton (1985)
and more recently by Moffitt (1993), has several advantages over real panels 47. Nonrandom attrition, for instance, is much less of an issue. On the other hand, one should
be careful about the econometric problems induced by these data. In particular, because
the size of the cell one uses to compute averages of the variables of interest is less than
infinite, one should consider explicitly the presence of sampling error in the data one
uses. Furthermore, because the averages are computed on the levels of variables and
one is typically interested in the first differences of variables, the presence of sampling
error induces an MA(1) structure on the residuals of the Euler equation estimated on
synthetic cohort data. The presence of MA(1) residuals obviously has implications
for the choice of the instruments and the computation of standard errors. The fact
that synthetic cohort data are typically constructed out of independent repeated cross
section, however, suggests simple valid instruments: by lagging the instruments an
extra period should guarantee consistency of the IV estimator 48.

47 Average cohort techniques can be interpreted as an example of an estimator using complementary

data sources of the kind discussed in Arellano and Meghir (1992).
48 The Consumer Expenditure Survey used, for instance, in Attanasio and Weber (1995) is a rotating
panel so that the construction of valid instruments is more complicated.

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O.P. Attanasio

The structure of the errors is even more complicated when one considers more
cohorts simultaneously. In this case, one has to keep into account the possibility
that the residuals of different cohorts in the same time period are correlated. The
variance covariance matrix of the residuals is therefore quite complex. Its computation
is, however, important to make correct inferences 49.
Besides adjusting the estimated standard errors for the presence of an MA(1) error
and the correlation among the expectationat errors of different cohorts, it is also
possible to use a GLS type of scheme to improve the efficiency of the estimator. One
should be careful, however, in filtering the data so to avoid the inconsistency caused
by the correlation of lagged expectational errors with the instruments 5o.
5.2.3. Conditional second (and higher) moments

In Equation (9~), as in Equation (10), I have neglected the presence of conditional

second (and, if the log-normality assumption does not hold, higher) moments that
follows from the log-linearization of the Euler equation in (6). In theory, this is
not quite correct in that these variables are likely to vary as new information
is made available to the individual consumer. This is particularly true for the
conditional variance of consumption which is endogenously determined by the model
(consumption is a choice variable). Incorporating these variables in the constant is
equivalent to assuming that innovations to the conditional second (or higher) moments
of consumption and interest rates are uncorrelated with the variables typically used as
instruments.
Assessing the plausibility of this assumption is very difficult, especially because
the answer is likely to depend on the time series properties (and in particular on the
heteroscedasticity) of the determinants of consumption levels (income, wages and so
on). In a recent paper, Ludvigson and Paxson (1997) have used numerical methods to
compare the consumption function obtained from a log-linearised Euler equation to the
'true' one. Their method, however, does not provide estimates for the bias introduced in
Euler equation estimation. Carroll (1997b) also uses numerical techniques to simulate
log-linearised Euler equations, but focuses on the cross sectional rather than time series
dimension, which, given the considerations in 5.2.1 is the relevant one.
An interesting and novel approach to this problem is the one used by Banks, Blundell
and Brugiavini (1997) in a recent paper. These authors use an approximation to the
consumption fimction derived by Blundell and Stoker (1999) which implies weighting
the conditional second moments by the ratio of income to wealth at a given point in
time. Banks et al. (1997) also try to identify separately the effect of aggregate and
cohort specific shocks. The main findings of the exercise are two. First, conditional

49 A technical problem arises from the fact that is not easy to guarantee that the estimated variance
covariance matrix is positive definite in finite samples.
50 See Hayashi and Sims (1983).

Ch. 11:

Consumption

789

second moments are significant in the Euler equation; and second, the estimate of some
important structural parameters, such as the elasticity of intertemporal substitution, is
not much affected by the introduction of the conditional second moments.
Yet another alternative to the log-linearization procedure is the one proposed in
Attanasio and Browning (1995) who start with a flexible functional form for the
(log) marginal utility of consumption so to avoid the necessity of approximating an
Euler equation. Should one be interested in the utility function that generates such a
function, one can obtain it by integration. Not only does this method avoid dealing with
the issue of linearization, but gives the possibility of estimating much more flexible
functional forms than the isoelastic one. This is not to say that precautionary motives
are unimportant, but that their relevance is going to depend on the curvature of the
marginal utility of consumption and is, in the end, an empirical matter.
The alternative of estimating a non-linearised Euler equation (such as Equation 8)
is particularly unappealing because it would imply assuming away measurement error
and would, in any case, make the use of average cohort techniques much harder, if
not impossible.
5.3. Micro data: some evidence

In this section, I do not discuss in detail all the papers that have estimated and tested
Euler equations for consumption using micro data. Rather, I summarise some of the
main contributions with an eye to the overall evaluation of the evidence which I give
in the next sub-section.
One of the first papers to consider the implications of the permanent incomelife cycle models with micro data is Hall and Mishkin (1982) in which the authors
used PSID data to test and reject the implication that consumption changes were
uncorrelated with lagged values of current income. Hall and Mishkin (1982) evidence
was later criticised by Altonji and Siow (1987) because it did not allow for
measurement error.
Hall and Mishkin (1982) focused on the permanent income hypothesis and did not
consider explicitly the Euler equation that one can get from the consumer intertemporal
optimisation problem. One of the first, and probably the most influential article to take
such an equation to the data, was the paper by Zeldes (1989a), who implemented
ideas very similar to those in Runkle (1991). In both articles, the Euler equation
is fitted to observations on food consumption from the PSID. In both articles, the
authors consider explicitly the possibility of liquidity constraints and the possibility
that these constraints affect different group in the population differently. Effectively,
Zeldes (1989a) and Runkle (1991) estimated versions of Equation (12) for different
groups of the populations that had, on the basis of an observable variable, different
probabilities of having/tt = 0.
The results they get, however, are quite different. Zeldes (1989a), in particular,
splits the sample according to the wealth held and finds that the rate of growth of
consumption is related with the lagged level of income for the low wealth sample. The

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O.P. Attanasio

same result does not hold for the high wealth sample. Zeldes interprets this results as
evidence of binding liquidity constraints for a large fraction of the population. Runkle
(1991), who uses a different extract of the PSID, and different econometric techniques,
obtains different results 51.
Since Zeldes (1989a) and Runkle (1991), many papers, including Hayashi (1985a,b),
Garcia, Lusardi and Ng (1997), Lusardi (1996), Mankiw and Zeldes (1994) and Shea
(1995), have used PSID data, either alone or in conjunction with other data, to estimate
and test various versions of the model. Shea (1995), in particular, identifies a subsample
of PSID households for whom he can track their union wage contracts and therefore
construct a good measure of their expected wage growth. As many others, Shea (1995)
tests (and marginally rejects) the hypothesis that consumption growth is not related to
wage growth. Shea (1995), however, also notices that liquidity constraints imply an
asymmetry between households who expect a decline and a rise in wages, because the
former should be saving rather than borrowing. As he fails to identify these effects,
his results cast doubts about the plausibility of liquidity constraints as an explanation
of the excess sensitivity of consumption growth to income or wage growth.
One of the main problems with the PSID is that the measure of consumption that
is included in the survey refers only to food consumption. I have stressed above the
theoretical problems with such a measure. Attanasio and Weber (1995) show how the
use of such a measure of consumption can lead to misleading results. In that paper,
my co-author and I use average cohort data constructed from the CEX for the period
1980-1992 to show that some of the excess sensitivity results obtained on micro data
can be accounted for by the non-separability of food and other consumption.
The other two issues on which Attanasio and Weber (1995) focuses are the effects
of aggregation over consumers and over commodities. As far as the aggregation over
commodities is concerned, Attanasio and Weber (1995) find significant effects of the
zero-homogeneous price index in Equation (14) that, however, are not quantitatively
important. This evidence is consistent with that for the UK FES reported in Blundell,
Browning and Meghir (1994) and Banks, Blundell and Preston (1994).
About the aggregation over individuals, Attanasio and Weber (1995) report evidence
which shows that the effect of the non-linearities in the Euler equation can be quite
important. This is consistent with the evidence reported in Attanasio and Weber
(1993) on FES data. In the latter paper, my co-author and I show that aggregating
the individual data so to obtain an aggregate conceptually similar to the National
Accounts statistics (i.e. taking the log of the arithmetic mean of consumption) one
obtains results that are quite similar to those obtained with aggregate times series
data. In particular, it is possible to obtain excess sensitivity to predicted income, a low
estimated elasticity of intertemporal substitution and rejection of the overidentifying

51 Keane and Rtmkle (1992) have recently re-estimated Zeldes' equations on his data but using
different econometrictechniques. Jappelli, Pischke and Souleles (1997) match SCF data, which contain
information on self reported 'liquidity constrained' status with PSID data.

Ch. 11:

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791

restrictions. The results obtained aggregating the data in the proper way (i.e. taking the
average of log consumption), however, are much more consistent with the theoretical
model. In particular, there is no rejection of the overidentifying restrictions. The
difference between the log of the average and the average of the log is a measure
of inequality which varies over the business cycle and is likely to be correlated with
the instruments used in estimating the Euler equation.
The last group of papers I have cited [Attanasio and Weber (1993, 1995), Blundell,
Browning and Meghir (1994), Banks, Blundell and Preston (1994), Attanasio and
Browning (1995)] all stress the importance of controlling for demographic factors
and for labour supply effects. These papers, which use average cohort data for the
UK and the USA (the data presented in Section 2) show that once one controls for
the influence that demographics and labour supply might have on the marginal utility
of consumption, there is no evidence of excess sensitivity of consumption to income
or rejection o f the overidentifying restrictions. Female labour force participation and
family size seem to be particularly important in this respect 52.
If one believes that the estimation of the Euler equations discussed in this section
yields consistent estimates, the parameter on the real interest rate can be interpreted
as the elasticity of intertemporal substitution. Such a parameter is of some importance
for a number of policy issues and its size has been discussed at length. Hall (1988) in
particular, claims that the use of the correct instruments delivers very low estimates of
this elasticity. However, the evidence that emerges from the micro studies which use
an isoelastic specification of preferences [such as Attanasio and Weber (1993, 1995),
and Blundell, Browning and Meghir (1994)], is that, both in the UK and in the USA,
the elasticity of intertemporal substitution of consumption (EIS) is just below 153.
From the discussion above, it is clear that in addition to the EIS, a number of other
parameters, measuring the effect of leisure, that of demographics or other variables
affecting the marginal utility of consumption are likely to be extremely important
in determining the level of consumption. Their interpretation, however, is not easy
without a solution for the level of consumption.

6. Where does the life cycle model stand?

It is now time to take stock on the empirical relevance of the models discussed so far.
My reading of the evidence briefly presented in Section 5 is that the life cycle model,
enriched to account for the effect of demographic and labour supply variables, is not
rejected by the available data. Alternatively, and perhaps more accurately, one could

52 Demographicvariablesmight be capturing the effect of the conditional second (and higher) moments
ignored in the log linearization procedure. Lusardi (1996) criticises the use of income data in the CEX
as they might be affected by measurement error.
53 As mentioned above, the use of aggregate rather than individual data and aggregation problems can
explain part of the differences in the size of the estimatesof the elasticity of intertemporal substitution.

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0.t?. Attanasio

say that the life cycle model can be made complex enough not to be inconsistent with
the available data. This view is not widely accepted in the profession so that it deserves
some discussion.
Before discussing these issues, however, a number of caveats are in order. First, the
model has been fitted with success only to households in the middle of their life cycle.
While these account for a large fraction of aggregate consumption, additional work is
needed to understand the behaviour of young and elderly households.
The behaviour of retirees in particular, can be quite difficult to model. I f leisure
and consumption are non-separable in the utility- function, a radical change in labour
supply could be linked to a change in consumption. Furthermore, a number of other
important factors, ranging from family size, to health status, to the probability of death,
changes dramatically in the years after retirement. In section 2, we have seen that both
in the USA and especially in the UK, consumption drops substantially at retirement.
This could be related to insufficient savings and a misperception about the amount
of (public and private) pension benefits. Alternatively, the drop in consumption could
be explained within the optimisation framework of the life cycle model if considered
together with all the changes mentioned above. This important topic is studied in a
recent paper by Banks, Blundell and Tanner (1998) who find that, even ignoring health
status and mortality issues, two thirds o f the drop in consumption observed around
retirement can be rationalised by an optimisation model.
Second, while the endogeneity of labour supply choices can be controlled for in
the empirical analysis, the joint modelling of consumption and of labour supply is
extremely valuable and is still at the beginning 54. Similarly, expenditure on durables,
which is an important component of total expenditure, needs to be modelled in a
different way, as discussed in Section 8.
Third, the fact that a particular specification of preferences fits the data reasonably
well and that one can obtain consistent estimates of the structural parameters, does not
mean that borrowing restrictions and liquidity constraints are unimportant. The Euler
equation can be a very poor tool for identifying the presence of such phenomena, as
the equation holds whenever the constraints are not binding. For the notion of liquidity
constraints to be useful, however, it is necessary to model the behaviour of constrained
individual explicitly and determine what the aggregate implications of these constraints
might be.
A literal interpretation of the papers mentioned in the last part of Section 5 is that
a flexible version of the life cycle model, which allows for demographic and labour
supply effects in the utility function, cannot be rejected by the data. Neither excess
sensitivity tests, nor tests of overidentifying restrictions reject the null. The strength

54 Surprisinglyfew studies analyse consumption and labour supply choicesjointly. An almost exhaustive
list includes MaCurdy (1983), Browning, Deaton and Irish (1985), Hotz et al. (1988), Altug and Miller
(1990), Blundell, Meghir and Neves (1993a) and Attanasio and MaCurdy (1997). Of these only the last
two papers consider female and male labour supply jointly.

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793

of a result that does not reject the null, however, obviously depends on the power of
the test used.
The power of the tests of overidentifying restrictions or of the excess sensitivity
tests that fail to reject within a sufficiently complex version of the model might
be questioned. If an Euler equation is saturated with demographic and labour
supply variables, it might be hard to measure precisely the coefficient on expected
income or, more generally, reject overidentifying restrictions. This problem might
be particularly serious if some of these variables, such as labour supply, are
correlated with expected income. In this sense, this criticism is equivalent to state the
difficulty in distinguishing hypotheses about preferences from hypotheses on budget
constraints.
A possible response to this kind of criticism is to check whether the preferences
parameters of the model that is not rejected by the data are sensible and, most
importantly, whether the model is able to explain facts other than those that have been
used to fit it. An example will make this argument clear.
In Attanasio et al. (1996), my co-authors and I consider a relatively simple version
of the life cycle model where the within-period utility function includes demographic
variables and whose parameters are assumed to be the same across education groups.
Such a specification of the model is estimated on US average cohort data and it is
not rejected by the data. The elasticity of intertemporal substitution is estimated to
be just below 1. Given some hypotheses about the stochastic process that generates
income, interest rates and demographic variables, and given an assumption on terminal
conditions, one can solve numerically for the consumption function at each age. We
do so and then simulate the model for income and demographic profiles calibrated on
different education groups.
With this technique we are able to reproduce some of the main feature observed in
the data, that is, that the consumption profiles are steeper for the groups that have a
steeped income profiles. This feature of the data has been interpreted as a failure of the
life cycle model by Carroll and Summers (1991). Our exercise, however, shows that
a flexible version of the life cycle model incorporating some realistic features, such
as the effect of family composition on utility, can explain it. The result is remarkable
because there is nothing, at the estimation level, that fits the particular feature of the
data (differences in consumption age profiles by education groups) that the estimated
preferences (assumed to be the same across groups) and the differences in demographic
profiles are able to explain. In this sense the exercise constitute a genuine 'out-ofsample' verification of the ability of the model to fit the data.
As the utility function is of the CRRA type, the model also incorporates the
precautionary motive linked to income uncertainty which Carroll (1997a) has recently
advocated as the most likely explanation of the relationship between the shape of
consumption profiles and that of income profiles. The simulations show, however,
that this effect is quantitatively less important than that generated by differences in
demographic profiles. Indeed, most of the 'tracking' of consumption and income
profiles is generated by corresponding similarities in demographics. This argument

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O.P. Attanasio

is also consistent with the evidence presented in Section 2 where consumption 'per
adult equivalent' profiles are quite flat over the life cycle 55.
The simulation techniques used in Attanasio et al. (1996) are similar to those used
by Deaton (1991) and by Hubbard, Skinner and Zeldes (1994), among others, to obtain
a closed form solution for consumption. These techniques are the only way, if one is
not willing to assume quadratic utility or CARA utility [as in Caballero (1990a)] 56, to
obtain a consumption function in the presence of uncertainty. They are quite expensive
as they are numerically intensive for any problem which goes beyond the simplest
assumptions and require the researcher to take a stand on any detail of the optimisation
problem (from the terminal condition to the nature of the income process). The payoff
one can obtain can, however, be quite large.
The Euler equation approach, first used by Hall (1978) in the consumption literature,
was a major innovation. It allowed the rigorous consideration of uncertainty in a
complicated dynamic decision problem while preserving the empirical tractability of
the model. The beauty of the approach consists in the fact that exploits the main
implication of the life cycle-permanent income model, that is that an optimising
consumer keeps the discounted expected value of the marginal utility of consumption
constant, to eliminate the unobservable 'fixed effect', the marginal utility of wealth,
which incorporates the influence of expectations and all the variables that are relevant
for the consumer optimisation problem. The price that one pays by differencing out
the marginal utility of wealth is, however, non-negligible. While it is true that one
can use the Euler equation to estimate structural parameters, one looses the ability of
saying anything about the l e v e l of consumption. This implies that without additional
information and structure, it is not possible to answer a number of extremely important
questions. In other words, the Euler equation for consumption is n o t a consumption
function and therefore it does not tell us anything about how consumption reacts to
news about the economic environment in which economic agents operate.
The symptom of this unsatisfactory state of affairs are apparent in the literature. If
one reads, for instance, the literature on saving, which in recent years has dealt with a
number of interesting issues that range from the decline in personal saving rates in the
USA to the effects of tax incentives on personal and national saving, one rarely finds
a systematic use of Euler equation estimates or even references to the Euler equation
literature. Indeed, the use of structural models of consumption behaviour is quite rare.
On the other hand, the same literature suffers from a number of identification problems
that arise from the inability or unwillingness to put more structure onto the descriptive
analysis. A good example is the debate on the effectiveness of fiscal incentives to
retirement saving.

55 It can be argued that the demographics in the Euler equation for consumption are picking up the
effect of the omitted conditional higher moments.
56 Both in the case of quadratic and CARA utility a number of additional assumptions about interest
rates are necessary.

Ch. 11: Consumption

795

It seems that, 40 years after the publication o f Friedman's book, we still have
not been able to construct a 'consumption function' which incorporates the main
features of the dynamic optimisation model without loosing analytical and empirical
tractability. The development o f the numerical solution techniques referred to above
is one possible avenue. The main problem with these techniques, however, is that
they require a complete specification of the economic environment (including terminal
conditions) in which the agent lives. Therefore, to make the problem treatable,
even with the use o f powerful computation methods, very strong assumptions are
needed. Furthermore, we cannot use the conditioning arguments which simplify the
estimation o f an Euler equation. While at the estimation level variables such as durables
and labour supply can be rigorously treated as endogenous without modelling them
explicitly, at the level o f numerical solutions, they cannot be ignored.

7. Insurance and inequality

One o f the main implications of the life cycle model sketched in Section 3, is the fact
that households attempt to smooth consumption over time. I f one sees an individual
household in isolation, this can be achieved only through the accumulation of buffer
stock saving or through borrowing. However, if one considers the interaction of many
households, one realises that if individual shocks are not perfectly correlated, there is
scope for the diversification o f idiosyncratic risk and for welfare improving contracts
that allow the individual households to share part o f the risk they face. The essence
o f a risk sharing situation, as formalised, for instance, by Townsend (1994), is well
described by one of the characters in Shipping News, the novel by Anne Proulx set in
Newfoundland. Describing life in one of the small islands off the coast, he declares
"... it was never easy ... on Gaze Island, but they had the cows and a bit of hay, and the berries,
the fish and the potato patches, and they'd get their flour and bacon in the fall from the merchant
over at Killiek-Claw, and if it was hard times, they shared, they helped their neighbor. No they
didn't have any money, the sea was dangerous and men were lost, but it was a satisfying life in
a way people today do not understand. There was a joinery of lives all worked together, smooth
(pp. 16~169)
in places, or lumpy, but joined."
Social and economic interactions in modern western societies are probably much
more complex than those that prevailed on Gaze Island. It is however an interesting
question to establish to what extent institutions of various kinds are used to smooth
consumption across households and to diversify idiosyncratic risk. In other words,
it might be interesting to establish the extent to which implicit or explicit contracts,
family networks, social safety nets and so on can approximate the intertemporal
allocation that would prevail under complete contingent markets o f the kind described
in an Arrow-Debreu equilibrium. Furthermore, it might be interesting to establish what
are the welfare costs implied by the lack o f complete contingent markets, given the
nature of the observed idiosyncratic shocks.

796

O.P Attanasio

From a theoretical point of view, the basic proposition can be derived if one
considers the allocation problem faced by a central planner who maximises, given a set
of Pareto weights, the average of individual utilities given the resource constraint. This
framework is particularly useful because it can be used to control easily for a number
of factors and in particular for the presence of multiple commodities, non-separable
leisure and so on. The basic implication is that the rate of change of the marginal utility
of consumption (which might depend on leisure and other commodities) is equalised
across individuals.
Townsend (1994) was one of the first to consider the empirical implications of
complete market, that is that under certain conditions "... individual consumptions are
determined by aggregate consumption, no matter what the date and history of shocks,
and so individuals' consumption will move together" (p. 540) 57. While Townsend
(1994) considered data from India, other studies, such as Mace (1991), Cochrane
(1991) and Hayashi et al. (1996), performed similar exercises using US data, that is
either the CEX or the PSID.
Both Cochrane (1991) and Hayashi et al. (1996) reject the implications of the risk
sharing hypothesis. Cochrane (1991) finds that food consumption changes in the P SID
are related to changes in health and employment status. Hayashi et al. (1996) use the
same data but control for the possibility that the relationship between changes in wages
and consumption is generated by the non-separability of leisure and consumption in
the utility function. By following spin-offs in the PS1D, they also test (and reject) the
hypothesis that risk is shared among families.
Attanasio and Davis (1996) have matched data from the Current Population Survey
and the CEX to test the hypothesis that movements in relative wages are reflected
into movements in relative consumption or, to be precise, in marginal utilities of
consumption. Attanasio and Davis consider education and year of birth cohorts. Most
of the variability in relative wages comes from the shifts in the wage distribution
across education groups that occurred during the 1980s. They find that such movements
were mirrored in movements in the consumption distribution, indicating a 'spectacular
failure' of the perfect insurance hypothesis 58. The analysis of Attanasio and Davis is
particularly damning for the perfect insurance paradigm because it focuses on economy
wide, well observed shifts, and therefore the relationship between consumption and
income cannot be explained with models which consider private information such as
those in Phelan and Townsend (1991).
Attanasio and Davis (1996) also try to evaluate the welfare cost of the lack of
an institutional framework that allows for the diversification of idiosyncratic risk.
The evaluation of such a cost obviously depends on preference parameters and on

57 Townsend (1994) credits Diamond (1967) and Wilson (1968) with the first versions of this
proposition.
58 As Hayashi et al. (1996), Attanasio and Davis (1996) use lead as well as lags of wages as instruments.
Both studies consider short and long tun shocks.

Ch. 11: Consumpgon

797

the nature o f the shocks considered. Attanasio and Davis (1996) under a set of
plausible assumptions and a coefficient o f relative risk aversion of two, evaluate the
cost of the lack of insurance to 'group specific shocks' at 2.5% of consumption. This
estimate is considerably larger than the cost of business cycle fluctuations evaluated
by Lucas (1987) and is more in line with the results reported by Imrohoroglu (1989).
It should also be stressed that Attanasio and Davis (1996) estimate completely ignores
'within-groups' shocks and focuses mainly on relative low (rather than business cycle)
frequencies.
Whilst the analysis of Attanasio and Davis (1996) can be framed in terms of a
test of the perfect insurance hypothesis, it can also be interpreted as documenting the
evolution in inequality in consumption and wages in the USA during the 1980s. The
increase in inequality in wages in the USA has been analysed in many studies by
labour economists. On the other hand, the evolution o f inequality in consumption has
not received much attention until quite recently. Little is known about the evolution
of consumption inequality over the business cycle and over different stages of the
process of economic growth. In addition to Attanasio and Davis (1996), Cutler and
Katz (1991) analyse the evolution of inequality in consumption during the 1980s using
CEX data. Goodman, Johnson and Webb (1997) provide an exhaustive analysis of the
recent trends in both income and expenditure inequality in the UK.
The lack of evidence on consumption inequality is somewhat disconcerting,
especially if one compares it to the amount of evidence on wage and income inequality.
From a theoretical point of view, it is not completely obvious which of the two
measures of inequality is more interesting. Blundell and Preston (1998) discuss the
advantages and drawbacks of both: consumption inequality is more likely to reflect
the cross sectional variability of permanent income, while income inequality is more
affected by temporary shocks. The relationship between the two, however, depends on
a number of factors that range from the specification of preferences to the nature of
the income shocks, to the institutions and instruments available to households to (self)
insure against idiosyncratic shocks.
More generally, a theoretically consistent analysis of consumption inequality cannot
avoid the discussion of the implications of different preference specifications and
market institutions. Suppose, for instance, that individual households are prevented
from borrowing. If labour supply behaviour is considered exogenous, these households
will engage in precautionary saving to avoid the effects of extremely negative
shocks to income. On the other hand, if one models labour supply choices and
in particular female participation in the labour market, it is quite possible that
the role of precautionary saving is taken by labour supply. That is to say, it is
possible that households, rather than consuming less goods, decide to consume less
leisure.
Another important element, which has been only recently analysed, is the availability
of means tested safety nets. Hubbard, Skinner and Zeldes (1994) consider the
effect that liquidity constraints and means tested safety nets have on the pattern of
consumption using numerical techniques to solve the consumption function.

798

O.P. Attanasio

Browning and Crossley (1997) have recently considered another potentially important channel that some households might use to smooth the marginal utility of
consumption over time: what they call small durables. The idea is intuitive: individuals
that have no access to savings or loans to smooth out fluctuations in income, might
postpone the replacement of small durables. The features that characterise the 'small
durables' in Browning and Crossley's problem are the durability and the irreversibility
(due to the lack of a second hand market) of such items, as well as the fact that
scrappage decisions are not only determined by the physical depreciation but also
by the economic situation faced by the agent. Browning and Crossley (1997) present
both some theoretical results and some empirical evidence on a sample of Canadian
unemployed supporting the importance of this type of smoothing behaviour. The
evidence I presented in Table 6, about the relative variability of durable expenditure
for groups of households with different levels of education is consistent with the idea
that poorer individuals might use durables to smooth out fluctuations in income.
Browning and Crossley (1997) focus on items that cannot be used as collateral (such
as clothes or small appliances) to obtain loans. It would be interesting to consider
the implications of the same ideas for the replacement of items for which reasonably
efficient second hand markets exists and which are collateralizable such as automobiles
and, to a certain extent, 'white goods'. Greenspan and Cohen (1996) have stressed
the important role that scrappage of old cars plays in forecasting expenditure on
automobiles which, in turn, is a very important indicator of the status of the business
cycle.
A few studies, recently, have started to study the evolution of inequality over the
life cycle. The idea is quite simple: if consumption follows a random walk, the cross
sectional distribution of individual consumption should 'fan out' over the life cycle.
That is, the cross sectional variance of individual consumption should be increasing,
on average, over long periods of time. This idea was first exploited by Deaton and
Paxson (1994) who analysed average cohort profiles for the variance of (log) nondurable consumption in three different countries, the USA, the UK and Taiwan.

8. Intertemporal non-separability
In the discussion so far, I have assumed that preferences are separable over time. While
this is an extremely convenient assumption, it is easy to think of situations in which it is
violated. In this section I consider the implications of the fact that current expenditure
might have lasting effects. After sketching the general problem, I discuss in detail two
particular examples of time non-separability of some importance: that of durability
and of habit formation. As is clear from the discussion, the complication implied by
time dependence of preferences is only one of the things that make the treatment of
these phenomena extremely hard.
The general problems can be stated in reasonably simple terms if one states the
problem in terms of a flow of services derived from a 'stock' and assumes that there

Ch. 11: Consumption

799

are no costs in changing the 'stock'. The simple problem in Section 3, can therefore
be re-written as:
T-t

max

Et v(s,+j)
j=0

IAt+j+l~l+rt+j)At+j+Yt+j-st+j,

subject to [St+j = Z

(18)

= 1

k=0

where St is the 'stock' from which utility is derived, st is expenditure and the
coefficients ak define the type of time dependency. As we see below, such a model
can easily incorporate durability as well as habit formation. It is also straightforward
to consider the case in which S is a vector whose components have different degrees
of durability 59.
A rational individual, in choosing the level of expenditure s will take into account
the effect that this has on the level of the 'stock' in the current as well as in the future
period. It is straightforward to verify that the first-order condition for such a problem
is going to be

Etmt = Et[3(1 + rt+l) mr+l,

T

(19)

where m t = ~-~'~k=0~ku1(St+k) ak" Notice that if the ak s are different from zero,
mt is not a variable known at time t as it depends on the future marginal utility of the
stock S. In general, therefore, it will not be possible to express Equation (19) in terms
of the rate o f growth of mt as is usually done [see, for instance, Equation (8)]. Notice
also that the marginal utility of expenditure mt depends on a potentially very large
number of terms. To make an equation such as (19) operational it will be necessary
to simplify it by some algebraic manipulation whose nature depends, once again, on
the pattern of the coefficients ak.
The two models of non-separability I consider below (durables and habits) differ on
the nature of the time dependence. In the first case we have substitutability, while in
the latter we have complementarity of expenditure over time.

8.1. Durables
As illustrated in Section 2, expenditure on durables, both at the aggregate level and
at the cohort level, is by far the most volatile component of consumption. In addition,
the dynamic of durable expenditure seems much more complex of that of the other
components o f consumption. A simple model of durable consumption can be obtained

59 See, for instance, Eichenbaum and Hansen (1990).

O.P Attanasio

800

from the system in Equation (18) if it is assumed that ak = (1 - 6) k. In this case S can
be interpreted as the value of the stock of durables, and 6 as the depreciation rate, and
the third equation in system (18) becomes
St = (1 - 6)St_1 +st.

(20)

Assuming quadratic utility, Mankiw (1982) generalised Hall's random walk model
to durable expenditure. In particular, he showed that under these circumstances the
model implies that changes in expenditure should follow an MA(1) process with
coefficient equal to ( 1 - 6). This implication is strongly rejected by the aggregate
data, as shown, for instance, in Section 2. Dunn and Singleton (1986) have used a
more attractive preference specification and considered the Euler equation for durable
consmnption and its implications for asset pricing. The most comprehensive treatment
of durability and of the Euler equations associated with a variety of preferences is
found in Eichenbaum and Hansen (1990) who use a Gorman-Lancaster technology that
converts expenditure into stocks and stocks into services over which utility is defined.
The aggregation issues I discussed in Section 4 are obviously relevant for durables
as well. The aggregation problems are actually even more complicated because of the
possibility of corner solutions, i.e. households that decide not to own a durable (a car
for instance), that can be safely ruled out for non-durables under the assumption that
the marginal utility goes to infinity at zero or low levels of consumption 6.
A possibility for the deviations of the dynamics of aggregate durable expenditure
from that implied by the simple model is that of the existence of adjustment costs. It
seems natural to assume that adjusting the stock of durables involves costs, motivated
both by the existence of imperfections in the second hand market and by 'pure'
adjustment costs (such as search costs, taxes and similar).
The literature first studied convex (typically quadratic) costs of adjustment. A typical
example is Bernanke (1984, 1985), who estimated models with quadratic costs both
with aggregate and individual data. Eichenbaum and Hansen (1990) also incorporate
the possibility of adjustment costs in their technology. Such attempts, however, have
turned out to be unsuccessful. The main reason for this is that convex adjustment
costs predict a smooth adjustment towards an equilibrium. To avoid increasing costs
households will adjust their stock of durables often and by small amounts. Even
casual observation suggests that this is not a very accurate description of household
behaviour.
The next step is then to consider non-convex costs of adjustment; that is either fix
or proportional costs. The characterisation of optimal behaviour under this type of
costs is obviously much harder because for many households in many periods the
optimal policy involves no adjustment. The first paper to characterise the optimal

6o Bernanke (1984) and Hayashi (1985a,b) are among the few studies that have used individual data to
analyse durable expenditure.

Ch. 11: Consumption

801

adjustment policy under non-convex costs was Grossman and Laroque (1990) who
studied a problem of a consumer deriving utility from a single durable and solving a
dynamic optimisation problem involving the choice of the optimal size for the durable
and the optimal portfolio investment for her financial wealth. Grossman and Laroque
(1990) proved that the optimal strategy involves an (S, s) rule of the kind considered
in the optimal inventory literature of the 1950s. Specifically, they proved that the value
function associated to the consumer problem is a function of a single state variable,
the ratio of the value of the durable to financial wealth, and that the durable is adjusted
to a 'target' level when the state variable crosses a lower or an upper bound. When the
state variable is within the two bounds the optimal policy is not to adjust the durable. In
addition, Grossman and Laroque (1990) characterised the size of the inaction band as
a function of the parameters of the problem, as well as the optimal portfolio strategy.
One of the problems of the Grossman-Laroque model is that a solution can be
obtained only if the problem can be expressed as a function of a single state variable.
This precludes, for instance, the consideration of labour income. More recently, Eberly
(1994) and Beaulieu (1993) have extended the Grossman-Laroque model in various
directions. Eberly (1994), has showed that changes in the durable stock between periods
in which an adjustment is performed obey to an Euler equation. Beaulieu (1993) has
reformulated the Grossman-Laroque model and expressed the (S, s) rule in terms of
the ratio of durables to non-durables.
The attractiveness of the (S,s) model of adjustment lies in its implications that,
in most periods, consumers do not adjust their stock of durables and when they do
adjust, they usually make substantial adjustments. These features (large and infrequent
adjustments), that can be generated by the (S, s) model, are the exact contrary of those
of the quadratic adjustment model which yields small and frequent adjustments.
The consideration of large and infrequent adjustments poses an entire new category
of aggregation problems. Caplin (1985) was the first to consider them. Caplin and
Spulber (1987), in the context of a model of price adjustment, provided (stringent)
conditions under which lumpy individual adjustment could result in a smooth aggregate
adjustment. Bertola and Caballero (1990) analysed the implications of the (S,s) type
of adjustment for the dynamics of aggregate durable expenditure and stressed that the
assumptions needed to generate the type of neutrality results obtained by Caplin and
Spulber are indeed very fragile. (S, s) models can generate very rich and complicate
dynamics that seem not to be inconsistent with the observed autocorrelation of durable
expenditure. Caballero (1990a,b, 1993), in particular, has stressed how (S,s) models
can generate patterns of MA coefficients that are similar to those I reported in
Section 2. Caballero and Engel (1991) have studied more generally the aggregate
properties of (S, s) economies. Caballero (1993) has tried to estimate the parameters of
the (S, s) model by fitting the highly non-linear model resulting from the aggregation
of a simple (S, s) rule to aggregate time series data.
The estimation of (S, s) models with individual data is not an easy task for several
reasons. First of all, the data requirements can be quite formidable: information on
the value of the stock of durables before and after the adjustment is necessary. It is

802

o.P Attanasio

also desirable to follow households over some time to bound the range of inaction by
the households that are observed not to adjust. In addition, the numerical problems in
estimation can be quite formidable.
The first attempt at estimating such a model with individual data was by Lam (1991)
who estimated by maximum likelihood an (S, s) rule defined in terms of the ratio of the
stock of automobiles over permanent income. Eberly (1994), also estimated the width
of the (S, s) rule for the subset of consumers who were observed to adjust the stock of
their automobiles in her sample 6~. B eaulieu (1992) also uses individual observations
but follows a different approach. He considers a single cross section and computes
the ergodic cross sectional distribution to which the economy would converge in the
absence of aggregate shocks. The parameters of this distribution will depend on the
parameters of the (S, s) rule. He can then estimate them from the parameters of the
observed cross sectional distribution which is assumed to coincide with the ergodic
distribution.
Like Lain (1991), I have estimated the parameters of the (S,s) rule by maximum
likelihood on individual data in Attanasio (1995a). However, I formulate the (S, s) rule
in terms of the ratio of the stock of automobiles to non-durable consumption, allow
for observed and unobserved heterogeneity in both the target and the band width
and consider a more flexible stochastic specification. The consideration of unobserved
heterogeneity in both the target level and the band width makes the model equivalent
to a recent formulation of lumpy adjustment by Caballero and Engel (1991) who
consider, rather than a strict (S, s) rule, a 'hazard function' which gives the probability
of adjusting as a function of the difference between the current stock and its target
level.
While substantial progress in the understanding of the behaviour of models with
lumpy adjustment has been made (not only in consumption but also in investment
and labour demand), a lot of research is still necessary to establish the empirical
relevance of these models and to quantify their parameters. The aggregate dynamics
of an (S, s) system depends crucially on the properties of several stochastic processes
about which we still have little or no information. These include the process by which
the state variable changes when no adjustment occurs, the process by which the target
level changes, the degree of heterogeneity in target levels and band width, the degree of
persistence of individual shocks to band width (cost of adjustment) and the correlations
among these variables.

8.2. Habit formation

A form of intertemporal persistence of preferences alternative to durability is that
of habits. As said above, habits can be obtained using a specific patterns for the
61 Eberly (1994) also splits the samplebetween consumers who are likelyto be liquidity constrained and
those that are liquid. In doing so she uses both the procedure used by Zeldes (1989a) and a switching
regression model.

Ch. 11:

803

Consumption

coefficients a in Equation (18). For instance, Heaton (1995) and Constantinides (1990)
use the following specification:
O<3

St = ct - a(1 - 0) ~

OJet a~;

O~a~l,

0~0~1.

(21)

j-0
The term (1 - 0) ~ ) ~ 00Jct-l-j is referred to as the 'stock of habits', which depreciates
according to the parameter 0. A particularly simple specification is obtained when
0 = 0, in which case the stock of habits is simply given by last period consumption.
As with the cases considered above, the marginal utility of time t expenditure is a
function of both present and future variables, so that it is now known at time t. The
habit formation model has a long history, dating back at least to Gorman (1967), Pollak
(1970) and Houthakker and Taylor (1970) 62. Spynnewin (1981) presents an ingenious
reparametrization of the optimisation problem which, by an appropriate redefinition of
prices and quantities, allows the maximisation of an intertemporally additive function.
However, it is only in the 1980s that habits models are coupled with the hypothesis
of rational expectations and preferences incorporating temporal persistence are used
to derive Euler equations analogous to Equation (19) above. Examples of this practice
include Eichenbaum and Hansen (1988) (for a model with habit forming consumption
and leisure), Eichenbaum and Hansen (1990), Novales (1990) and Constantinides
(1990), while Hotz, Kydland and Sedlacek (1988) and Kennan (1988) consider habit
formation in leisure. Browning (1991) uses a dual approach to derive the equivalent of
'Frisch' consumption functions in the presence of intertemporal non-separability 63.
More recently, Heaton (1993, 1995) has considered the interplay between time
aggregation and habit formation. His argument is that at high frequency consumption
seems to exhibit substitutability, while at lower frequencies, there is evidence of
complementarities. Heaton argues that the local substitutability of consumption could
be explained by time aggregation. In general, he presents preferences that are flexible
enough to accommodate the 'slow' formation of habits.
Most of the work on habit models so far has been done on aggregate time series data.
One of the reasons for this is the fact that very few panel data contain information on
consumption. The CEX, which I used in Section 2, contains only up to four quarterly
observations per households. The average cohort analysis that is used in the study of
dynamic models of consumption, cannot be used in the analysis of habit formation,
because these models involve the covariance of subsequent consumption observations
f o r the s a m e household. In other words, we cannot aggregate the product C h
t C ht k over
the household index h, unless we have observations for times t and t - k for the same
households.
62 Browning (1991), however, has citations from Marshall and Haavelmo.
63 Browning's simple structatre can encompass both substitutability and complementarities over time.
The main problem with his approach is that he can only introduce uncertainty by considering points
expectations about the future.

804

O.P. Attanasio

The only paper that studies time dependence in preferences using micro data is, to
the best of my knowledge, Meghir and Weber (1996), that I discussed in the section
on liquidity constraints. Another novelty of that paper is that it considers different
components of consumption and allows for different levels of persistence depending on
the commodity considered. The interesting evidence is that, when durable commodities
are controlled for, there is no evidence of persistence in the 3 equations demand system
that Meghir and Weber (1996) consider.

9. Conclusions

Rather than summarising the various sections that compose the chapter I prefer to
conclude the chapter comparing the status of our knowledge and understanding of
consumption behaviour to that of twenty years ago. It is fair to say that substantial
progress has been made. In the last twenty years we have learned how to deal with
uncertainty in a rigorous fashion and have recognised the importance that this may
have for consumption and saving decision. Indeed an entire branch of the literature,
that on precautionary saving, has developed to deal with these issues.
While the emphasis given to the proper treatment of uncertainty and the lack of
appropriate data sources has meant that many studies have focused on aggregate data,
it has now become clear that it is very hard, if not impossible, to estimate preference
parameters from aggregate time series data. Aggregation issues are important in
many dimensions. In addition to the standard aggregation problems created by the
non-linearity of the relevant theoretical relationships, there are other ways in which
aggregation issues become important. Corner solutions and participation decisions (in
labour and financial markets), inertial behaviour and transaction costs, all add a new
dimension of complexity and make the cross sectional distribution of the variables
under study relevant for the dynamics of the aggregate.
The Euler equation has been the main instrument to analyse consumption both in
micro and macro data, to estimate preference parameters and to test the overidentifying
restrictions implied by the consumers' optimisation problem. In the process we have
learned a lot about the econometric problems of estimating Euler equations. In
particular, we have learned what are the identifying assumptions that one needs to
make to get consistent estimates from the available data.
The Euler equation is a powerful tool in that it allows the consideration of complex
and flexible preference specifications without loosing the empirical tractability. As long
as the variable over which one is optimising can be adjusted without cost and is not
at a corner, one can derive an Euler equation which, even if it includes the values
of other endogenous variables, delivers orthogonality restrictions that can be used to
estimate preference parameters. The empirical research has used Euler equations for
non-durable consumption and its components that have become, in the attempt to fit
the observable data, increasingly complicated. This level of complexity is probably
unavoidable if one is serious about taking the model to the data.

Ch. 11: Consumption

805

As I stressed several times during the chapter, the price one pays in dealing
with Euler equations is not negligible: one loses the ability of saying anything
about the level of consumption. The empirical tractability of the Euler equation is
obtained differencing out the marginal utility of wealth, and therefore one of the
main determinants of consumption levels. The challenge for future research is to
construct a consumption function that incorporates the insights of the Euler equation
and yet allows us to say something about the levels o f consumption and about how
consumption reacts to changes in the economic environment. Such a consumption
function is necessary to make predictions about future consumption, about saving
behaviour, and about the effects of alternative policy measures.
One possibility that is being explored is the use of numerical techniques. They
have proved to be useful both to improve our understanding of the dynamic
optimization problems typically postulated and to characterise the implications of
different preference structures and economic environments on consumption and saving
behaviour. They can also be used to validate, indirectly, the preference specifications
implied by the Euler equation estimates that best fit the consumption growth data.
Their main limitation, however, is an important one: they can only be used to analyse
extremely simplified models and they require the full characterisation of the agents'
economic environment.
Several other areas of research are important and exciting. I will just mention two.
Our understanding of consumption smoothing and of the evolution of inequality is still
at the beginning. The development of this understanding and of the importance that
different institutional frameworks and financial instruments have for these issues is an
extremely important research agenda both from a positive and from a normative point
of view. Related to this is also the issue of the time series properties of individual
consumption: unlike for earnings and hours of work, next to nothing is known about
this. Our understanding of durable expenditure is still very limited and yet it is an
extremely important issue, both because durables are the most volatile component of
consumption and because they have a number of features (the fact that they can be
used as collateral, transaction costs, the durability itself) that make them difficult to
model.

References

Abowd, J., and D. Card (1989), "On the covariancestructureof earnings and hours changes",Econometrica
57:411-445.
Alessie, R., B. Melenberg and G. Weber (1989), "Consumption, leisure and earnings related liquidity
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104:275-298.

Chapter 12

AGGREGATE INVESTMENT

RICARDO J. CABALLERO
MIT and NBER

Contents
Abstract
Keywords
1. Introduction
2. Basic investment t h e o r y and findings
2.1. Pre 1990s: Dismay
2.2. "Econometrics": Cost of capital and q matter
2.2.1. Long-run
2.2.2. Short-run
3. L u m p y and irreversible investment
3.1. Plant/firm level
3.1.1. Microeconomic adjustment: characterization
3.1.2. "Representative" problem
3.1.3. A detour: q-theory and infrequent investment
3.1.3.1. On the fragility of marginal q
3.1.3.2. When does q-theory work?
3.1.3.3. Taking stock
3.1.4. Another detour: Several misconceptions about irreversible investment
3.1.5. Adjustment hazard
3.2. Aggregation
3.3. Empirical evidence
.
.
.
.
.
3.3.1. Microeconnmic data
3.3.2. Aggregate data
3.3.3. Pent-up demand
3.4. Equilibrium
4.

814
814
815
816
816
818
820
821
822
822
823
824
828
828
830
832
832
835
837
838
838
839
841
842

Entry, exit and scrapping

844

4.1. Competitive entry and irreversibility

4.2. Technological heterogeneity and scrapping

844
847

* I am grateful to Andrew Abel, Steve Bergantino, Olivier Blanchard, Jason Cummins, Esther Duffio,
Eduardo Engel, Austan Goolsbee, Luigi Guiso, Kevin Hassett, Glenn Hubbard, John Leahy, Kenneth
West, and Michael Woodford for many useful comments. I thank the NSF for financial support.
Handbook of Macroeconomics, Volume 1, Edited by JB. Taylor and M. WoodJbrd~
1999 Elsevier Science B.V. All rights reserved

813

814
5. Inefficient investment
5.1. Informationalproblems
5.2. Specificityand opportunism
5.2.1. Genericimplications
5.2.2. Credit constraints
6. Conclusion and outlook
References

R.J. Caballero
848
849
851
854
856
857
858

Abstract

The 1990s have witnessed a revival in economists' interest and hope of explaining
aggregate and microeconomic investment behavior. New theories, better econometric
procedures, and more detailed panel data sets are behind this movement. Much of the
progress has occurred at the level of microeconomic theories and evidence; however,
progress in aggregation and general equilibrium aspects of the investment problem also
has been significant. The concept of sunk costs is at the center of modern theories. The
implications of these costs for investment go well beyond the neoclassical response to
the irreversible-technological friction they represent, for they can also lead to firstorder inefficiencies when interacting with informational and contractual problems.

Keywords
sunk costs, irreversible investment, (S, s) models, adjustment hazard, aggregation,
non-linearities, private information, incomplete contracts, pent-up investment

JEL classification: E22, D21, D23, E32

Ch. 12: Aggregate Investment

815

1. Introduction

Aggregate investment is an important topic. Cotmtries and firms are often judged by
their performance along this dimension, since investment is viewed as providing hope
for future prosperity. It is not surprising, therefore, that much has been written about
investment. It is even less surprising that many surveys, and surveys of surveys, already
exist ~. Rather than surveying the surveys of surveys, as one would expect from a
handbook chapter, I have chosen to focus most of my discussion on that which is
relatively new. The cost of this, of course, is that most of the theories I will discuss
have not yet passed the test of time and are often only half the distance toward full
development.
Most, but not all, of the subjects I plan to discuss relate directly to investment
in equipment and structures. Investing means trading the present for the future; as
is the case, for example, when a firm purchases equipment, builds structures, trains
its workers, restructures production, spends resources on R&D, hoards labor during a
recession; or when a worker leaves a job to search for another one, invests in human
capital; or when a country undergoes a structural adjustment, a trade liberalization or
a fiscal reform. The more theoretical sections of this survey apply to most of these
examples. Further, except for specific empirical results, a large part of the discussion
about equipment and structures also applies to other forms of investment.
The style of this review article is mostly empirical in early sections and mostly
theoretical in later ones. This ordering is highly correlated with the chronology of
research on investment. It follows that I am implicitly advocating for more empirical
work on the newest theories.
The layout of the chapter is as follows. Section 2 is rather traditional in content.
It describes the basic investment theory and findings, taking the view that the pre
1990s empirical literature was in disarray with respect to finding a role for the cost
of capital in investment equations. During the 1990s, however, we have learned from
long run relationships and "natural experiments" that the cost of capital does indeed
have significant effects on investment, although it is probably not the most important
explanatory variable. Neither, I should add, is measured q.
Section 3 describes what has been well known but largely ignored until recently:
that microeconomic investment is lumpy and mostly sunk. It turns out that changes
in the degree of coordination of lumpy actions play an important role in shaping the
dynamic behavior of aggregate investment. The old concept of pent-up demand is back.
This section contains a more detailed description of models and techniques than the
others. It also attempts to clarify several misconceptions about the implications of these
models.
Section 4 is about equilibrium interactions and scrapping. It describes the consequences of free entry and different assumptions about the elasticity of the supply
1 See, for example, Chirinko (1993), Hassett and Hubbard (1996b), for excellent surveys of traditional
investment equations.

816

R.J. Caballero

of capita~'~.for equilibrium investment anti, scrapping, :Vimage and putty-clay models

are briefly mentioned as a natural environment in which to address the economic
obsolescence issue. This concept is particularly relevant for understanding capital
accumulation during episodes of rapid growth and after substantial shocks to the price
of intermediate inputs.
Section 5 discusses inefficient investment. The first part of the section deals with
informational problems. Discontinuous action due to irreversibility and fixed costs
are compounded by the presence of private information and create a powerful drag
on investment. Inaction is a natural information trap, small information flows lead
naturally to further inaction, and the feedback process goes on. Aggregate investment
will appear too sluggish given the ex-post information of an econometrician, and it
will probably be too slow in responding to new conditions relative to first and second
best scenarios.
The second part of this section describes how the sunk nature of investment,
when combined with contractual incompleteness, can lead to underinvestment and,
through general equilibrium, to a series of distortions in the scrapping margin
and in the response of investment to aggregate shocks. Financial constraints are
discussed within this context. The concept of rationing, the effects of underinvestment
on complementary factors (and vice versa) and the relation between excessive
capital/tabor substitution and investment are also part of this section. The issue of
property rights and investment also fits very naturally here.
Section 6 concludes.

2. Basic investment theory and findings

2.1. Pre 1990s: Dismay

Since very early on, economists have attempted to explain investment behavior using
both scale and relative price variables, and since very early on, the former have been
more successful than the latter.
One of the first "theories" of investment was the accelerator model [Clark (1917)].
Scarcely a theory, the accelerator model is derived by inverting a simple fixed
proportion production function and taking first differences. Unable to account for the
serial correlation of investment beyond that o f output growth, this model was soon
transformed into the flexible accelerator model [Clark (1944), Koyck (1954)]:
n

I, = Z/3~AKT-r'

(2.1)

"~-0

where I denotes investment, the/3r's are distributed lag parameters, and K* is the
desired, as opposed to actual, level of capital. In the simple fixed proportions world,
K* can be written as a linear function of the output level, Y:
K* = a Y

where a is a parameter.

Ch. 12: AggregateInvestment

817

The absence of prices (the cost o f capital, in particular) from the right-hand side of
the flexible accelerator equation has earned it disrespect despite its empirical success.
Jorgenson's (1963) neoclassical theory o f investment intended to remedy this situation.
Starting from the optimization problem o f a perfectly competitive firm facing no
adjustment costs, myopic expectations, and constant returns Cobb-Douglas technology,
Jorgenson obtained the standard static first-order condition:

K = aY/Ck,
where Ck stands for the cost of capital and a is now the share o f capital in a simple
Cobb-Douglas production function. As with the accelerator model, this model was
unable to account for the serial correlation o f investment, and so gave way to the
flexible neoclassical model o f Hall and Jorgenson (1967), where

K* = aY/Ck,

(2.2)

was now used in Equation (2.1).

Soon it was shown, however, that by constraining the coefficient o f the cost o f capital
to be the same as the coefficient of out-put, this model imposed rather than found a role
for the cost o f capital in the investment function. Eisner (1969) estimated a modified
Hall and Jorgenson model which allowed for different coefficients on output and the
cost o f capital and found no independent role for the cost o f capital.
The cost o f capital's rise and fall from grace was not an unknown experience,
however. Several decades before, authors such as Tinbergen (1939) and Meyer and
Kuh (1957) had pointed out the dominance o f liquidity variables over interest rates
for short run investment 2.
None o f these are full theories of investment, rather they are theories conditional
on the level o f output 3. The famous q-theory o f Tobin (1969) and Brainard and Tobin
(1968) went one step further. They argued that investment should be an increasing
function o f the ratio o f the value of the firm to the cost o f purchasing the firm's
equipment and structures in their respective markets. This ratio, known as average q4,
summarizes most information about future actions and shocks that are of relevance
for investment 5. Indeed, average q would later be shown to be a sufficient statistic for
investment in a wide variety o f scenarios. Thus, the new canonical investment equation
became
I = yq,
where is a strictly positive parameter.
2 See Chirinko (1993) for a more thorough review of the history of the debate over the role of the cost
of capital, profits and output in investment decisions.
3 Things are even worse for the basic frictionless neoclassical model; it is ill defined as a full model
because firm level output is not determined under constant reta.trns and perfect competition.
4 It is also often referred to as Tobin's q.
5 This includes the optimal path of output.

818

R.J. Caballero

The elegant theoretical contributions o f Abel (1979) and Hayashi (1982) connected
the existing theories and partial theories. They showed that the neoclassical model
with convex adjustment costs yields a q-model. This q, known as marginal q,
should be interpreted as the marginal value o f an installed unit o f capital, which
corresponds to the shadow value o f a trait o f capital in the firm's optimization problem.
Further, Hayashi showed that (for price-taking firms) when the production function and
adjustment cost function are linearly homogeneous in capital and labor, marginal and
average q are equal. This is an important result from an empirical standpoint because
marginal q is unobservable to the econometrician whereas average q is, in principle,
observable to the econometrician 6.
Soon, however, the q-model, along with expanded and ad-hoc "flexible-q" models
(i.e. with additional lags o f q on the right-hand side), joined models based on the cost
o f capital in their lack o f empirical success. Scale variables such as cash-flows always
seemed to matter more in investment equations than q which, in principle, should have
been a sufficient statistic 7.
Figure 2.1, which reproduces figures 1 and 3 o f Hassett and Hubbard (1996b), helps
us understand the statistical reasons for the problem. The bottom line is clear: In
aggregate US data (which is probably representative o f many other data sets for this
purpose) the unconditional correlation between cost o f capital and investment is low,
and so is that between average q and investment. On the other hand, cash flows and
sales's growth closely track aggregate investment.
The 1980s discontent with respect to investment equations is probably well captured
in Blanchard's (1986) discussion o f Shapiro's (1986) investment paper at Brookings:
"... it is well known that to get the user cost to appear at all in the investment equation, one
has to display more than the usual amount of econometric ingenuity, resorting most of the time
to choosing a specification that simply forces the effect to be there ..." [my emphasis]
Today, the first emphasized statement still holds, but the second one probably does
not. This takes me to the next subsection.
2.2. "Econometrics": Cost o f capital a n d q matter

Econometric "ingenuity" eventually pays off, although this often means isolating that
part o f the relationship which conforms with the theory, rather than explaining a
6 I have mixed feelings about this equivalence result, however. Not about its theoretical derivation,
which is elegant and useful; rather about its abuse in empirical work. Too often, it is used to justify
substituting average for marginal q on the right-hand side of investment equations, even though the
assumptions required for the equivalence between the two are not nearly satisfied in the industry or
firms studied (e.g. Compustat). This does not mean that average q should not be used, but it says that
we should not pretend that the foundation for its use is beyond the basic intuition provided by Tobin
(1969), and that the additional properties that hold for marginal q are to be expected from average q
(e.g. sufficiency).
7 Fazzari et al. (1988) started a large literature documenting the role of these variables, even after
conditioning for average q. I will return to the interpretation of these regressions later in the survey.

Ch. 12: Aggregate Investment

o

819

o
-

0
o

cq

"/"

:'.::::::5 :

~:~
--

.~- ~ ~

ixl

:+:+:.:.:.:.~
. . . . ........................

.:.:.:::.:::::~ .~:::::::::::::::::::::::::::,
k

]~.

v,
o

. ..

!~!!!iiii:: ;

i!: ~

"~! i :-:+:+ ~ ' :~: : : : :

::i ~

~
o

I g :i

,'~

"

e~

820

R.J Caballero

substantial fraction of the movements of the left-hand side variable, or even relating
a significant fraction of the volatility of the right-hand side variables to that of the
left-hand side variable. In my view, this is the type of payoff obtained from the recent
incarnations of the "traditional" line. Still, it is progress.
Going from less to more ambitious, there are two generic developments I wish
to discuss. First, ignoring high and medium frequency variations, we have come to
the realization that the low frequency aspects of the data are not inconsistent with
theories that assign an important role to the cost o f capital in determining the rate of
capital accumulation. Second, there are distinctive episodes during which changes in
the cost of capital are sufficiently dramatic that it becomes possible to demonstrate the
importance of the cost of capital at higher frequencies as well.
Other recent developments within the traditional line include the use of Euler
equation procedures. In my view, and unlike the case in basic finance and consumption
applications, these procedures are a form of morphine rather than a remedy: their lack
of statistical power allows us to sometimes not see the problem. Since my goal is to
discuss progress, I will skip results obtained with these procedures s.
2.2.1. L o n g - r u n

Many of the problems with investment equations have to do with the presence of
complex and not well understood dynamic issues (more on this in the next sections).
From early on, researchers have found it useful to think about investment in two
steps: first, derive some simple expression for a "target" stock of capital, which I have
called K* here; and second, model dynamics as a, possibly complex, function of
contemporaneous and lagged changes in K*. It seems sensible, therefore, to start by
asking whether the first step resembles what we expect before going into the difficult
issues of timing.
Taking logs on each side of Equation (2.2), disregarding constants, and relaxing the
unit elasticity constraint on the cost of capital, yields
k* - y

= yck,

(2.3)

where lower case letters denote logarithms and y is the parameter of interest.
This expression cannot be estimated, of course, because k* is not observed. There
is a simple argument based on cointegration, or a close small sample "cousin," which
allows us to get around this observability problem, however. The whole purpose of
deriving k* is to then model k as trying to keep pace with it. Thus, differences
between these two variables should only be transitory (up to constants). I f k* and k are

See Oliner, Rudebusch and Sichel (1995) for a damaging evaluation of the statistical properties of
these procedures.

Ch. 12: Aggregate Investment

821

sufficiently volatile (ideally with unit roots, in large samples), then we can "ignore"
the discrepancy between these two variables in estimating y. Let
k = k* + e,
with c a stationary residual that captures transitory discrepancies between the two
variables due to adjustment costs. Substituting this expression into Equation (2.3)
yields an equation that can be estimated:
k - y = yck + c.

(2.4)

Estimating this equation by OLS (the simplest o f the cointegration procedures) yields,
for aggregate US data, an estimate o f y o f -0.4; significantly different from zero 9.
We can do better, however. In any small sample, the cointegration argument will not
take its full bite, and the estimates o f ~/will be affected by the correlation between regressors and e. Caballero (1994a) argues that this is particularly serious and systematic
in models with slow adjustment (e.g. due to adjustment costs). The intuition behind
this idea is simple. A partial adjustment mechanism implies that, in any finite sample,
the variance o f K/Y ought to be less than the variance o f K * / Y , which means the lefthand side o f Equation (2.4) ought to be less volatile than the right-hand side of Equation (2.3), or yck lo. However, by the normal equations o f OLS, the estimated counterparts o f yck and e on the right-hand side o f Equation (2.4) must be orthogonal, so that
the variance o f k - y is greater than the variance o f )ck, which is equal to the variance
o f the estimated '* - y . Since this inequality is in contradiction with what is implied by
adjustment cost mechanisms, we conclude that the estimate o f y is biased toward zero.
Using Monte Carlo simulations, I showed in that paper that this bias can be
substantial, and then proceeded to correct it using Stock and Watson's (1993)
procedure. I obtained an estimate o f ~/close to minus one, very near the neoclassical
benchmark 11.
2.2.2. Short-run

Demonstrating a relationship between capital accumulation and the cost of capital

at higher frequencies has required two changes in approach: first, a change in
emphasis from aggregate to microeconomic data; and second, the use of natural

9 This estimate of g was obtained using US quarterly NIPA data for the period 1957:1-1987:4. Capital
corresponds to equipment capital and cost of capital is constructed as in Auerbach and Hassett (1992).
l0 Note that if adjustment costs are non-convex it is possible, at the microeconomic level, and in a
sufficiently short sample, to have these relative volatilities reversed. This is not an issue for the aggregate
data results discussed here. See the next section for more on non-convex adjustment cost models.
11 Similar estimates were obtained by Bertola and Caballero (1994) and Caballero, Engel and
Haltiwanger (1995) with different data sets.

822

R.J Caballero

experiments, such as periods of tax reform, which present the econometrician with
more accurate measures of (often substantial) changes in the cost of capital and q.
Measures of q, for example, are not only very noisy because of the substitution of
average q for marginal q, but also because there may be substantial "non-fundamental"
movements in the value of firms, making average q mismeasured as well. However,
there are certain episodes (e.g., periods of tax reform) when the movements in q are
likely to be large, in a predictable direction, and for the "right reasons". As with
cointegration, during those episodes problems with the residual can be more or less
disregarded.
The movement from aggregate to microeconomic data, by itself, has not done
much to improve affairs. Although microeconomic data has improved precision,
coefficients on the cost of capital and q in investment equations have remained
embarrassingly small. Combined with the use of natural experiments, however,
emphasis on microeconomic data has had much higher payoffs. The work of Cummins,
Hassett and Hubbard (1994, 1996a) is salient in this regard. They isolate periods
with important tax reforms and find that the coefficient on q is much larger in those
episodes. Most recently, using firm level data for 14 developed countries, they find that
while using standard instrumental variable procedures yields coefficients on q which
range from 0.03 to 0.1, when contemporaneous tax reforms are included among the
instruments, the estimates jump to a range between 0.09 to 0.8, with median and mean
not very far from 0.5. In the USA, for example, the estimate of the coefficient on q
jumps from 0.048 to 0.6512
Although these empirical results represent significant progress, there is still plenty
of work needed to retrace the steps back to the aggregate and we must not forget that
a substantial component of the variation in aggregate and microeconomic investment
remains unexplained. The next sections describe progress on both fronts.

3. Lumpy and irreversible investment

Investment is a flow variable, and as such it is very sensitive to obstacles. Investment
is the by-product of the process by which the capital stock catches up with its desired
level; but there are many paths leading the former to the latter. In this section I begin
discussing some of these obstacles, emphasizing those that have had prominence in
the recent literature.
3.1. Plant~firm level

The most basic form of friction occurs at the level of microeconomic units, and goes
under the general heading of adjustment costs.

12 See Caballero (1994b) for a discussion of their results, interpretations and procedures.

Ch. 12: Aggregate Investment

823

3.1.1. Microeconomic adjustment: characterization

There are essentially three basic types o f adjustments observed at the establishment
level: (a) ongoing frictionless flow (maintenance); (b) gradual adjustments (e.g. refinements and training dependent improvements); (c) major and infrequent adjustments 13
The structural literature o f the 1980s and before, based explicitly or implicitly on
convex adjustment cost models (the quadratic adjustment cost model, in particular)
dealt with (a) and (b). The implicit "hope" was that the smoothness brought about
by aggregation would make disregarding the importance o f infrequent adjustments
for individual units, unimportant for aggregate phenomena. Instead, the idea was to
derive aggregate investment equations as coming from the solution to the optimization
problem of a fictitious agent facing adjustment costs which only led to smooth
adjustments o f type (a) and (b). Many authors disagreed with this strategy [e.g.
Rothschild (1971)]; but for most the relative simplicity of the quadratic model was
too enticing to resist.
A combination of factors eventually led economists to revisit and reevaluate some
o f the shortcuts which were in widespread use by the end o f the 1980S 14. First,
there was frustration with the disappointing empirical results described above. Second,
techniques which could handle models of lumpy investment became part of the modern
economist's tool kit. And third, microeconomic data made the obvious even more
apparent: microeconomic investment is extremely lumpy, and this lumpiness is unlikely
to fully "wash out" at the aggregate level.
The work o f Doms and Dunne (1993) was instrumental in stressing the last point.
They documented investment patterns o f 12 000 plants in US manufacturing over the 17
year period, 1972-1989. Their findings are many, of which I have chosen to emphasize
those that are most closely related to the purpose o f this survey.
For each establishment, Doms and Dunne constructed a series o f the proportion o f
the total equipment investment o f the establishment (over the 17-year period) made
in each year. They found that on average the largest investment episode accounts for
more than 25 percent o f the 17 year investment o f an establishment and that more than
half o f the establishments exhibited capital growth close to 50 percent in a single year.
They also note that the second largest investment spike often came next to the largest
investment spike (right before or right after) suggesting that both spikes correspond to
a single investment episode. 15 Combining the two primary spikes, they find that nearly

~3 Which may, in turn, have a time to build aspect.

14 Chronologies are never exact, of course. For example, Nickell had already discussed irreversible
investment and many of its implications in 1978; but the mode did not move until much later.
15 All investment project may not be fully counted within one year since not all projects start on
January 1, and certainly may take more than a few days to implement. One should not confuse "time
to build" with the standard convex adjustment costs. Time to build is the optimal scheduling of a
given lumpy project, while in the standard convex adjustment costs model the firm changes this project
continuously and smoothly [see Caballero and Leahy (1996)].

R.J Caballero

824

40 percent of the sample investment of the median establishment probably corresponds

to a single investment episode 16. Moreover, this is likely to be a lower bound on
the lumpiness of investment since these numbers correspond to establishments that
remained in the sample during the entire 17-year period. Adding entry and exit would
undoubtedly make the evidence on microeconomic lumpiness even more apparent.
As for evidence on the macroeconomic relevance of microeconomic lumpiness,
Doms and Dunne offer several hints. First, using data on about 360 000 establishments
for Census years 1977 and 1987, they document that about 18 percent of aggregate
investment is accounted for by the top 100 projects. As a metric, only 6 percent
of employment is in the top 100 employers, and less than 10 percent of production
occurs in the top 100 producers. More importantly, they show that the time series
correlation between aggregate investment and a Herfindahl index of microeconomic
investments is very high (close to 0.45). They also constructed a series with the number
of firms undergoing their primary investment spike during each year. They show that
this measure, rather than the average size of these spikes, closely tracked aggregate
investment 17.
The subsections that follow describe models which are broadly consistent with these
findings, and reviews structural evidence based on these models which lends further
support to the view that microeconomic lumpiness is very important for aggregate
investment dynamics.

3.1.2. "'Representative" problem

There is by now a vast literature (and surveys of it) describing microeconomic models
able to capture the essence of the lumpy and discontinuous adjustment highlighted
by the evidence described above. Rather than giving a thorough presentation of the
canonical model, I refer the interested reader to one of these surveys 18. Instead, I will
only sketch the problem, mostly to characterize the nature of the solution and to
develop notation which will prove useful later.
Let actions and realizations of shocks evolve in discrete time, with time intervals,
At. Having optimized over all inputs but capital during the period, a firm with stock of
capital K and facing conditions 0, has a flow of profits net of rental cost of capital:

II(K, O)At = (KYO- rK)At

0 < ~ < 1,

(3.1)

where K is the firm's stock of capital; 0 is a profitability index that combines demand,
productivity and wage shocks; r is the discount rate; and 7 represents the elasticity
16 Cooper, Haltiwanger and Power (1994) go one step further in characterizing infrequent lumpiness.
Using a data set similar to that of Doms and Dtmne, they show that the probabilityof a firm experiencing
a major investment spike is increasing in the time since the last major spike. This feature of the data is
highly consistent with the implications of the models reviewed later in this section.
17 Where aggregate investmentcorrespondsto the investmentof all the establishmentsin their sample.
18 Dixit (1993) provides an excellent discussion of the basic problem and the mathematicaltechniques
needed to solve it.

Ch. 12: AggregateInvestment

825

o f gross profits with respect to capital. It is less than one as long as the firm exhibits
some degree o f decreasing returns or market power, which ! assume to be the case.
For convenience, capital does not depreciate.
It will also facilitate things to assume that increments in the logarithm o f 0 are
i.i.d., and that time and the sample paths of 0 are "ahnost" continuous (i.e. At is
small and changes in the value of 0 over an interval o f time At are small). I make
these assumptions so I can, informally, use all the convenience o f Ito's lemma and
Brownian motions. I choose to depart from strict continuous time, on the other hand,
because discrete time will allow me to present this section in a more ratified manner.
As in the previous section, we can find an expression for the static optimum of the
stock o f capital, or "desired" capital:
I
I-y

K* = argmaxxH(K, 0) =

(3.2)

It is apparent from this expression that K* inherits the stochastic properties of 0, so it

also follows a geometric random walk. Moreover, the measure o f capital "imbalance":
Z=

K
K*

'

also inherits the geometric random walk process, for any given K. Substituting this
expression into Equation (3.1) and using Equation (3.2) to solve for 0 yields

H(Z,K*) = 7r (ZY - 7Z) K*

0 < 7 < 1.

(3.3)

In order to generate infrequent actions, the cost of adjusting the stock o f capital must
increase sharply around the point of no adjustment. A cost proportional to the size of
adjustment is enough to do so. Lumpiness requires a little more, for there must be an
advantage in bunching adjustment; increasing returns in the adjustment technology is
the standard recipe, o f which a fixed cost is the simplest. Let C(rI, K*) denote the cost
o f adjusting the capital stock by K ' t / :

C(rI, K . ) = { A K ~ e O } K .

(cf+c~rl

/ cf-Cprl

if
if

t/>0,
t/<0,

(3.4)

where the K* term ensures that the relative importance of adjustment costs remains
unchanged over time 19. Figure 3.1 illustrates an example of C(., .)/K*.

19 This goal would also be accomplished by K, but K* yields slightly simpler mathematical expressions
at a low cost in terms of substantive issues.
Also, I have allowed proportional costs to differ with respect to upward and downward adjustments in
order to talk later about the irreversible investment case; for this purpose, I could have done it equally
well through asymmetric fixed costs. Allowing for both forms of asymmetries simultaneously is a trivial
but uninteresting extension.

826

R.J. Caballero

\
J
Cf

<

)rl

Fig. 3.1. Adjustment costs.

The problem of the firm can be characterized in terms of two functions of Z and
K*: V(Z,K*) and ~'(Z, K*). The function V(Z,K*) represents the value of a firm with
imbalance Z and desired capital K* if it does not adjust in this period, and V(Z,K*)
is the value of the firm which can choose whether or not to adjust. Thus,
v ( z , , I,:?) = rt(z,, I<t)At + (1 - rat) Et [~(Zt+A~, K,~At)],

(3.5)

~'(Zt,K[)=max {V(Zt,K[),m~x {V(Zt + rI,K[)-CQI, K[)} }.

(3.6)

and:

The nature of the solution of this problem is now intuitive. Given the function

V(Z, K*), Equation (3.6) provides most of what is needed to characterize the solution.
First, since C is positive even for small adjustments, it is apparent that when Z is
near that value for which V(Z,K*) is maximized, the first term on the right-hand side
of Equation (3.6) is larger than the second term; that is, there is a range of inaction.
Second, since both adjustment costs and the profit function are homogeneous of degree
one with respect to K*, so are V and ~'. Thus, it is possible to fully characterize the
solution in the space of imbalances, Z. Among other things, this implies that the range
of inaction described before, is fixed in the space of Z. Let L denote the minimum value
of Z for which there is no investment, and U the maximum value for which there is no
disinvestment; thus the range of inaction is (L, U). Third, conditional on adjustment,
changes must not only be large enough to justify incurring the fixed cost, but also the
(invariant) target points must satisfy
Vz(/) = Cp

(3.7)

and

Vz(u) = -Cp,
where Vz is the derivative of

(3.8)

V with respect to Z, while 1 and u denote the target

points from the left and right of the inaction range, respectively. These first-order

827

Ch. 12." AggregateInoestment

"-..
............."..... '...........

el

I ..../........

V ( z, K*) / K*

i"
<

>
L

Fig. 3.2. Value fimction.

conditions are known as "smooth pasting conditions," and simply say that, conditional
on adjustment taking place, it must cease when the value of an extra unit of investment
(or disinvestment) is equal to the additional cost incurred by that action.
There are two additional smooth pasting conditions:

Vz(L) = Cp

(3.9)

and
v z ( u ) = -Cp,

(3.10)

which ensure no expected advantage from delaying or advancing adjustment by one

At around the trigger points.
These smooth pasting conditions are enough to find the optimal (L, l, u, U) rule,
given the value function. In order to find the latter, however, we need to go back to
Equation (3.5). Standard steps reduce this equation, in the interior of the inaction range,
to a second-order differential equation. The two boundary conditions required to find V
are obtained from equalizing the two terms on the right-hand side of Equation (3.6):

V(L,K*) = V ( I , K * ) - (cy + c p ( l - L ) ) K*,

(3.11)

V(U,K*) = V ( u , K * ) - (of + cp(U - u)) K*,

(3.12)

which simply say that since the investment rule (optimal or not[) dictates that once
a trigger point is reached, adjustment must occur at once, the only difference in the
value of being at trigger and target points must be the adjustment cost of moving from
the former to the latter.
Figure 3.2 illustrates the value function. Smooth pasting says that the tangents at
L and l have slope Cp, while those at U and u have slope -Cp. Value matching says

828

R.J. Caballero

that the value function evaluated at the target minus the value function evaluated at
the trigger point is equal to the variable cost paid at adjustment plus the fixed cost (all
these normalized by K* in the figure).
There are a few particular cases which are worth highlighting because they appear
often in the literature:
(1) If there is no variable cost of investment, once the adjustment decision has
been taken, adjustment from both sides is complete since the marginal cost of
adjustment is zero. Thus, the (L, l, u, U) rule reduces to an (L, c, U) rule, where
c is the common target for investment as well as disinvestment, and is that value
which maximizes V(Z, K*) for any K* 2o.
(2) If there are variable costs but no fixed cost, there is no reason for adjustment
to be lumpy, for there are no increasing returns in the adjustment technology 21.
Once the boundaries of the inaction range, L and U, are reached, the firm adjusts
just enough to avoid crossing outside the inaction range; that is L and U become
reflecting barriers.
(3) If there is a large (not necessarily infinite) cost to disinvestment, then investment
becomes irreversible. In the absence of investment costs, the investment rule
reduces to a single reflecting barrier L, which is to the left of one (reluctance
to invest). This is the standard irreversible investment case.

3.1.3. A detour." q-theory and infrequent investment

One of the main manifestations of the empirical failure o f previous investment theories,
has been the difficulty in finding either a significant and sizable role for q, or evidence
that it is a sufficient statistic for investment.
Do the theories studied in this section help explain these empirical failures? I see
two reasons to believe so. The first one is rather negative, q-theory is no longer robust
in our setting, so there :are many scenarios where we should not expect it to work.
The second one is more positive. In the subclass o f models where it does work, the
functional form relating q and investment is likely to be highly non-linear, thus quite
different from the standard linear regressions leading to the rejection o f q-theory.

3.1.3.1. On the fragility of marginal q. It is apparent from the lack of global concavity
o f the value function in Figure 3.2, that traditional q-theory is not likely to work in the
presence o f jumps. Caballero and Leahy (1996) develop the argument in detail, which
I summarize below.

20 Note that in general c ~ 1. That is, the optimal dynamic target is generally different from the static
one.
21 And we have already assumed that shocks are "small" in any given At.

829

Ch. 12." Aggregate Inoestment

(a)

lqw...-....-..---.---.....~
J ~ ~ q m
1+ C+p
S

qm(z)

il-c<

(b)
qm

1 + C+p

1 - c-p

>

<

U=u

L=I

Fig. 3.3. Marginalq.

The value of the firm is equal to K + V, thus marginal q is 22
qM(Z) = 1 + Vx = 1 + K~.

(3.13)

Figure 3.3a plots qM against the imbalance m e a s u r e Z 23. Smooth pasting implies that
qM must be the same at trigger and target points (because Vz must be the same at
trigger and target points); if there are jumps, these are points very far apart in state

22 Recallthat P was definedas the presentvalueof profitsnet of adjustmentcosts and interestpayments

on capital.
23 See, for example, Dixit (1993) for a characterizationof the (L, l, u, U) solutionin terms of a similar
diagram.

830

R.J. Caballero

space. Two points with the same value of qM lead to very different levels of investment
(zero and large). Moreover, since the value function becomes linear outside the inaction
range, all points outside the inaction range (on the same side) have the same q~t, and
all of them lead to different levels of investment. It is apparent, therefore, that the
function mapping qM into investment no longer exists. Worse, in between trigger and
target points, the relation between qM and Z is not even monotonic.
What is happening? Marginal q is the expected present value of the marginal
profitability o f capital. Far from an adjustment point, it behaves as usual with respect
to the state o f the firm: if conditions improve, future marginal profitability of capital
rises, and so does q~. Close to the investment point, on the other hand, the effect of
a change in the state of the firm over the probability o f a large amount of investment
in the near future dominates. An abrupt increase in the stock of capital brings about
an abrupt decline in the marginal profitability o f capital as long as the profit function
is concave with respect to capital 24. Thus, an improvement in the state of the firm
makes it very likely that it invests in the near future, reducing the expected marginal
profitability o f capital in the near future, thus lowering the value of an extra unit of
installed capital.
Caballero and Leahy (1996) show that adding a convex adjustment cost to the
problem does not change the basic intuition of the mechanism described above. They
also show, somewhat paradoxically, that average q, which is often thought o f as a
convenient albeit inappropriate proxy for marginal q, turns out to be a good predictor
of investment even in the presence of fixed costs, although it is no longer a sufficient
statistic, except for very special assumptions about the stochastic nature of driving
forces.
3.1.3.2. When does q-theory work?. The failure o f q-theory described above is rooted
in the presence of increasing returns in the adjustment cost function (3.4). This feature
of the adjustment technology is responsible for the loss of global concavity of the value
function, which is behind the non-monotonicity o f marginal q 25.
Monotonicity of qM inside the inaction range is recovered by dropping the fixed cost
from Equation (3.4), as was done in cases 2 and 3 in Section 3.1.2. Figure 3.3b portrays
this scenario. Adjustment at the trigger points no longer involves large projects, thus
proximity to these triggers no longer signal the sharp changes in future marginal
profitability of capital which were responsible for the "anomalous" behavior of qM 26
There is still the issue that in the (very) rare event that a firm finds itself outside the
inaction range it will adjust immediately to the trigger, at a constant marginal cost, so

24 Which I take to be the standard case.

z5 Indeed, value functions for (S, s) models are often only K-concave.
26 Of course, once at the trigger, large projects may result from the accumulated and - more or less continuous response to a sequence of shocks with the same sign. But this does not give rise to a
sharp change in profitability since investment occurs only in response and to offset new, as opposed to
accumulated, changes in profitability.

Ch. 12: AggregateInvestment

831

different levels of investment are consistent with the same value o f qM. This is easily
remedied by adding a convex component to the adjustment cost function27:

c(.,K*) =

0tK* {c l,I +c l.I

> 1.

(3.14)

This is essentially what Abel and Eberly (1994) do 28. Absent the advantage of lumping
adjustment brought about by the presence o f fixed costs, standard q-theory is recovered
whenever the firm invests. Provided adjustment takes place, the firm equalizes the
marginal benefit of adjustment and the marginal cost o f investing, which is now an
increasing function o f adjustment:
qM = 1 + sgn(r/)

(Cp +/3Cqlr/l~-l) ,

for t / ~ 0. By setting ~ to zero, we can obtain the boundaries o f inaction in qM_space.

Indeed, investment will not occur if

1-cp <qM < l+ep.

Abel and Eberly (1994) go further, and show that their insight is robust to
the presence of flow-fixed costs. That is, fixed costs which are multiplied by At;
if adjustment occurred instantaneously, the firm effectively would pay no fixed
cost. Because o f the convex adjustment component, the firm chooses not to adjust
instantaneously and pays the fixed costs instead. In a sense, the endogenous adjustment
decisions and the fact that the fixed cost goes to zero as adjustment speeds up, ensures
that the fixed cost remains relatively "small" and so do investment projects 29. It is
important to realize that their paper "unifies" q-theory with irreversible investment
and regulation (i.e. infrequent but infinitesimal adjustments) problems, but it does not
unify it with the standard (S, s) literature on lumpy adjustment, which is, unfortunately,
the way many have interpreted their results.
Barnett and Sakellaris (1995) study a panel o f US firms searching for evidence on
a reduced sensitivity o f investment to changes in q when the latter is close to one (the
"inaction" range). They find the opposite; in their panel, a firm's investment seems to
be more rather than less responsive to q when q is close to one. Abel and Eberly
(1996a), however, show that allowing for unobserved heterogeneity in the inaction

27 Which, at the same time, makes transitions outside the inaction range less rare.
28 Needless to say, it is trivial to add asymmetries to the adjustment cost function. But that is beside
the point of this section.
29 Alternatively, if one assumes perfect competition and constant returns to scale, the profit function
becomes linear with respect to capital (if the other factors of production can be adjusted at will), so
changes in investment do not feed back into q. In this extreme case, the modified (i.e. with an inaction
range) q-theory works well even in the presence of traditional fixed costs.

832

R.J Caballero

range relevant for different types of investments could explain the negative BarnettSakellaris finding.
3.1.3.3. Taking stock. One may be inclined to conclude from this section that before
going ahead with q-theory one should check whether investment literally exhibits
jumps or not. This is not the lesson I draw, however.
For once, this is not right. It is not difficult to add a time to build mechanism such
that a lumpy project is decomposed into a fairly smooth flow, without altering the
argument of why marginal q fails in the presence of fixed costs. But more importantly,
I suspect the main lesson is one of modesty. I doubt that researchers will often find the
required data and/or patience to determine whether one scenario or the other holds. In
this case, we might as well acknowledge that the relationship between marginal q and
investment is not robust, and that average q is unlikely to be a sufficient statistic for
investment. Of course it is important to include variables that capture knowledge of
the future on the right-hand side of investment equations, but we should avoid reading
"too much" from these regressions.
3.1.4. Another detour." Several misconceptions about irreuersible investment
As I mentioned before, when describing the special case of irreversible investment,
the regulation barrier, L, is to the left of one. That is, investment occurs only when the
stock of capital is substantially below the frictionless stock of capital. Alternatively,
investment occurs when the marginal profitability of capital is substantially above the
cost of capital. This is the famous "reluctance to invest" result.
There are several misconceptions about the implications of this "reluctance" result.
I will mention three of them. It is often said that, (a) reluctance implies that, in the
presence of irreversibility, the firm accumulates less capital; (b) since reluctance rises
with uncertainty (the regulation point moves further to the left), more uncertainty
implies less capital; and (c) standard present value techniques are inappropriate because
reluctance reflects the value of the "option to wait" for more information before
irreversibly sinking resources and this is not taken into account by the standard
formulae.
In order to show the fallacious nature of the first statement, it is useful to go back
to our canonical problem and simulate the path o f the (log of) stock of capital of a
firm facing no irreversibility constraint. Panel (a) in Figure 3.4 does so for a random
realization of the path of 0. Panel (b) in the figure shows the corresponding path of
the marginal profitability of capital, which is equal to the constant - frictionless - cost
of capital, r 3.
Imagine now imposing an irreversibility constraint on the firm, but assume that the
firm does not modify its "frictionless" investment rule whenever it can invest. This is

3o These figures are from Caballero (1993a).

833

Ch. 12: Aggregate Investment

(a)

(b)

[I

~r

~L
IlL
o;

~L
~o
s

lo

rs

20

~o

40

4S

~0

t~ne

P~E~ ]

tlme

(c)

(d)

I~rg. Prof.

~o

,;

io ,',

tlme

'i

| .............

i
Is

i ............
I?'--

t
Io

(f)

Al

i
~

tlme

(e)

i
zo

r
zls

time

i
ao

i
~

- -

In Kf

- - -

In K d

--

InK
i
4o

tl
4s

c
--

c+h

Mar'g.
so

,_

.:

I0

~o

J
2'~

time

Fig. 3.4. Reluctance and its counterpart.

t
~

~
4o

Prof
i
45

"

so

834

R.J Caballero

portrayed in panel (c) of the figure. The solid and dashed lines represent the actual
and frictionless stocks o f capital, respectively. It is apparent that the firm would, on
average, have too much capital, for it would have the same stock o f capital in good
times, but too much in bad times. The counterpart o f this is in panel (d), which shows
that on average the marginal profitability of capital is below the cost o f capital.
Reluctance to invest in good times is an optimal response attempting to offset the
natural tendency to over-accumulate capital induced by the irreversibility constraint.
Panel (e) illustrates this point. The solid and dashed lines represent the same variables
as in panel (c), while the dotted line illustrates the target stock of capital when the firm
behaves optimally. The counterpart o f the negative value of ln(Ka/Kf ) is a positive
constant h in the marginal profitability o f capital required for investment to take place
(panel f). It is apparent that whether the stock o f capital is on average higher or lower
than without the irreversibility constraint is unclear; the firm has too little capital
during good times but too much during very bad times. A precise answer depends
on things about which we know little, and which may turn out to yield only secondorder effects 31.
It is now easy to see the fallacious nature of the second statement. More uncertainty
raises reluctance precisely because it raises the need to reduce the extent o f excessive
capital during the now deeper recessions. Without raising reluctance, an increase in
uncertainty would raise the average stock o f capital in the presence of irreversibility
constraints. This occurs because there would now be greater capital accumulation
during extremely good times which would not be offset by large disinvestment during
extremely bad times 32.
The third misunderstanding is o f a different nature. In my view, it is the result of
insightful but, unfortunately, abused language. First, what is right: there is nothing
mysterious about irreversibility constraints as a mathematical problem. Dynamic
programing works, in the same way it does with other, more traditional, adjustment
frictions. This means that present value formulae, using the correct calculation of
future marginal profitability of capital also work. O f course such calculations must
be performed along the optimal investment path, constraints included! What is wrong:
the standard analysis must be modified to consider the value of the "option to wait".

3a See Bertola (1992), Caballero (1993a), Bertola and Caballero (1994) for early discussions of this
issue and of the related uncertainty-investment misconception. More recently, Abel and Eberly (1996b)
have formalized these claims and made them more precise.
32 This does not mean that one cannot construct scenarios where an increase in uncertainty reduces
investment. For example, if there is an increase in perceived future uncertainty, the investment threshold
may jump today - i.e., before the variance of shocks does - resulting in an unambiguous decline in
investment.
Also, one should not confuse changes in uncertainty with changes in the probability of a bad event.
The latter links increases in uncertainty to a reduction in expected value, an entirely different and more
straightforward effect on investment. One can find traces of this confusion in the (informal) credibility
literature.

Ch. 12: Aggregate Investment

835

As we have seen, there is no need to do so. However, one may choose to follow
an alternative path, in which one starts by evaluating the future marginal profitability
o f capital without considering the effect o f future optimal investment decisions on
marginal profitability. This "mistake" can then be "corrected" with a term that has
an option representation. This alternative way o f doing things is akin to the arbitrage
approach in finance, and it was nicely portrayed in Pindyck (1988). The confusion
arises, in my view, from mixing the language in the two approaches 33.
A related claim exists for a once and for all project (as opposed to incremental
investment). It is said that the simple positive net present value rule used in business
schools to decide whether a project should be implemented does not hold because it
does not consider the option to wait and decide tomorrow, when more information
is available. Since I have never taught at a business school I cannot argue directly
against that claim. However, if the issue is whether to invest today or tomorrow, the
right criterion has never been invest if NPV is positive - at least that is what we
teach economics undergraduates. This is a case of mutually exclusive projects, thus
the fight criterion has always been to compare their net present value and take that
with the highest NPV, provided it is positive. If investment is irreversible, the project
invest tomorrow has a lower bound at zero (because investment will not occur if
N P V looks negative tomorrow), which the project invest today does not. Thus, other
things equal, irreversibility necessarily makes investing tomorrow more attractive than
investing today.
3.1.5. Adjustment hazard

At a qualitative level, the (L, l, u, U) models described above capture well the nonlinear
nature o f microeconomic adjustment. Maintenance expenditures aside, investment is
mostly sporadic and often lumpy; scarcely reacting to small changes in the environment
but abruptly undoing accumulated imbalances when they become sufficiently large, and
with possibly significant asymmetries between investment and disinvestment.
At an empirical level, however, these characterizations are too stark. For reasons,
some o f which we understand and most of which we do not, firms respond differently
to similar imbalances over time and across firms. Caballero and Engel (1999) propose
a probabilistic instead o f a deterministic adjustment rule. Rather than having a clear
demarcation between regions o f adjustment and inaction, they model a situation where
large imbalances are more likely to trigger adjustment than small ones 34.

33 See Bertola (1988) for one of the first discussions of this issue in the economics literatme. There
is also a related discussion in applied mathematics; see, for example, E1 Karoui and Karatzas (1991).
Abel et al. (1996) have recently revisited and expanded the discussion on the relation between the two
approaches.
34 Another advantage of this approach is that it nests linear models as the probability of adjustment
becomes independent of Z.

R.J. Caballero

836

There are many formal motivations for such an assumption. A particularly simple
one, pursued by Caballero and Engel (1999), is to assume that cf in the adjustment
cost fimction (3:4) is an i.i.d, random variable, both across firms and time. Although
technically more complex, the nature of the problem is not too different from that of
the simpler (L, l, u, U) model. Let ~o denote the random fixed cost, and G(w) its time
invariant distribution. It is possible to characterize the problem of the firm in terms
of two functions similar to those used before: V(Z, K*) and ~'(Z, K*, w), the value of
a firm with imbalance Z, desired capital K*, and realization of fixed adjustment cost
w. In particular, V(Z,K*) is the value o f the firm provided it does not adjust, while
[/(Z,K*, w) is the value o f the firm when it is left free to choose whether or not to
adjust. Thus,

V(Zt, 17) = H(Zt, K t )At + (1 - rAt)Et [V(Zt+At,K~+At,Wt+At,)],

V(Zt,K; ,~o)-max

{ V(Zt,K[),max {V(Zt+ tl, K[)-C(tI, K[,wt)}

(3.15)

(3.16)

Not surprisingly, the nature of the solution is not too different from that o f the
(L, l, u, U) case. Indeed, conditional on c~ it is an (L, l, u, U) rule, although there are
additional intertemporal considerations, since the firm weighs the likelihood of drawing
higher or lower adjustment costs in the future. Without conditioning on ~o, it is a
probabilistic rule in the space of imbalances.
In order to simplify the exposition, I will suppress the proportional costs. Thus,
conditional on adjustment, the target point is the same regardless of whether the firm
is adding or subtracting to its stock of capital (i.e. l = u = c). Moreover, let me define
a new imbalance index centered around zero:
x - In (Z/c).
The probability of adjustment rises with the absolute value of x because there are
more realizations of adjustment costs which justify adjustment. This is the sense in
which the (S, s) nature of the simpler models is preserved. Let A(x) denote the function
describing the probability of adjustment given x, and call it the adjustment hazard
function [see Caballero and Engel (1999)].
Given an imbalance x, it is no longer possible to say with certainty whether or not
the firm will adjust, but the expected investment by the firm is given by
E

11, ]

K/t x = (e ~ -

1)A(x) ~ - x A ( x ) ,

(3.17)

which is simply the product of the adjustment if it occurs, and the probability that
adjustment occurs 35. Aggregation is now only a step away.
35 Caballero and Engel (1999) refer to A(x) as the "effective hazard" to capture the idea that, through a
normalization, it also captures scenarios where adjustment, if it occurs, is only a fraction of the imbalance
X.

Ch. 12: AggregateInvestment

837

3.2. Aggregation
Unlike microeconomic data, aggregate investment series look fairly smooth. Large
microeconomic adjustments are far from being perfectly synchronized. The question
arises, and this was the maintained hypothesis during the 1980s, as to whether
aggregation eliminates all traces of lumpy microeconomic adjustment. The answer is
a clear no. Doms and Dunne's evidence on the role of synchronization of primary
spikes in accounting for aggregate investment, and on the high time series correlation
between aggregate investment and a Herfindahl index of microeconomic investments,
as well as the more structural empirical evidence reviewed in the next section, support
this conclusion,
With the setup at hand, aggregation proceeds in two easy steps. To simplify things
further, I will define the aggregate as the behavior of the average, rather than the
weighted average 36.
Both steps rely on having a large number of establishments, so that laws of
large numbers can be applied. In the first step, one takes as the average investment
rate (i.e. the ratio of investment to capital) of establishments with more or less
the same imbalance of capital, x, the conditional expectation of this ratio given in
Equation (3.17):

It ,~x = -xA(x),

(3.18)

g)

where the superscript x denotes the aggregate for plants with imbalance x.
The second step just requires averaging across all x. Let f(x, t) denote the cross
sectional density of establishments' capital imbalances just before investment takes
place at time t. Then the aggregate investment rate at time t, (It/Kt) A, is

( It ~A = - f xA(x)f(x,t)dx.

g)

(3.19)

This is an interesting equation, with macroeconomic data on the left and microeconomic data on the right-hand side. An example serves to illustrate this aspect of the
investment equation: If the adjustment hazard is quadratic,

A(x) = )~o+ ;qx + )~2x2,

Equation (3.19) reduces to
I, ~A = __~r~,-(1)__~lXt(2)
g)

_ 2X(3),

(3.20)

where Xt(1), Xt(2) and Xt(3) denote, respectively, the first, second and third moments of
the distribution of establishments' imbalances.
36 Using microeconomicdata, Caballero, Engel and Haltiwanger (1995) show that in US manufacturing
this approximationis. See Caballero and Engel (1999) for a detailed discussion of the issue.

838

R.J. Caballero

If t l l = ,~2 = 0, the model only has aggregate variables, both on the right and left hand side. Indeed this case corresponds to the celebrated partial adjustment model, and
it also coincides with the equation obtained from a quadratic adjustment cost model
with a representative agent [e.g. Rotemberg (1987) and Caballero and Engel (1999)]. If
either )!.1 or/~2 is different from zero, however, information about the cross sectional
distribution o f imbalances is needed on the right-hand side. All the microeconomic
models discussed in this section yield situations where higher moments o f the cross
sectional distribution play a role.
3.3. Empirical evidence
There are two polar empirical strategies used to estimate Equation (3.19), with a
continuum o f possibilities in between. At one extreme, one can use microeconomic
data to construct all the elements on the right-hand side; in particular one can construct
the path o f the cross sectional distribution and estimate the adjustment hazard as an
accounting identity, or estimate a parametric version o f it. At the other extreme, one
can attempt to learn about the adjustment hazard from aggregate data only, by putting
enough structure on the stochastic processes faced by firms and by starting with a
guess on the initial cross sectional distribution. Both avenues have been explored, with
similar results along dimensions they can be compared.
3.3.1. Microeconomic data
Caballero, Engel and Haltiwanger (1995) use information on approximately seven
thousand US manufacturing plants from 1972 to 1988 to empirically recreate the steps
described in the previous section 37. The figures below were constructed with data from
that paper 3s.
The procedure used by Caballero, Engel and Haltiwanger is essentially accounting,
except for the first step, which requires estimating a series of frictionless capital for
each establishment, and, from this, a m e a s u r e ofxit (an index of the capital imbalance
o f firm i at date t).
The series o f frictionless capital were constructed using a procedure similar to
that described in Section 2, but cointegration regressions were run at the individual
establishment level 39. The average estimate of the long run elasticity of capital with

37 As in Doms and Dunne (1993), we used data from the Longitudinal Research Datafile (LRD). The
LRD was created by longitudinally linking the establishment-level data from the Annual Survey of
Manufacturing. The data used in that paper is a subset of the LRD, representing all large, continuously
operating plants over the sample. The data sets include information on both investment and retirement
of equipment (i.e. the gross value of assets sold, retired, scrapped, etc.
38 Warning: x in that paper corresponds to ~ in this survey.
39 The results reported there constrained the coefficient on the elasticity of capital with respect to its
cost to be equal across two-digit sectors, but all principal results were robust to different constraints and
specifications.

Ch. 12: Aggregate lnvestment

839

0.4

0.3

0.2

0.1

I
-2

-1

o.o

Fig. 3.5. Adjustment hazard.

respect to its cost was close to minus one, with substantial heterogeneity across sectors.
The measures ofxit, up to a constant, correspond to the difference between actual and
estimated frictionless capital4.
There are two results from that paper which seem particularly relevant for this
section of the survey. One on the shape o f the adjustment hazard, and the other on
the consequences o f this shape for aggregate dynamics. I discuss the former here
and the latter after the next subsection. Figure 3.5 reports the average adjustment
hazard constructed from simply averaging the investment rates o f establishments in
a small neighborhood o f each x, divided by minus the corresponding x. The hazard
is clearly increasing for positive adjustment (i.e. expected investment rises more
than proportionally with the shortage o f capital), as one would expect from the
nonlinearities implied by (L, 1, u, U) type models, and unlike the linear models which
imply a constant hazard. The estimated hazard is also very low for negative changes,
suggesting irreversibility 41 .
Following a similar procedure, Goolsbee and Gross (1997) have studied very
detailed and high quality microeconomic data on capital stock decisions in the US
airline industry. They found clear evidence of behavior consistent with non-convex
adjustment costs.

3.3.2. Aggregate data

I f only aggregate data are available, one needs to make some inference about the path
o f the cross sectional distribution of capital imbalances, f ( x , t), from these data. This
is possible if enough structure is placed on the stochastic processes faced by firms.

40 The establishment specific constants were estimated as the average gap between their respective kit
and k/t for the five points with investment closest to their median (broadly interpreted as maintenance
investment).
41 Retirements include assets sold, scrapped or retired. It is possible that observations are very noisy
on this side. The right-hand side of the figure should therefore be viewed with some caution.

840

R.J Caballero

The basic operations affecting the evolution o f f ( x , t) are quite simple. Given the
density, or histogram, at time t - 1, there are three basic operations in its transformation
into f ( x , t). First, aggregate shocks and common depreciation shift everybody's x in
the same direction; second, given the adjustment hazard, the density at each x is split
into those that stay there and those that adjust and move to some other position in
the state space (in the simplest case, they move to x = 0, but this is not necessary);
and third, idiosyncratic shocks hit, which amounts to a convolution o f the density
resulting from the second step and that o f idiosyncratic shocks. Making distributional
assumptions about idiosyncratic shocks and the initial cross sectional distribution,
is enough, therefore, to keep track o f the evolution o f the cross sectional density,
conditional on aggregate shocks and for a given adjustment hazard.
In continuous time, and assuming Brownian motions for aggregate and idiosyncratic
shocks, Bertola and Caballero (1994) estimated the irreversible investment model, and
Caballero (1993b) did so for the (L,/, u, U) model. 42
In discrete time but continuous state space, Caballero and Engel (1999), estimated
the more general adjustment hazard model described in the previous sections, assuming
that both idiosyncratic and aggregate shocks were generated by log-normal processes.
We did so for US manufacturing investment in equipment and structures (separately)
for the 1947-1992 period 43. The results were largely consistent with those found
with microeconomic data by Caballero, Engel and Haltiwanger (1995). There is clear
evidence o f an increasing hazard model; that is, the expected adjustment o f a firm
grows more than proportionally with its imbalance 44. An important point to note is that
since only aggregate data were used, these microeconomic nonlinearities must matter
at the aggregate level, for otherwise they would not be identified. The improvement
in the likelihood function from estimating this non-linear model rather than a simple
linear model (including the quadratic adjustment cost model) was highly significant,
and so was the improvement in the out-of-sample forecasting accuracy 45.

42 See Bertola and Caballero (1990) for a discrete time and space model and estimation procedure.
43 Another important difference between this and the previous papers is that estimation was done
by a single step maximum likelihood procedure, which did not require estimating frictionless capital
separately.
44 We did not allow for asymmetries between ups and downs but this turned out not to matter much
because given the strong drift induced by depreciation and the small value we found for the hazard in
an interval around zero, the model effectively behaves as if investment is irreversible (i.e. It is very
asymmetric around the median value of x and with a very small hazard for values of x much higher
than that.).
45 For within sample criteria, we ran Vuong's [Rivers and Vuong (1991)] test for non-nested models,
and we rejected strongly the hypothesis that both models (linear and non-linear) are equally close to
the true model against the hypothesis that the structural (non-linear) model is better. For out-of-sample
criteria, we dropped the last ten percent of the observations and evaluated the Mean Squared Error of
the one step ahead forecasts for these observations [see Caballero and Engel (1999)].

841

Ch. 12." Aggregate Investment

3.3.3. Pent-up demand

What is the aspect of the data that makes these models better than linear ones at
explaining aggregate investment dynamics?
The simplest answer comes from an example. Suppose that a history of mostly
positive aggregate shocks displaces the cross sectional distribution of imbalances
toward the high part of the hazard. Such a sequence of events will not only lead to more
investment along the path but also to more pent-up investment demand; indeed, the
cross sectional distribution represents unfulfilled investment plans. But as unfulfilled
demand "climbs" the hazard, more units are involved in responding to new shocks;
incremental investment demand is more easily boosted by further positive aggregate
shocks, or depressed by a turnabout of events. This time-varying/history-dependent
aggregate elasticity plays a very important role for aggregate investment dynamics. It
captures the aggregate impact of changes in the degree of synchronization of large
adjustments; already an important explanatory variable in Doms and Dunne's less
structural study. In particular, their observation that the Herfindahl of investment rises
during episodes of large aggregate investment matches well this mechanism.
Using the path of cross sectional distributions and hazards described at the beginning
of this subsection, Caballero, Engel and Haltiwanger (1995) found an important role
for the mechanism described above. Figure 3.6 depicts the relative contribution of the
time-varying aggregate elasticity for aggregate investment dynamics. A positive value
reflects an amplification effect (micro-nonlinearities exacerbate the economy's response
to aggregate shocks), while a negative value reflects an offsetting effect. The impact
of the time-varying elasticity appears to be especially large after the tax-reform of
1986 (when tax-incentives for investment were removed). The decline in investment
was 20 percent greater than it would have been under a linear model.

Fraction
0.15
0.10 /
0.05
0
- 0.05

-0.10
-0.15
I

1976

1978

1980

1982

1984

1986

Fig. 3.6. Relative contributionof time-varyingmarginal response, 1974-1988.

842

R.J. Caballero
d
CD

LO
0

[___

c)

Fig. 3.7. Equipment-mean-difference.

The importance of the time-varying elasticity is confirmed by Caballero and Engel
(1999), this time using only aggregate data. As before, it is the flexible cyclical
elasticity o f the increasing hazard model which allows it to better capture the high
skewness and kurtosis imprinted on aggregate data by brisk investment recoveries 46.
The solid line in Figure 3.7 plots the difference between the path o f the US
manufacturing equipment investment-capital ratio and the predictions o f a linear model
(partial adjustment) fed with the shocks estimated for the increasing-hazard model; the
dashed line portrays the path o f the aggregate investment-capital ratio around its mean.
It is apparent from these figures that the linear model makes its largest errors at times
o f large investment changes.
3.4. Equilibrium
The literature described in the previous section only considers exogenous aggregate
shocks. What the econometric procedures identified as aggregate shocks are in all
likelihood a combination o f " d e e p " aggregate shocks and the feedback and constraints
brought about by factor markets, goods markets, and intertemporal preferences, among
other things. Bottlenecks may certainly limit the extent o f synchronized investment.
Equilibrium constraints not only affect the response of aggregate investment to
deep aggregate shocks, but also affect the nature o f the stochastic processes faced

46 Note that just allowing for skewness and kurtosis in shocks, although it improves the performance of
linear models, is not nearly enough to make the linear model as good as the non-linear one. In Caballero
and Engel (1999) we compared the structural model with normal shocks (to the rate of growth of desired
capital) with a linear model which flexibly combined normal and log-normal shocks (which allows for
skewness and kurtosis). We found that Vuong's test still favored the non-linear model very clearly.
Moreover, in Caballero, Engel and Haltiwanger (1995) we found no evidence that would allow us to
reject the hypothesis that shocks have a normal distribution.

Ch. 12: Aggregate Investment

843

by firms and the dimension of the state space. It is this last observation which has
inhibited progress in constructing general equilibrium versions of these models. In
principle, the entire cross sectional distribution is needed to forecast future prices
faced by any particular firm, which means that actions today, and therefore equilibrium
determination, depend on these complex forecasts, and so on.
We are, however, beginning to see progress along this dimension. Much of this has
occurred in models with active extensive margins, and will be discussed in the next
sections, together with the reasons why the presence o f an extensive margin (entry
and/or exit) may facilitate rather than complicate the solution of the model.
However, there has also been recent progress along the lines of the intensive
margin models discussed up to now. Krieger (1997) embeds the heterogeneous agents
irreversible investment model of Bertola and Caballero (1994) into a more or less
standard Real Business Cycle model. He deals with the curse of dimensionality by
arguing that, except for very high frequency aspects of the data, expectations can be
well approximated by keeping track of a finite (and not too large) number of statistics of
the Fourier representation of the cross sectional distribution. I suspect that the quality
of this approximation is facilitated by the fact that, in Krieger's model, aggregate
shocks occur only infrequently. Nonetheless, I view his as an important step forward.
At this stage, the primary effect of general equilibrium is not surprising. It brings
important sources of aggregate convexity into the problem, smoothing further the
response of aggregate investment to aggregate shocks. How important are aggregate
sources of convexity? I suspect that, together with time to build considerations, they
are among the main sources of convexity in the short run. On one hand, we have
already presented substantial evidence on microeconomic lumpiness, which is largely
inconsistent with a dominant role for generalized convexity at the microeconomic level.
On the other, not only is it well known that estimated partial adjustment coefficients
grow with the degree of disaggregation of the data, but we also have direct evidence
on the importance of bottlenecks. Goolsbee (1995a) provides interesting evidence on
the latter. He exploits the variation across time and assets (capital) in investment tax
incentives, as instruments for short-run investment demand. He shows that the price
of assets is highly responsive to ITCs: A 10 percent increase in ITCs leads to an
average increase in the price of capital goods of about 6 percent. This price effect
slowly vanishes over the following three years 47.
Equilibrium considerations will play a central role in the sections that follow. In
particular, the issue of the elasticity of the supply of capital, generally interpreted, as
well as that of other bottlenecks will be revisited often.

47 In further work, Goolsbee (1997) concludes that an important fraction of the increase in short rnn
marginal cost is due to an increase in the wages of workers who produce capital goods. In the last part
of Section 5 I will discuss the connection between sunk investment and payments to complementary
factors.
Questioning the robustness of Goolsbee's(1995a) findings, Hassett and Hubbard (1996a), find evidence
of a positive effect of tax credits on prices of capital goods before 1975 but not after that.

R.J Caballero

844

4. Entry, exit and scrapping

Changes in the aggregate stock of capital are not only due to the expansion of
existing establishments and projects, but also result from the entry (creation) decisions
of existing and new entrepreneurs, the exit decisions of some incumbents, and the
restructuring of possibly outdated forms of production. There is a very extensive and
interesting industrial organization literature on these issues which I will not discuss
here. Instead, I will focus on issues that directly relate to our current discussion:
the impact of sunk costs on aggregate investment and the feedback of equilibrium
considerations into individual decisions about lumpy actions.
This section contains three main messages: First, by truncating the distribution of
perceived future returns, free entry acts as if each competitive investor internalized
the negative effect of its entry decision on expected future industry prices. Second,
equilibrium scrapping and creation are closely connected: if industry wide creation
costs are linear, scrapping will be less responsive to aggregate shocks than if these
costs are convex (i.e. if there is an upward sloping short-rtm supply of (newly) installed
capital). Among other things, this is important for capital accumulation and the patterns
of its mismeasurement. And third, in equilibrium, shocks to the scrapping margin can
lead to investment booms, and to double-counting problems in the measurement of
capital 48.

4.1. Competitive entry and irreversibility

Dixit (1989), Leahy (1993), and Caballero and Pindyck (1996), among others, have
provided simple models of competitive equilibrium investment in which the only
meaningful investment decision of firms is whether or not to enter into and, in some
cases, exit from the industry 49. Below, I sketch a representative model of this type.
Investment is sunk upon entry in the sense that selling the firm's capital does not
change its productivity. The flow accruing to a firm i at time t is summarized by the
product of an idiosyncratic productivity level, Sit > 0 and the industry price, Pt. The
idiosyncratic productivity level is such that industry output, Yt, is

Yt =

/o

Sit d i = N~,

(4.1)

where Nt is the measure of firms at time t. Given Art, the industry price is determined
from the demand equation:

Pt

= V t Y t -1/~1 =

VtNt 1/~,

(4.2)

48 See Greenspan and Cohen (1996), for a discussion of the importance of considering endogenous
scrappage to forecast sales of new motor vehicles in the USA.
49 See Hopenhayn (1992) for an elegant characterization of the steady state properties of a competitive
equilibrium model of entry and exit.

Ch. 12: AggregateInvestment

845

where Vt is an aggregate demand shock that follows a geometric Brownian motion

with drift/~ > 0 and standard deviation a, and t/ is the elasticity of demand with
respect to price 50.
Let there be an infinite supply of potential entrants, whose initial productivity upon
entry is drama from the distribution of productivities of existing firms. There is an
entry cost F and no depreciation or higher productivity alternative use (issues of exit
will be discussed in the next subsection). Free entry implies:

F >~Ei { Et [f ~ PsSi,e-r(" Odsl } .

(4.3)

Using Fubini's Theorem (i.e. moving the expectation with respect to the idiosyncratic
shocks inside the integral) allows us to remove the idiosyncratic component from
Equation (4.3), yielding

F>~EtlftP,.er(St)dsJ.

(4.4)

Given Nt, the industry price is exclusively driven by the aggregate demand shock. Thus,
absent entry, the right-hand side of Equation (4.4) is an increasing function of Pt, call
it j~(P). Entry, however, cannot always be absent, for that would occasionally violate
the free entry condition. Indeed, as soon as J~(P) > F, there would be infinite entry
which, in turn, would lower the equilibrium price instantly. There is only one price, call
it/5o, such that the free entry condition holds with equality. Once this price is reached,
enough entry will occur to ensure that the price does not cross this upper bound; but,
to be justified, entry must not occur below that bound either. Entry, therefore, changes
the stochastic process of the equilibrium price from a Brownian Motion to a regulated
Brownian Motion. This change in the price process, however, means that.]~ is no longer
the right description of the expression on the right-hand side of Equation (4.4). There
is a new function, Ji(P), which is still monotonic in the price, but which satisfies
Ji(P) < J~(P) for all P because of the role of entry in preventing the realization of
high prices. This, in turn, implies a new reservation/entry price P1 > P0, which leads
to a new function )~(P), such that j~ > y~ > Ji, which leads to a new regulation
point in between the previous ones, and so on until convergence to some equilibrium,
~(p),p)51.
Thus, through competitive equilibrium, we have arrived at a solution like that of the
irreversible investment problem at the individual level, but now for the industry as a
whole. Periods of inaction are followed by regulated investment (through entry) during
favorable times. The constructive argument used to illustrate the solution isolates

50 Adding an aggregate productivity shock is straightforward. The Brownian Motion assumption is not
needed, but it simplifiesthe calculations.
51 Needless to say, this iterative procedure is not needed to obtain the solution of this problem.

846

R.J Caballero

the feedback of equilibrium on individual decisions. Potential entrants (investors)

know that if market conditions worsen they will have to absorb losses (this is where
irreversibility kicks in), while if market conditions improve, entry will occur, limiting
the potential gains (since the price will never be higher than/5). As a result, they delay
entry because the expected value of future market prices is necessarily lower than the
current/entry price.
There is a methodological angle in this literature. Entry (and exit) is a very powerful
mechanism. With the "appropriate" assumptions about potential entrants, entry often
simplifies the computation of equilibrium in models with heterogeneity and sunk
costs. Essentially, the methodological "trick" is that the degree of complexity of the
computational problem in cases where both extensive and intensive margins are present
is often largely determined by the nature of the distribution of potential entrants,
which can be made much simpler than the endogenous evolution of the cross sectional
distributions discussed in the previous section. Of course, in reality there is substantial
inbreeding, so the distribution of potential entrants is in all likelihood related to that
of incumbents. Nonetheless, the current set of models are convenient machines that
allow us to cut the chain of endogeneity before it gets too forbidding, but after the
first stage, where there are no endogenous interactions.
This methodological advantage has allowed researchers to explore some of the
equilibrium issues left open in Section 3. Caballero and Hammour (1994) have
explored in more detail the consequences of different assumptions on the supply
of capital for the pattern of aggregate investment (job creation) and scrapping (job
destruction). The latter is a very important, and often disregarded, aspect of the timing
of capital accumulation. I will return to the scrapping issue in the next sections, but
for now I just want to interpret it as an incumbent's decision (as opposed to a potential
entrants' decision). The issue at hand is how does the entry pattern affect the response
of incumbents to aggregate shocks.
A scrapping margin can easily be added to the entry model discussed above by, for
example, allowing Si to take negative values (e.g. due to the increase in the price of
an intermediate input). Imagine, however, that the drift in the aggregate shock (and/or
the failure rate of incumbents) is strong enough so there is continuous entry. Since
the supply of capital faced by the industry is fully elastic (the entry cost is constant),
continuous entry implies that the industry price is constant and equal to/5 (corrected
for the exit possibility). That is, aggregate shocks are accommodated by the flow of
investment by new entrants; fully insulating insiders from aggregate shocks. Insiders
go about their scrapping decisions only considering their idiosyncratic shocks; adding
a standard intensive margin does not change the basic insight [see Campbell and Fisher
(1996)]. Caballero and Hammour (1994) refer to this result as perfect insulation.
From a technical point of view, the simplicity of the computation of equilibrium in
the perfect insulation case carries through to situations where the cost of investment
fluctuates exogenously, although in that case perfect insulation breaks down. If the
industry faces an upward sloping supply of capital, a sensible assumption at least in the

Ch. 12: Aggregateinvestment

847

short run (remember Goolsbee's evidence), we return to a scenario in which the "curse
of dimensionality" appears. Caballero and Hammour (1994, 1996a) have dealt with this
case in scenarios where aggregate shocks follow deterministic cycles 52. Besides the
specific issues addressed in those papers, the main implication for the purpose of this
survey is that investment by potential entrants becomes less responsive to aggregate
shocks, which also means a break down of perfect insulation and therefore a more
volatile response of the scrapping and intensive margins.
Krieger (1997) also discusses equilibrium interactions between creation and destruction margins, although he obtains positive rather than negative comovement between
investment and scrapping. In his model, a permanent technology shock leads to a short
term increase in interest rates which squeezes low productivity units relative to high
productivity ones. The ensuing increase in scrapping frees resources for new higherproductivity investment. Similarly, Campbell (1997) studies the equilibrium response
of entry and exit to technology shocks embodied in new production units. He argues
that the increase in exit generated by positive technological shocks is an important
source of resources for the creation of new production sites.
4.2. Technological heterogeneity and scrapping
Scrapping is an important aspect of the process of capital accumulation. Understanding
it is essential for constructing informative measures of the quantity and quality
of capital at each point in time. Nonetheless, the scrapping margin is seldom
emphasized, I suspect, mostly because of the difficulties associated with obtaining
reliable data53. As a result, many time series comparisons of capital accumulation
and productivity growth (especially across countries) are polluted by inadequate
accounting of scrapping. Effective capital depreciation must surely be higher in
countries tmdergoing rapid modernization processes.
Partly to address these issues, vintage capital and putty-clay models have regained
popularity lately. Benhabib and Rustichini (1993), for example, describe the investment
cycles that follow scrapping cycles in a vintage capital model. While Atkeson and
Kehoe (1997) argue that putty-clay models outperform standard putty-putty models
with adjustment costs in describing the cross sectional response of investment and
output to energy shocks. Gilchrist and Williams (1996), on the other hand, embody
the putty-clay model in an otherwise standard RBC model and document a substantial
gain over the standard RBC model in accounting for the forecastable comovements of
economic aggregates. And Cooley et al. (1997) describe the medium/low frequency

52 In work in progress [Caballero and Hammour (1997b)], we have obtained an approximate solution
for the stochastic case, in a context where the sources of convexity are malfimctioninglabor and credit
markets.
53 See Greenspan and Cohen (1996) for sources of scrapping data for US motor vehicles.

848

R.J Caballero

aspects of a multisectoral vintage capital economy, and show how tax policy can have
significant effects on the age distribution of the capital stock 54.
The technological embodiment aspect of these models captures well the creativedestruction component of capital accumulation and technological progress 55. Salter's
(1960) careful documentation of the technological status of narrowly defined US and
UK industries is very revealing with respect to the simultaneous use of different
techniques of production and the negative correlation between productivity ranking
and the technological age of the plant 56. For example, his table 5 shows the evolution
of methods in use in the US blast furnace industry from 1911 to 1926. At the
beginning of the sample, the "best practice" plants produced 0.32 gross tons of pigiron per man-hour, while the industry average was 0.14. By the end of the sample,
best practice plants productivity was 0.57 while the industry average was 0.30. While
at the beginning of the sample about half of the plants used hand-charged methods of
production, only six percent did at the end of the sample.
As mentioned above, obsolescence and scrapping are not only driven by slowly
moving technological trends, but also by sudden changes in the economic environment.
Goolsbee (1995b) documents the large impact ofoil shocks on the scrapping of old and
fuel-inefficient planes. For example, he estimates that the probability of retirement of a
Boeing 707 (relatively inefficient in terms of fuel) more than doubled after the second
oil shock. This increase was more pronounced among older planes. Once more, the
endogenous nature of the scrapping dimension must be an important omitted factor in
our accounting of capital accumulation and microeconomie as well as macroeconomic
performance.
The sunk nature of technological embodiment is a source of lumpy and discontinuous actions at the microeconomic level. The (S, s) apparatus, with its implications for
aggregates, is well suited for studying many aspects of vintage and putty-clay models.
In particular, episodes of large investment which leave their technological fingerprints,
and remain in the economy, reverberating over time.

5. Inefficient investment

Fixed costs, irreversibilities and their implied pattern of action/inaction, have microeconomic and aggregate implications beyond the mostly technological (and
neoclassical) ones emphasized above. Indeed, they seed the ground for powerful
inefficiencies. This section describes new research on the consequences o f two of

54 Jovanovic(1997) studies the equilibrium interactionof the cross sectionalheterogeneityimplied by

vintage capital and putty-claymodels with heterogeneityin labor skills.
55 Besides obsolescence and scrapping, these models are also useful for studying the issues of
"mothballing" and capital utilization.
56 This correlation is less clear in modern data; perhaps because retooling occurs within given
structures.

Ch. 12: AggregateInvestment

849

the most important sources of inefficiency in aggregate investment: informational and

contractual problems.
5.1. Informational problems

Information seldom arrives uniformly and comprehensively to every potential investor.

Each investor probably holds part of a truth which would be more easily seen if all
investors could (or would) pool their information. Actions by others are a partial
substitute for information pooling, for they reveal, perhaps noisily, the information
of those that have taken actions.
If, however, investment is irreversible, it may pay to wait for others to act and reveal
their information before investing. Moreover, if lumpiness leads to periods of no or
little action, information may remain trapped for extended periods of time, and when
agents finally act, an avalanche may occur because accumulated private information is
suddenly aggregated. These issues form the crux of a very interesting new literature,
summarized in Gale (1995) under the heading of "social learning."
There are two themes emerging from this literature which are of particular
importance for this survey. The first is the existence of episodes of gradualism, during
which industry investment can occur at an excessively slow pace, or even collapse
altogether. The second is an exacerbation of the aggregate nonlinearities implied by the
presence of fixed costs; aggregation of information coincides with the synchronization
of actions, further synchronizing actions.
Caplin and Leahy (1993, 1994) cleanly isolate the issues I have chosen to stress
here. Caplin and Leahy (1993) describe a model very similar to the free entry model
reviewed in Section 4.1, except that their model has neither aggregate nor idiosyncratic
shocks. Instead there is a flow marginal cost of producing which is only known to
industry insiders. Insiders have the option to produce one unit of output or none
and they will produce if price is above marginal cost. This generates an information
externality. If all incumbents are producing, potential investors know that marginal cost
is below the current equilibrium price; if not, the industry's marginal cost is revealed
to be equal to the current price. Whenever a new establishment is created, equilibrium
price either declines or stays constant, improving the precision of potential investors'
assessment of the industry's marginal cost.
In a second best solution, investment occurs very quickly up to a point at which, even
if marginal cost has not yet been reached, no further investment takes place because
it is very unlikely that the present value of future social surpluses is enough to cover
the investment costs.
The industry equilibrium outcome has the same critical point at which investment
stops, but unlike the second best outcome, it yields a much slower pace of industry
investment. A potential entrant must weigh the value of coming early into the industry
(expected profits are higher than they will be later), not only against the cost of capital
(as in the second best solution) but also against the probability o f learning in the
next second from the investment decisions of others that it was not worth entering

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R.J. Caballero

the industry. Caplin and Leahy show that the price process x(t) obeys the following
differential equation:

where F is the fixed entry cost paid by the firm and r is the real interest rate. This
equation has a natural interpretation which captures the idea that competitive firms
are indifferent between entry today and entry tomorrow. The left-hand side represents
the loss in current revenue incurred by a firm which delays entry for a brief instant
beyond t s7. The right-hand side captures the expected gain from this delay. The term
rF reflects the gain due to the postponement of the entry cost, while the last term
represents the saving due to the possibility that delay will reveal the true industry's
marginal cost, aborting a wasteful investment sS.
In equilibrium, entry is delayed and price declines slowly; "gradualism" maintains
prices high enough for sufficiently long so as to offset (in expectation) the risk incurred
by investors who act early rather than wait and free-ride off of others' actions s9.
Caplin and Leahy (1994) characterize the opposite extreme, one of delayed exit. The
key connection with the previous sections is that the problem of information revelation
arises from the fact that, as we have seen, fixed costs of actions make it optimal not
to act most of the time. Thus, information that could be revealed by actions remains
trapped.
Their model is one of time-to-build. Many identical firms simultaneously start
projects which have an uncertain common return several periods later (e.g. a real estate
boom). Along the investment path, firms must continue their investment and receive
private signals on the expected return. The nature of technology is such that required
investment is always the same if the firm chooses to continue in the project. The firm
has the option to continue investing ("business as usual"), to terminate the project,
or to suspend momentarily, but the cost of restarting the project after a suspension is
very large. Project suspension reveals (to others) negative idiosyncratic information; if
nobody suspends, it is good news. However, the costly nature of suspension delays it,
and therefore information revelation is also delayed. Bad news may be accumulating
but nobody suspends, because everybody is waiting for a confirmation of their bad
signals by the suspension of other people. Eventually, some firms will receive enough
bad signals to suspend in spite of the potential cost of doing so (i.e., if they are wrong

57 At the time when the industry starts, potential investors' priors are that the price is distributed
uniformly on [0, I]. As entry occurs and the price declines, the priors are updated. If convergence has
not happened at time t, marginal cost is assumed uniformly distributed on [0,x(t)]. The expected cost
of waiting is, therefore, equal to the price minus the expected marginal cost, x(t).
58 Here ~ d t is the probabilitythat price hits marginal cost during the next dt units of time.
59 Even though entrants make zero profits in expectation, ex-post, early entrants earn positive profits,
while late entrants lose money.

Ch. 12: Aggregate Investment

851

in their negative assessment o f market conditions). Since the number of firms in their
model is large, the number of firms that suspend for the first time fully reveals future
demand: if demand is low, everybody exits; if it is high, all those that suspended
restart.
If it were not for the interplay between inaction (investment as usual) and private
information, the fate of the market would be decided correctly after the first round of
signals. Information aggregation does not take place until much later, however. Thus,
substantial investment may turn out to be wasted because the discrete nature of actions
inhibits information transmission. The title of their paper beautifully captures the expost feeling: Wisdom after the fact.
The "classic" paper from the literature on information and investment is due to
Chamley and Gale (1994). In their model all (private) information arrives at time zero;
the multiple agent game that ensues may yield many different aggregate investment
paths, including suboptimal investment collapses. In reviewing the literature, Gale
(1995) illustrates the robustness of the possibility of an inefficient investment collapse
(or substantial slowdown and delay). He notices that in order for there to be any value
to waiting to see what others do before taking an action (investing for example) it must
be the case that the actions of others are meaningful. That is, the action taken in the
second period by somebody who chose to wait in the first period must depend in a non
trivial way on the actions of others at the first date. If a firm chooses to wait this period,
possibly despite having a positive signal, it will only invest next period if enough other
firms invest this period. It must therefore be possible for every firm to decide not to
invest next period because no one has invested this period, even though each firm may
have received a positive signal this period, in which case, investment collapses.
This is a very interesting area of research for those concerned with investment issues
and is wanting for empirical developments.
5.2. Specificity and opportunism

The quintessential problem of investment is that it is almost always sunk, possibly

along many dimensions. That is, the number of possible uses of resources is reduced
dramatically once they have been committed or tailored to a specific project or use.
Every model I discussed in the previous sections, at some stage hinges in a fundamental
way on this feature of investment.
To invest, often means opening a vulnerable flank. Funds which were ex-ante
protected against certain realizations of firm or industry specific shocks, for example,
are no longer so. In equilibrium, investment must also allow the investor to exploit
opportunities which would not be available without the investment. If the project is
well conceived, the weight of good and bad scenarios is such that the expected return
is reasonable. Indeed, this is precisely the way I characterized the standard irreversible
investment problem early on.
The problem is far more serious, and more harmful for investment, when the
probability of occurrence of the bad events along the exposed flanks are largely

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R.J Caballero

controlled by economic agents with the will and freedom to behave opportunistically.
In a sense, this is a property rights problem, and as such it must have a first-order effect
in explaining the amount and type o f capital accumulation and, especially, differences
in these variables across countries.
Thus, the window for opportunism arises when part o f the investment is specific to
an economic relationship, in the sense that if the relationship breaks up, the potential
rewards to that investment are irreversibly lost. Further, such opportunism is almost
unavoidable when this "fundamental transformation" from uncommitted to specialized
capital is not fully protected by contract [Williamson (1979, 1985)] 60
Specificity, that is, the fact that factors o f production and assets may be worth
more inside a specific relationship than outside o f it, may have a technological or an
institutional origin. Transactions in labor, capital and goods markets are frequently
characterized by some degree o f specificity. The creation of a job often involves
specific investment by the firm and the worker. Institutional factors, such as labor
regulations or unionization also build specificities.
There is a very extensive and interesting microeconomic literature on the impact of
unprotected specificity on the design o f institutions, organizations and control rights.
Hart (1995) reviews many o f the arguments and insights. For the purpose o f this survey,
however, the fundamental insight is in Simons (1944), who clearly understood that
hold-up problems lead to underinvestment:
... the bias against new investment inherent in labor organizations is important .... Investors
now face ... the prospect that labor organizations will appropriate most or all of the earnings
.... Indeed, every new, long-term commitment of capital is now a matter of giving hostages to
organized sellers of complementary services.
More recently, Grout (1984) formalized and generalized Simons' insight, and
Caballero and Hammour (1998a) studied, at a general level, the aggregate consequences o f opportunism 61. Here, I borrow the basic model and arguments from that
paper to discuss those aspects o f the problem which are most relevant for aggregate
investment.
Everything happens in a single period 62. There is one consumption good, used as
a numeraire, and two active factors o f production, 1 and 2 63. Ownership o f factors
1 and 2 is specialized in the sense that nobody owns more than one type of factor.

60 This is known as the hold-up problem.

61 For specific applications which relate to investment see Kiyotaki and Moore (1997) [credit
constraints]; Caballero and Hammour (1996a, 1998b) and Ramey and Watson (1996) [turnover and
unemployment]; Caballero and Hammour (1996b), Blanchard and Kremer (1996) [transition economies
and structural adjustments]; Caballero and Hammour (1997b) [interactions between labor market and
credit market oppor~nism]; Acemoglu (1996) [human capital investment].
62 Many of the insights discussed here can and have been made in dynamic, but more specialized
contexts. I am confident, therefore, that this section's discussion is fairly robust to generalizations along
this dimension.
63 Also, there is a passive third factor which earns the rents of decreasing returns sectors.

Ch. 12: Aggregate Investment

8 5 3

There are two modes o f production. The first is joint production, which requires, in
fixed proportions, xl and x2 units of factors 1 and 2, respectively, to produce y units
o f output. Let E denote the number of joint production units, so Ei = x i E represents
employment o f factor i in joint production. The other form o f production is autarky
where each factor produces separately, with decreasing returns technologies Fi(Ui),
and where Ui denotes the employment of factor i in autarky, such that Ei + Ui = 1.
The autarky sectors are competitive, with factor payments, pi:
Pi = F;(Ui).

(5.2)

For now, there are no existing units. At the beginning of the period there is mass
one o f each factor o f production. There are no matching frictions so that, in the
efficient/complete contracts economy, units move into joint production (assuming
corners away) until
y-p~xl

+p2x2,

(5.3)

where asterisks are used to denote efficient quantities and prices.

Specificity is captured by assuming that a fraction q~i of each factor of production
cannot be retrieved from a relationship once they have agreed to work together. I f
the relationship breaks up, (1 Oi)xi units of factor i can return to autarky, where it
produces for the period, while )ixi is irreversibly wasted. In the simple deterministicsingle-period model discussed here, specificity plays no role in the efficient economy,
where there are no separations.
Contracts are needed because investment occurs before actual production and factor
participation. There are myriad reasons why contracts are seldom complete. An
extreme assumption which takes us to the main issues most directly, is the assumption
that there are no enforceable contracts. It turns out that, in equilibrium, the incomplete
contracts economy has no separations either; but unlike the efficient economy, the mere
possibility o f separations alters equilibrium in many ways.
Generically, equilibrium rewards in joint production will have ex-post opportunity
cost and rent-sharing components. For simplicity, let us assume that factors split their
joint surplus 50/50. Thus, the total payment to the xi units of factor i in a unit of joint
production is 64
-

wixi = (1

~)i) xiPi -1- ~S,

(5.4)

where s denotes the (ex-post) quasi-rents of a production unit:

s ~- y - (1

- q}l)plXl

- (1 - q}2)p2x2.

64 Factors bargain as coalitions within the production unit.

(5.5)

854

R.J. Caballero

For a factor of production to willingly participate in joint production it must hold

that
WiXi ~ pixi.

(5.6)

Substituting Equations (5.4) and (5.5) into Equation (5.6), transforms factor i's
participation condition into
y ~ p l x t +p2x2 + Ai,

(5.7)

Z~i ~ ~)iPiXi -- ~ j p j x j ,

(5.8)

with

which measures the net sunk component of the relationship for factor i. In other words,
it is a measure of the "exposure" of factor i to factor j. When Ai is positive, part of
factor i's contribution to production is being appropriated by factor j 65.
5.2.1. Generic implications

Figure 5.1 characterizes equilibrium in both efficient and incomplete contract economies. The two dashed curves represent the right-hand side of condition (5.7) for factors
1 and 2. They are increasing in the number of production units because the opportunity
cost of factors of production (the pis) rise as resources are attracted away from autarky.
The thick dashed curve corresponds to that factor of production (here factor 1) whose
return in autarky is tess responsive to quantity changes 66. If one thinks of capital and
labor, arguably capital is this factor; which is a maintained assumption through most
of this section. The horizontal solid line is a constant equal to y, which corresponds to
the left-hand side of condition (5.7). Equilibrium in the incomplete contracts economy
corresponds to the intersection of this line with the highest (at the point of intersection)
of the two dashed lines. In the figure, the binding constraint is that of capital.
An efficient equilibrium, on the other hand, corresponds to the intersection of the
horizontal solid line with the solid line labeled Eft. The latter is just the sum of the exante opportunity costs of factors of production [the right-hand side of Equation (5.3)].
This equilibrium coincides with that of the incomplete contracts economy only when
both dashed lines intersect; that is, when net appropriation is z e r o (A i = - A j = 0).
There are several features of equilibrium which are important for investment (or
capital accumulation). First, there is underinvestment; equilibrium point A is to the
left of the efficient point A*. Because it is being appropriated, capital withdraws into
autarky (e.g. consumption, investment abroad, or investment in less socially-valuable

65 It should be apparent that A i = -Aj.

66 That is, autarky exhibitsrelativelyless decreasingreturns for this factor.

855

Ch. 12: Aggregate Investment

(2) Eft.
B ~ y , ~ (1)
~
l /

.'i//

//

///

U. / / /

~.

Fig. 5.1. Opportunism in general equilib-

rium.

activities) 67. Second, the withdrawal of capital constrains the availability of jobs and
segments the labor market 68. In equilibrium, not only are there fewer joint production
units, but also the right-hand side of condition (5.7) for labor is less than y, reflecting
the net appropriation of capital; outside labor cannot arbitrage away this gap because
its promises are not enforceable. Third, investment is more volatile than it would be
in the efficient economy 69. Changes in y translate into changes in the number of joint
production units through capital's entry condition (thick dashes), which is clearly more
elastic (at their respective equilibria) than the efficient entry condition ("Eft" line).
If profitability in joint production is high enough, equilibrium is to the right
of the balanced specificity point, B. In that region, it is the labor entry condition
which binds. In principle, problems are more easily solved in this region through
contracts and bonding. I f not solved completely, however, there are a few additional
conclusions o f interest for an investment survey. First, there is underinvestment since
the complementary factor, labor, withdraws (relative to the first best outcome) from
joint production. Second, capital is now rationed, so privately profitable investment
projects do not materialize. Third, investment is now less volatile than in the efficient
economy. Changes in y translate into changes in the number of joint production units
through labor's entry condition (thin dashes), which is clearly less elastic than the
efficient entry condition ("Eft" line).

67 See Fallick and Hassett (1996) for evidence on the negative effect of union certification on firm level
investment.
68 This holds even in the extreme case where capital and labor are perfect substitutes in production.
See Caballero and Hammour (1998a).
69 In a dynamic model, this translates into a statement about net capital accumulation rather than,
necessarily, investment. The reason for the distinction is that the excessive response of the scrapping
margins and intertemporal substitution effects on the creation side may end up dampening actual
investment. See Caballero and Hammour (1996a).

856

R.J Caballero

The equilibrium implications of incomplete contracts also affect the scrapping

decisions of firms. The easiest way to see this is to examine an existing production
unit and ask how low its profitability would have to be for it to scrap itself and seek
other opportunities. Moreover, assume that neither factor suffers from specificity in
this production unit, so that the efficient rule is scrap whenever profitability is less
than y. Two, apparently contradictory, features characterize the incomplete contracts
economy. First, because the opportunity cost of factors of production is depressed
by the excessive allocation to autarky, there is sclerosis; that is, there are units with
profitability below y which are not scrapped because the opportunities in autarky
are depressed. Second, given the depressed level of investment, there is excessive
destruction. Since the appropriating factor earns rents in joint production, some of
them leave socially valuable production units in order to improve their chances of
earning these excess returns.
Caballero and Hammour (1998a,b) argue that, over the long run, capital/labor
substitution takes place. If capital is being appropriated, it will seek to exclude labor
from joint production by choosing a capital intensive technology. This effect goes
beyond purely neoclassical substitution, as it also seeks to reduce the appropriability
problem 70.
At a general level, of course, unenforceability of contracts results from the absence
of well defined property rights. There is plenty of evidence on the deleterious
consequences of such problems for investment. Two recent examples in the literature
are Besley (1995) and Hall and Jones (1996). The former provides a careful description
of land rights in different regions of Ghana. He documents that an "extra right" over
a piece of land increases investment in that land by up to 9 percent in Anloga and up
to 28 percent in Wassa 71. Hall and Jones (1996) use a large cross section of countries
to show, among other things, that capital/labor ratios are strongly negatively related to
"divertment activities."
5.2.2. Credit constraints

There is by now a large body of evidence supporting the view that credit constraints
have substantial effects on firm level investment. Although there are a number of
qualifications to specific papers in the literature, the cumulative evidence seems
overwhelmingly in favor of the claim that investment is more easily financed with
internal than external funds 72. I will not review this important literature here because
there are already several good surveys 73.

70 We argue that this is a plausible factor behind the large increase in capital/labor ratios in Europe
relative to the USA.
71 Rights to sell, to rent, to bequeath, to pledge, to mortgage, etc.
72 For a dissenting view, see e.g. Kaplan and Zingales (1997) and Cummins, Hassett and Oliner
(1996b).
73 See e.g. Bernanke et al. (1996, 1999) and Hubbard (1995) for recent ones.

Ch. 12: Aggregate Investment

857

While there are extensive empirical and theoretical microeconomic literatures, the
macroeconomics literature on credit constraints is less developed. Notable exceptions
are: Bernanke and Gertler (1989, 1990), Kiyotaki and Moore (1997) and Greenwald
and Stiglitz (1993)74. Although the exact mechanisms are not always the same, many
of the aggregate insights of this literature can be described in terms of the results in
the preceding subsections.
Changing slightly the interpretation of factor 2, from labor to entrepreneurs, allows
us to use Figure 5.1 to characterize credit constraints. Rationing in the labor market
becomes rationing of credit available to projects. To the left of point B, which is the
region analyzed in the literature, net investment is too responsive to shocks; there is
more credit rationing as the state of the economy declines; and there is underinvestment
in general.
Internal funds and collateralizable assets reduce the extent of the appropriability
problem by playing the role of a bond, and introduce heterogeneity and therefore
ranking of entrepreneurs. Since the value of collateral is likely to decline during a
recession, there is an additional amplification effect due to the decline in the feasibility
of remedial "bonding" 75.

6. Conclusion and outlook

This survey started by arguing that the long run relationship between aggregate capital,
output and the cost of capital is not very far from what is implied by the basic
neoclassical model: in the US, the elasticity of the capital-output ratio with respect
to permanent changes in the cost of capital is close to minus one.
In the short run things are more complex. Natural-experiments have shown that, in
the cross section, the elasticity of investment with respect to changes in investment
tax credits is much larger than we once suspected.
How to go from these microeconomic estimates to aggregates, and to the response
of investment to other types of shocks is not fully resolved. We do know, however,
that these estimates represent expected values of what seems to be a very skewed
distribution of adjustments. A substantial fraction of a firm's investment is bunched
into infrequent and lumpy episodes. Aggregate investment is heavily influenced by the
degree of synchronization of microeconomic investment spikes. For US manufacturing,
the short run (annual) elasticity of investment with respect to changes in the cost of
capital is less than one tenth the long run response when the economy has had a
depressed immediate history, while this elasticity can rise by over 50 percent when
the economy is undergoing a sustained expansion.

74 Also see Gross (1994) for empirical evidence and a model integrating financial constraints and
irreversibility.
75 See e.g. Kiyotaki and Moore (1997).

858

R.J Caballero

Still, the mapping from microeconomics to aggregate investment dynamics especially equilibrium aggregate investment dynamics - is probably more complex
than just the direct aggregation o f very non-linear investment patterns. Informational
problems lead to a series o f strategic delays which feed into and feed off o f the natural
inaction o f lumpy adjustment models. This process has the potential to exacerbate
significantly the time varying n a c r e o f the elasticity o f aggregate investment with
respect to aggregate shocks.
Moreover, sunk costs provide fertile ground for opportunistic behavior. In the
absence o f complete contracts, aggregate net investment is likely to become excessively
volatile. The lack o f response o f equilibrium payments to complementary - and
otherwise inelastic - factors (e.g. workers), exacerbates the effects o f shocks
experienced b y firms. Also, the withdrawal o f financiers' support during recessions
further reduces investment. Thus, capital investment seems to be hurt at both ends:
workers that do not share fairly during downturns, and financiers that want to limit
their exposure to potential appropriations from entrepreneurs which cannot credibly
commit not to do so during the recovery.
The last two themes, equilibrium outcomes with informational problems and
opportunism, are wanting for empirical work. I therefore suspect that we will see plenty
o f research filling this void in the near future.

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of Law and Economics 22(2, October):233-261.
Williamson, O.E. (1985), The Economic Institutions of Capitalism (Free Press, New York).

Chapter 13

INVENTORIES *
VALERIE A. RAMEY

University of California - San Diego

KENNETH D. WEST

University of Wisconsin

Contents
Abstract
Keywords
Introduction
1. Sectoral and secular behavior of inventories
2. Two stylized facts about inventory behavior
2.1. Procyclical inventory movements
2.1.1. Illustrative evidence
2.1.2. A survey of results
2.2. Persistent movements in the inventory-sales relationship
2.2.1. Illustrative evidence
2.2.2. A survey of results

3. Linear quadratic models

3.1. Introduction
3.2. A model
3.3. A first-order condition
3.4. Whose inventories?

4. Decision rule
4.1. Introduction
4.2. Derivation of decision rule
4.3. Persistence in the inventory-sales relationship
4.4. Summary on persistence in the inventory-sales relationship

5. The flexible accelerator model

864
864
865
868
872
873
873
875
877
877
880
882
882
882
885
887
887
887
888
891
892
893

* We thank the National Science Foundation and the Abe Foundation for financial support; Clive
Granger, Donald Hester, James Kahn, Anil Kashyap, Linda Kole, Spencer Krane, Scott Schuh, Michael
Woodford and a seminar audience at the University of Wisconsin for helpful comments and discussions;
and James Hueng and especially Stanislav Anatolyev for excellent research assistance. Email to:
kdwest @ facstaff, wisc. edu; vrameyOweber, ucsd. edu.

Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford

1999 Elsevier Science B.V. All rights reserued
863

864
6. Dynamic responses
7. Empirical evidence
7.1. Introduction
7.2. Magnitude of cost parameters
7.3. Shocks
7.4. Interpretation
8. Directions for future research
8.1. Introduction
8.2. Inventories in production and revenue functions
8.3. Models with fixed costs
8.4. The value of more data
9. Conclusions
Appendix A. Data Appendix
Appendix B. Technical Appendix
B.1. Solution of the model
B.2. Computation of E(Q2 - S2)
B.3. Estimation of
B.4. Social planning derivation of the model's first-order conditions
References

V.A. Ramey and K.D. West

894
902
902
903
906
906
909
909
909
910
911
912
913
914
914
919
919
919
920

Abstract
We review and interpret recent work on inventories, emphasizing empirical and
business cycle aspects. We begin by documenting two empirical regularities about
inventories. The first is the well-known one that inventories move procyclically. The
second is that inventory movements are quite persistent, even conditional on sales.
To consider explanations for the two facts, we present a linear-quadratic model. The
model can rationalize the two facts in a number o f ways, but two stylized explanations
have the virtue o f relative simplicity and support from a number o f papers. Both
assume that there are persistent shocks to demand for the good in question, and that
marginal production cost slopes up. The first explanation assumes as well that there
are highly persistent shocks to the cost o f production. The second assumes that there
are strong costs of adjusting production and a strong accelerator motive.
Research to date, however, has not reached a consensus on whether one of
these two, or some third, alternative provides a satisfactory explanation o f inventory
behavior. We suggest several directions for future research that promise to improve
our understanding o f inventory behavior and thus o f business cycles.

Keywords
J E L classification: E22, E32

Ch. 13:

Inventories

865

Introduction
In developed countries, inventory investment typically averages less than one-half of
one percent of GDP, whereas fixed investment averages 15% of GDP and consumption
two-thirds. Perhaps with these fractions in mind, macroeconomists have concentrated
more on the study of consumption and fixed investment than on inventories. Inventories
generally do not appear as separate variables in dynamic general equilibrium models,
nor in exactly identified vector autoregressive models.
It has long been known, however, that other ways o f measuring the importance
of inventories suggest that inventories should receive more attention, especially in
business cycle research. Half a century ago, Abramowitz (1950) established that US
recessions prior to World War II tended to be periods of inventory liquidations. Recent
experience in the G7 countries indicates this regularity continues to hold, and not
just for the USA. In six of the seven G7 countries (Japan is the exception), real
GDP fell in at least one recent year. Line 2 of Table 1 shows that in five of those
six countries (the United Kingdom is now the exception), inventory investment also
declined during the period of declining GDP, accounting in an arithmetical sense for
anywhere 12-71% of the fall in GDE And Table 1 's use of annual data may understate
the inventory contribution: Table 2 indicates that for quarterly US data, the share is 49
rather than 12% for the 1990-1991 recession, with 49 a typical figure for a post-War
US recession.
Such arithmetical accounting of course does not imply a causal relationship. But
it does suggest that inventory movements contain valuable information about cyclical
fluctuations. In this chapter, we survey and interpret recent research on inventories,
emphasizing empirical and business cycle aspects. Among other points, we hope
to convince the reader that inventories are a useful resource in business cycle
analysis. They may be effective in identifying both the mechanisms of business cycle
propagation and the sources o f business cycle shocks.
Our chapter begins by documenting two facts about inventories. The first is the
well-known one that inventories move procyclically. They tend to be built up in
expansions, drawn down in contractions. The second, and not as widely appreciated,
fact is that inventory movements are quite persistent, even conditional on sales. In
many data sets, inventories and sales do not appear to be cointegrated, and the firstorder autocorrelations of supposedly stationary linear combinations of inventories and
sales are often around 0.9, even in annual data.
To consider explanations for the two facts, we use a linear quadratic/flexible
accelerator model, which is the workhorse for empirical research on inventories. In
our model, one source of persistence is from shocks to demand for the good being
put in inventory - "demand" shocks. ("Demand" is in quotes because we, and the
literature more generally, do not attempt to trace the ultimate source of such shocks;
for example, for an intermediate good, the shocks might be driven mainly by shocks
to the technology of the industry that uses the good in production.) But even if this
shock has a unit root, our model yields a stationary linear combination of inventories

V.A. Ramey and K.D. West

866

Table 1
Arithmetical importance of inventory change in recessions of the 1990s (annual data)a
Country

Canada France

(1) Peak year

trough year b
(2) Peak-~ough change in inventory change
as percentage ofpeak-to-~oughfallin GDP c

West
Italy Japan
Germany

UK

USA

1989
1991

1992
1993

1992
1993

1992
1993

n.a.

1990
1992

1990
1991

50

71

19

30

n.a.

-0.

12

a The figures are based on annual real data. The inventory change series is computed by deflating the
annual nominal change in inventories in the National Income and Product Accounts by the GDP deflator;
see the Data Appendix.
b The trough year was found by working backwards from the present to the last year of negative real
GDP growth in the 1990s. There were no such years in Japan. The peak year is the last preceding year
of positive real GDP growth.
c Computed by multiplying the following ratio by 100:
inventory change in trough year-inventory change in peak year
GDP in trough year- GDP in peak year
By construction, the denominator of this ratio is negative. A positive entry indicates that the numerator
(the change in the inventory change) was also negative. The negative entry for the United Kingdom
indicates that the change in the inventory change was positive.

Table 2
Arithmetical importance of inventory changes in post-war US recessions (quarterly data) a
Peak quarter-trough quarter

Peak-to-trough inventory change as a percentage of peak-to-trough

fall in GDP

1948:4-1949:2

130

1953:2-1954:2

41

1957:1-1958:1

21

1960:1-1960:4

122

1969:3-1970:1

127

1973:4-1975:1

59

1980:1-1980:3

45

1981:3-1982:3

29

1990:2-1991:1 b

49

a The figures are based on quarterly real data. See the notes to Table 1 for additional discussion.
b The figure for the 1990-1991 recession differs from that for the USA in Table 1 mainly because
quarterly data were used. It also differs because in this table the inventory change is measured in
chain weighted 1992 dollars, whereas Table 1 uses the nominal inventory change deflated by the GDP
deflator.

Ch. 13: Inventories

867

and sales. This stationary linear combination can be considered a linear version of
the inventory-sales ratio. We call it the inventory-sales relationship. And our second
inventory fact is that there is persistence in this relationship.
While the model is rich enough that there are many ways to make it explain the two
facts, we focus on two stylized explanations that have the virtue of relative simplicity,
as well as empirical support from a number of papers. Both explanations assume a
upward sloping marginal production cost (a convex cost function). The first explanation
also assumes that fluctuations are substantially affected by highly persistent shocks to
the cost of production. Cost shocks will cause procyclical movement because times of
low cost are good times to produce and build up inventory, and conversely for times of
high cost. As well, when these shocks are highly persistent a cost shock that perturbs
the inventory-sales relationship will take many periods to die off, and its persistence
will be transmitted to the inventory-sales relationship.
The second explanation assumes that there are strong costs of adjusting production
and a strong accelerator motive. The accelerator motive links today's inventories to
tomorrow's expected sales, perhaps because of concerns about stockouts. Since sales
are positively serially correlated, this will tend to cause inventories to grow and
shrink with sales and the cycle, a point first recognized by Metzler (1941). As well,
with strong costs of adjusting production, if a shock perturbs the inventory-sales
relationship, return to equilibrium will be slow because firms will adjust production
only very gradually.
Both explanations have some empirical support. But as is often the case in empirical
work, the evidence is mixed and ambiguous. For example, the cost shock explanation
works best when the shocks are modelled as unobservable; observable cost shifters,
such as real wages and interest rates, seem not to affect inventories. And the literature
is not unanimous on the magnitude of adjustment costs.
While the literature has not reached a consensus, it has identified mechanisms and
forces that can explain basic characteristics of inventory behavior and thus of the
business cycle. We are optimistic that progress can continue to be made by building
on results to date. Suggested directions for future research include alternative ways
of capturing the revenue effects of inventories (replacements for the accelerator),
alternative cost structures and the use of price and disaggregate data.
The chapter is organized as follows. Section 1 presents some overview information
on the level and distribution of inventories, using data from the G7 countries, and
focussing on the USA. We supply this information largely for completeness and to
provide a frame of reference; the results in this section are referenced only briefly in
the sequel.
Section 2 introduces the main theme of our chapter (business cycle behavior of
inventories) by discussing empirical evidence on our two facts about inventories.
Procyclical movement is considered in Section 2.1, persistence in the inventory-sales
relationship in Section 2.2. In these sections, we use annual data from the G7 countries
and quarterly US data for illustration, and also summarize results from the literature.

868

V.A. Ramey and K.D. West

Sections 3 - 7 develop and apply our linear quadratic/flexible accelerator model.

Sections 3-5 present the model. Much o f the analysis in these three sections relates
to the process followed by the inventory-sales relationship, because this process has
not received much direct attention in existing literature. The discussion focuses on
analytical derivations, for the most part deferring intuitive discussion about how the
model works to Section 6. That section aims to develop intuition by presenting impulse
responses for various configurations o f parameters. Section 7 reviews empirical
evidence from studies using the model.
In Section 8, we discuss extensions and alternative approaches, including models
that put inventories directly in production and profit functions, models with fixed costs,
and the use o f different data. Section 9 concludes. A Data Appendix describes data
sources, and a Technical Appendix contains some technical details.

I. Seetoral and secular behavior of inventories

In this section we use basic national income and product account data from the
G7 countries, and some detailed additional data from the USA, to provide a frame of
reference for the discussion to come. As just noted, for the most part this is background
information that will not loom large in the sequel.
Lines 1(a) and 1(b) of Table 3 present the m e a n and standard deviation of the real
annual change in economy wide inventory stocks in the G7 countries, over the last
40 years. These were computed from the national income and product account data on
Table 3
Basic inventory statistics
Canada

France

West
Germany

Italy

Japan

UK

USA

(1) Annual NIPA change in inventories, 1956 1995a,b

(a) Mean

2.32

37.4

12.3

12.3

2.41

1.81

23.6

(b) Standard deviation

3.91

40.1

12.7

9.8

1.44

3.04

21.6

(2) Reference: 1995 GDP c

721

6882

2608

1351

453

584

6066

(3) 1995 Inventory leveld

131

n.a.

411

n.a.

71

104

971

a The inventory change series is computed by deflating the annual nominal change in inventories in the
National Income and Product accounts by the GDP deflator; see the Data Appendix. Units for all entries
are billions (trillions, for Italy and Japan) of units of own currency, in 1990 prices.
b Sample periods are 1957-1994 for West Germany and 1960-1994 for Italy, not 1956-1995.
c GDP entries for Italy and Germany are for 1994, not 1995.
d The "level" entries for Canada, West Germany, Japan and the UK are computed by deflating the
nominal end of year value by the GDP deflator; see the Data Appendix. The entry for the US is the
Department of Commerce constant (chained 1992) dollar value for non-farm inventories, rescaled to
a 1990 from a 1992 base with the GDP deflator.

869

Ch. 13." Inventories

Table 4
Sectoral distribution of US non-farm inventories a,b
(1) Percent of total
level, 1995

(2) Mean (s.d.) of

change

(3) Mean (s.d.) of

growth

100

21.4
(22.5)

3.5
(3.5)

37

7.0
(11.6)

2.8
(4.2)

Finished goods

13

2.5
(4.4)

3.0
(4.8)

Work in process

12

2.3
(5.9)

2.8
(6.0)

Raw materials

12

2.2
(5.4)

2.6
(6.2)

52

12.2
(13.4)

4.4
(4.5)

Retail

26

5.9
(10.3)

4.2
(6.7)

Wholesale

26

6.2
(7.3)

4.5
(4.8)

11

2.2
(5.1)

3.1
(5.8)

Total
Manufacturing

Trade

Other

a Data are in billions of chained 1992 dollars, 1959:I-1996:IV.

b The inventory change differs from the US data on changes in Tables 1 7 in coverage (Tables 1-3
include changes in farm inventories), in sample period (195%1996 here, 1956-I995 in Table 3) and in
base year (1992 here and Table 2, 1990 in Tables 1 and 3).
the change in aggregate inventories. See the notes to the table and the Data Appendix
for details.
Upon comparing line 1(a) to line 2, we see that in all seven countries, the average
change in inventories is small, about one percent o f recent GDP in Italy, well less than
that in other countries. Inventory changes are, however, reasonably volatile, with the
standard deviation roughly as large as the mean in all seven countries.
We have less complete data on the level (as opposed to the change) o f inventory
stocks. Line 3 o f Table 3 indicates that in the countries for which we have been able
to obtain data, total inventories are about one-sixth o f GDP. This implies a monthly
inventory-sales ratio o f about 2, a value that will be familiar to those familiar with
monthly US data.
Table 4 has a breakdown o f US non-farm inventories by sector. We see in column 1
that about h a l f o f non-farm inventories are held by retailers and wholesalers (including

V.A. Ramey and K.D. West

870
I

,I

06

o6

.9

current dollars

.8

,7

,'\ ,..,,,,',,,",

,,.

.6
"t " ~ ""

""~

'

chained 1992 dollars

,5

56

6b

66

76

year

ob

Fig. 1. Quarterly ratio of nonfarm inventories to final sales.

non-merchant wholesalers who are associated with particular manufacturers), whereas

somewhat over a third are held by manufacturers. The remaining "other" category
reflects holdings by a number of industries, including utilities, construction, and service
companies.
Like the aggregates in Table 3, investment in each of the components is positive
on average, and has standard deviations about the same size as means. This applies
whether one looks at arithmetic changes (column 2) or growth rates (column 3). For
future reference, it will be useful to note that manufacturers' inventories of finished
goods, which have received a fair amount of attention in the inventory literature, are
only 13% of total inventories, and are not particularly volatile.
Figure 1 plots the ratio of total non-farm inventories to final sales of domestic
product. The dashed line uses real data (ratio of real inventories to real sales), the solid
line nominal data. In the real data, the inventory series matches that in line 1 of Table 4,
but over the longer sample 1947:I-1996:IV (Table 4 uses the 1959-1996 subsample
because the disaggregate breakdown is not available 1947-1958.) The real ratio shows
a run-up in the late 1960s and early 1970s, followed by a period of slight secular
decline. At present, the ratio is modestly above its value at the start of our sample
(0.63 vs. 0.56). It will be useful to note another fact for future reference. The figure
suggests considerable persistence in the inventory-sales ratio, an impression borne out
by estimates of first-order autocorrelations. These are 0.98 for the sample as whole,
0.93 if the autocorrelation is computed allowing for a different mean inventory-sales
ratio for the 1947:I-1973:IV and 1974:I-1996:IV subsamples.

871

Ch. 13: Inuentories

I
1096.7

.pi

.S
I

20t.8
3513

'

17A3.97

final sales of domestic business

Fig. 2. Quarterly inventories and sales, 1947:1-1996:4, in billions of chained 1992 dollars.

Readers familiar with the monthly inventory-sales ratios commonly reported in the
US business press may be surprised at the absence of a downward secular movement.
Such monthly ratios typically rely on nominal data. The solid line in Figure 1
shows that the ratio of nominal non-farm inventories to nominal sales of domestic
product indeed shows a secular decline. Evidently, the implied deflator inventories
has not been rising as fast as that for final sales. We do not attempt to explain the
differences between the nominal and real series. We do note, however, the nominal
ratio shows persistence comparable to that of the real ratio. The estimate of the firstorder autocorrelation of the ratio is 0.97 whether or not we allow a different mean
inventory-sales ratio for the 1947:I-1973:IV and 1974:I-1996:IV subsamples.
To return to the secular behavior of the real series: we see from column 3 in Table 4
that the rough constancy of the overall ratio hides some heterogeneity in underlying
components. In particular, raw materials, and to a lesser extent, work in progress,
have been growing more slowly than the aggregate, implying a declining ratio to final
sales. This fact was earlier documented by Hester (1994), who noted that possible
explanations include just-in-time inventory management, outbasing of early stages of
manufacturing to foreign countries, and a transitory response to transitory movements
in costs.
In the sequel we do not attempt to explain secular patterns in inventory-sales ratios;
see Hester (1994) for a discussion of US data, for retail as well as manufacturing, West
(1992a) and Allen (1995) for discussions of Japanese data. Instead we hope that the
reader will take the message away from these tables that inventories and sales are
positively related in the long run: they tend to rise together. This is illustrated quite

872

V.A. Ramey and K.D. West

strikingly in Figure 2, which is a scatterplot o f the inventory and sales data. A second
message in the tables and the autocorrelations reported above is that while inventory
movements are small relative to GDP, they are volatile and persistent. Characterizing
and explaining the stochastic, and especially business cycle, behavior o f inventories is
the subject o f the rest o f this chapter.

2. Two stylized facts about inventory behavior

Our essay focuses on the business cycle aspects o f inventory behavior, and is oriented
around two stylized facts: (1) inventory movements areprocyclicaL (2) the inventorysales relationship is highly persistent (the inventory-sales relationship is our term for a
linear version o f the inventory-sales ratio). These facts serve two purposes. First, they
demonstrate the potential role o f inventories in understanding economic fluctuations.
Second, they serve as a measure by which we j u d g e inventory models and, more
generally, theories o f the business cycle.
For each o f the two "facts", we present illustrative evidence from annual, postWorld War II data, for the G7 countries, as well as from quarterly post-War US data. We
then review estimates from the literature. For the first o f our stylized facts (procyclical
movements), Section 2.1.1 below presents estimates, Section 2.1.2 presents the review.
Sections 2.2.1 and 2.2.2 do the same for the second o f our facts (persistence in the
inventory-sales relationship). The remainder o f this introductory subsection describes
the data used in both 2.1 and 2.2.
For the G7 countries, we continue to use the aggregate (nation-wide) change in
inventory stocks used in previous sections, and construct a time series o f inventory
levels b y summing the change 1. We measure production as GDP and sales as final
sales. The quarterly US inventory data are that used in the previous section, total
non-farm inventory and final sales o f domestic product in chained 1992 dollars, and
with sales measured at quarterly rates 2.

1 When we summed the AH t series, we initialized with H 0 _: 0. Given the tinearity of our procedures,
the results would be identical if we instead used the AH t series to work forwards and backwards from
the 1995 levels reported in Table 3. The reader should be aware that when prices are not constant, a
series constructed by our procedure of summing changes typically will differ from one that values the
entire level of stock at current prices. Those with access to US sources can get a feel for the differences
by comparing the inventory change that figures into GDP (used in the G7 data, and in NIPA Tables
5.10 and 5.11) and the one implied by differencing the series for the level of the stock (used in our
quarterly US data and NIPA Tables 5.12 and 5.13).
2 We repeated some of our quarterly calculations using final sales of goods and structures, which differs
from total final sales because it excludes final sales of services. There were no substantive changes in
results.

Ch. 13: Inventories

873

All of these measures are linked by the identity production = sales + (inventory
investment), or

Qt = st +AHt,

(2.1)

where Qt is production, St are sales, and Ht is end of period t inventories. This

relationship holds by construction, with St being final sales.

2.1. Procyclical inventory movements

2.1.1. Illustrative evidence
Procyclicality o f inventory movements can be documented in several ways. A simple
indication that inventories move procyclically is a positive correlation between
inventory investment and final sales. Consider the evidence in Table 5. In column 1
we see that all the point estimates of the correlation are positive, with a typical value
being 0.1-0.2.
The correlation between sales and inventory investment is related to the relative
variances of production and sales. As in Table 5, let "var" denote variance,
"cov" covariance. Since (2.1) implies var(Q) = var(S) + var(AH) + 2 cov(S, AH), it
follows from the positive correlation in column 1 that var(Q)> var(S) (column 2).
Other indications of procyclical behavior include two variance ratios robust to the
possible presence of unit autoregressive roots. The column 3 estimates indicate that
var(AQt)/var(ASt)> 1, the column 4 estimates that E(Q2-S2t)>O. [E(Q~-S~) is
essentially an estimate of var(Q)-var(S) robust to the presence of unit autoregressive
roots; see the Technical Appendix.]
To illustrate the pattern of correlation over different short-run horizons, we present
impulse response functions. The responses are based on a bivariate VAR in the level
of inventories and sales for the quarterly US data, including eight quarterly lags, a
time trend, and breaks in the constant and trend at 1974. In accordance with this
section's aim of presenting relatively unstructured evidence, we present responses
to a one standard deviation shock to the VAR disturbances themselves, and not to
orthogonalized shocks. Figure 3 shows the responses of inventories and sales to a
disturbance to the sales equation, Figure 4 the responses to a disturbance to the
inventory equation. To prevent confusion, we note that on the horizontal axis, we plot
the pre-shock (period - 1 ) values of the variables; the shock occurs in period 0.
Figures 3 and 4 both show a positive comovement of inventories and sales. In
Figure 3, by construction the contemporaneous (period 0) response of inventories is
zero. But the 7 billion (approximately) dollar rise in sales in period 0 is followed in
the next quarter by a 1.5 billion dollar increase in inventories. Inventories continue to
rise for the next five quarters, even after sales turn down. Both series smoothly decline
together.
Figure 4 shows that after a 3 billion dollar shock to inventories, sales rise by
nearly 2 billion dollars. Both inventories and sales subsequently show some wiggles.

874

V.A. Ramey and K.D. West

Table 5
Relative variability of output and final sales a-e
Country

Period

(1)
corr(S, AH)

(2)
var(Q)/var(S)

(3)
var(AQ)/
var(AS)

(4)
1 + [E(Q 2 - S 2)/
var(AS)]

Canada

1956 1995
1974-1995
1956 1995
1974-1995
1957-1994
1974-1994
1960-1994
1974-1994
1956-1995

0.14
0.17
0.17
0.32
0.12
0.13
0.13
0.11
0.23

1.16
1.21
1.36
1.63
1.10
1.08
1.30
1.27
1.07

1.53
1.55
1.65
2.09
1.36
1.27
1.81
1.83
1.10

1.41
1.24
1.68
1.41
1.01
1.03
1.12
1.08
1.30

1974-1995
1956-1995
1974-1995
1956-1995
1974-1995
1947:I-1996:IV
1974:I-1996:IV

0.51
0.28
0.26
0.26
0.25
0.30
0.14

1.15
1.21
1.17
1.19
1.21
1.26
1.13

1.08
1.52
1.38
1.48
1.50
1.39
1.40

1.12
1.10
1.04
1.12
0.98
1.41
1.48

France
West Germany
Italy
Japan
UK
USA
USA

a "var" denotes variance, "corr" correlation, Q = output, S = final sales, A H - change in inventories. The
variables are linked by the identity Q = S + AH.
b In all but the last row, data are annual and real (1990 prices), with Q=real GDP, S=real final sales,
AH=real change in aggregate inventories. In the last row the data are quarterly and real (1992 prices),
with S=final sales of domestic business goods and structures, AH=ehange in non-farm inventories,
and Q _=S + AH. See the text and Data Appendix for sources.
c In colmnns 1 and 2, Q and S were linearly detrended, with the full sample estimates allowing a shift in
the constant and trend term in 1974 (1974:I in the last row); AH was defined as the difference between
detrended Q and S. In columns 3 and 4, AQ and AS were simply demeaned, again with the full sample
estimates allowing a shift in the mean in 1974 (1974:I).
d In column 4, the term E(Q 2 - S 2) essentially is the difference between the variance of Q and the
variance of S, computed in a fashion that allows for unit autoregressive roots in Q and S. See the
Technical Appendix for further details.
e The post-1973 sample, as well as the post-1973 shifts in the full sample estimates, were included to
allow for the general slowdown in economic activity.

This s h o c k a p p e a r s to h a v e m o r e p e r s i s t e n t e f f e c t s t h a n does the sales s h o c k , w i t h

i n v e n t o r i e s still over 2 b i l l i o n dollars a b o v e t h e i r initial level after six years.
T h e i m p o r t a n t p o i n t is t h a t b o t h sets o f i m p u l s e r e s p o n s e f u n c t i o n s offer t h e s a m e
p i c t u r e o f p r o c y c l i c a l i n v e n t o r i e s as t h e statistics i n Table 5. T h u s , i n v e n t o r i e s s e e m
to a m p l i f y r a t h e r t h a n m u t e m o v e m e n t s i n p r o d u c t i o n .

Ch. 13. Inventories

875
I

Ig

2b

2~

lg

2b

2a

8.7077

v,%.

o~
01

/
o

inventories

,--4

/
i ...........................................

quarter

Fig. 3. Response to sales equation shock, quarterly VAR.

I

5.01083

/ " ~__ inventories

d
\
/.f-~

f_

(7}
01

quarter

Fig. 4. Response to inventory equation shock, quarterly VAR.

2.1.2. A survey o f results

As many readers no doubt are aware, similar findings have been reported for many
though not all data sets. A brief summary of estimates o f variance inequalities in
studies using aggregate data: Fukuda and Teruyama (1988) report comparable results

876

V.A. Ramey and K.D. West

for industrialized countries, but also conclude that by contrast in less developed
countries GDP tends to be smoother than final sales 3. Beaulieu and Miron (1992)
report that in manufacturing in some industrialized countries, seasonals in production
are no less variable than those in sales.
For US quarterly economy-wide or monthly two-digit manufacturing data, the
pattern is as pronounced as in Table 5. This applies first of all to demeaned or
detrended data such as is reported in Table 5. For example, Blinder (1986a) reports
var(Q)/var(S) > 1 for 18-20 two-digit manufacturing industries. It also applies to
deterministic seasonals [West (1986), Miron and Zeldes (1988), Cecchetti et al.
(1997)]: in US manufacturing, seasonal variation in production tends to be larger than
seasonal variation in sales 4.
Finally, for both deterministic and stochastic terms, studies that have taken sampling
error into account sometimes but not always find it quite unlikely that sampling error
alone accounts for the lack o f evidence production smoothing [West (1986, 1990b)].
Does aggregation substantially account for the lack of production smoothing
evident in these studies, either because o f measurement error in aggregate data sets,
or heterogeneity across firms? Probably not. It has been argued persuasively that
disaggregate data measured in physical units are more accurate than the aggregate data
used in most studies [see Fair (1989), Krane and Braun (1991), and Ramey (1991)] 5
But as summarized below, studies with disaggregate data still find production more
variable than sales in many cases.
For evaluation of the effects o f firm heterogeneity, analytical arguments are not
particularly helpful. I f var(Q) > var(S) for a single firm, the inequality may be shown
analytically to apply to an aggregate o f firms if each individual firm solves a
linear quadratic problem such as the one presented below with identical parameters,
regardless o f the correlation o f demand shocks across firms [West (1983)]. But if
the cost functions are different for different firms, analytical results appear not to
be available. Lai (1991) and Krane (1994) show by example that aggregate variance
ratios might differ substantially from individual firm ratios. And even if we assume
identical parameters across firms, which as just noted implies that var(Q)/var(S)<~ 1 in
the aggregate, this aggregate ratio may be larger (or smaller) than that o f individual
firms, with the direction o f the bias depending on the correlation across firms of
demand shocks.
So to consider possible biases from aggregation we must turn from analytical to
empirical studies of data disaggregated to the firm or perhaps physical product level.

3 So far as we know, there have been no systematic attempts to explain this finding. It is possible that
measurement error plays a large role.
4 Carpenter and Levy (1998) report a related finding: for manufacturing, the spectra of inventory
investment and production show very high coherence at seasonal frequencies.
5 And the G7 data that we use for illustration are among the worst measured. In some countries, the
change in inventories apparently is constructed at least initially as the difference between product and
income estimates of GDP, and thus includes the statistical discrepancy. See West (1990a).

Ch. 13." Inventories

877

The disaggregate picture is broadly similar though less striking than the aggregate one,
at least in the relatively well-studied USA. Production smoothing is markedly absent in
the automobile industry [Blanchard (1983), Kashyap and Wilcox (1993)]. But Krane
and Braun (1991) found production is less variable than sales in about two thirds of
a set of 38 physical products. Finally, Schuh (1996) found deseasonalized production
less variable than deseasonalized sales in only one fourth of 700 manufacturing firms;
deterministic seasonals in production were less variable than those in sales in about
half the firms. For the deseasonalized data, Schuh reports that the median ratio of
production to sales variance was about 1.1, which is consistent with the US figure
reported in column 2 of Table 5.
2.2. Persistent movements in the inventory-sales relationship
Our second stylized fact is that the inventory-sales relationship is highly persistent.
While there may be a steady state linear relationship between inventories and sales,
movement towards that steady state is very slow. This characteristic may be more
recognizable to inventory experts if it is stated as a "slow speed of adjustment"; a link
between persistence in the inventory-sales relationship and the speed of adjustment is
demonstrated formally in Sections 4 and 5 below. Section 2.2.1 illustrates this with the
annual G7 and quarterly US data used above, Section 2.2.2 documents it with citations
to various papers.
2.2.1. Illustrative evidence
To illustrate persistence, we use a standard technique described in the Technical
Appendix to attempt to find a stationary relationship between the levels of inventories
and sales. This yields Ht - ~OSt for a parameter 0 estimated from the data. Those
familiar with the literature on cointegration will recognize Ht - OSt as the (estimated)
error-correction term if inventories and sales have unit autoregressive roots and are
cointegrated. We refer to H t - OSt as the inventory-sales relationship, sinee it is a
generalized linear version of the inventory-sales ratio. More precise terminology for
this variable is "deviation from the long-run inventory-sales relationship." In our view,
the disadvantages of the length of this term outweigh the advantages of being more
precise.
After obtaining 0, we estimate the first two autocorrelations in the putatively
stationary variable Ht - "OSt, to gauge the extent of persistence in the relationship. We
emphasize that our aim is merely to document quickly evidence of high persistence,
not to work towards a complete time series model, nor even to endorse the use of unit
roots as a modeling device; among other tasks, the latter would require testing for unit
roots in Ht and St, perhaps allowing for a one-time shift in mean in 1974, and so on.
Rather, this is a way of organizing facts and theories about inventories that has some
rough plausibility for a wide range of data.

878

V..A. Ramey and K.D. West

Table 6
Persistence in stationary linear combinations of inventories and sales a,b
Country

Period

(1) Estimate of cointegrating

parameter 0

(2) First two autocorrelations

of H t - OSt

Canada

1956-1995

0.16

0.92

0.82

France

1956-1995

0.31

0.95

0.89

West Germany

1957 1994

0.27

0.93

0.82

Italy

1960 1994

0.45

0.88

0.80

Japan

1956-1995

0.22

0.97

0.91

UK

1956-1995

0.20

0.95

0.87

USA

1956-1995

0.24

0.88

0.82

USA

1947:I-1996:IV

0.68

0.94

0.88

USA

1947:~1996:IV,
H and S in logs

1.12

0.95

0.90

a See notes to Table 5 for description of data and variable definitions.

b In the inventory-sales relationship H t - O S t , the estimate 0 is obtained with the Stock and Watson
(1993) procedure to estimate a cointegrating vector. Details are in the Technical Appendix. If the
inventory and sales series have unit autoregressive roots, the adjective "stationary" used in the title to this
table applies only if the inventory and sales series in fact are cointegrated, and then only asymptotically.

Table 6 p r e s e n t s results. T h e T e c h n i c a l A p p e n d i x d e s c r i b e s c o m p u t a t i o n a l details.

C o l u m n s 1 a n d 2 p r e s e n t the e s t i m a t e s o f 0 a n d t h e first two a u t o c o r r e l a t i o n s o f
H t - OSt. I n c o l u m n 1, the e s t i m a t e s o f 0 are all p o s i t i v e , s u g g e s t i n g t h a t i n v e n t o r i e s
a n d sales m o v e t o g e t h e r p o s i t i v e l y in t h e l o n g r u n 6. B u t e v e n i f this is the case, the
result t h a t w e w i s h to e m p h a s i z e is in c o l u m n 2: all o f the first-order a u t o c o r r e l a t i o n s
are a b o v e 0.8. T h e r e is o f c o u r s e a d o w n w a r d b i a s i n e s t i m a t e s o f a u t o c o r r e l a t i o n s
n e a r 1, a n d a n a d d i t i o n a l b i a s i m p a r t e d b y t i m e a g g r e g a t i o n (recall t h a t t h e d a t a are
a n n u a l or q u a r t e r l y r a t h e r t h a n m o n t h l y ) . T h e c o l u m n 2 e s t i m a t e s t h u s s u g g e s t that
m e a n r e v e r s i o n takes p l a c e quite s l o w l y 7.

6 The technique used is not invariant to normalization. For the annual data, we re-estimated with
S t on the left instead of H t. Positive estimates of (1/0) resulted. On the other hand, if time trends are

included, negative estimates of 0 result for 4 of the 7 annual data sets.

7 Consistent with the high autocorrelation, the null of no cointegration cannot be rejected at the 5% level
in three of the seven annual data sets (Canada, Japan, USA), nor in the quarterly US data. This suggests
that for these three countries an appropriate model might be one in which there is no steady-state linear
relation between inventories and sales. As we shall see, the model to be presented rationalizes such lack
of a steady state with unit root cost shocks. When we quickly investigated the extent to which a onetime change in regime in 1974 could account for the persistence, we got mixed results. With post-1974
annual data, the autocorrelations fell; what is perhaps notable is that in one case (the USA) the fall was
dramatic, to 0.28 (vs. the 0.88 reported in Table 6). Next, using the quarterly data, we re-estimated using

Ch. 13: Inventories

879

P-_ B.7077

B.7077
P-_
I/
-4.58753

inventory-sales
relationship

V'
quapteP
Fig. 5. Response to sales equation shock, quarterly VAR.

We note that this g e n e r a l i z a t i o n applies w h e n we use logs instead o f levels o f

inventories and sales (last r o w o f the table). We noted above that the i n v e n t o r y - s a l e s
ratio displays h i g h autocorrelations. The upshot o f the last row is that transforming
to logs, and a l l o w i n g 0 1 - that is, considering not log(Hi~St) but log(Ht/S ) for a
freely estimated 0 - still suggests considerable persistence 8.
To illustrate the persistence f r o m a different perspective, Figures 5 and 6 depict the
response o f sales and the i n v e n t o r y - s a l e s relationship to shocks, u s i n g the same V A R
estimated for Figures 3 and 4. The sales responses are identical to those in Figures

the whole sample but allowing for different means in the 1947:I-1973:IV and 1974:I-1996:IV sample.
This reduced the estimate only slightly, to 0.89 and 0.94 (vs. the 0.94 and 0.95 values in Table 6).
Rossana (1998) carefully investigates the question of stability in two-digit US data. He finds evidence
of instability, and lack of cointegration within subsamples.
s Now seems an appropriate time to comment on the use of logs versus levels of the data, in response to
comments by two of the readers of an earlier version of this paper. Much empirical work in inventories,
and a distinct majority of work using intertemporal dynamic models, has relied on levels rather than
logarithms of the variables in question. We follow that convention in most of this paper. Working in
levels has the advantage of preserving the identity that links inventories, production and sales [see
Equation (2.1)]. In addition, inventory investment, as reported by the National Income and Product
Accounts, is defined as the change in the level of inventories, and is frequently negative, which further
discourages the use of logarithms. In a few cases, such as in the last row of Table 6, we do use logarithms.
That little turns on levels versus logs is suggested by the similarity of the results in the last two rows
in Table 6, and, more generally of the review of the literature that we are about to present: flexible
accelerator studies typically use data in logs, while linear quadratic studies typically use levels. Both
find great persistence.

V.A. Ramey and K.D. West

880
I

3.74996

~ . ,,'~'~

~4
"0
t~
t~
O~
~4

quapter,
Fig. 6. Response to inventoryequation shock, quarterlyVAR.
3 and 4. The inventory-sales relationship is computed using the estimated value of
= 0.68 from Table 6 to form a linear combination of the impulse response functions
for sales and inventories.
In response to a positive one standard deviation shock to the sales equation,
inventories rise, but less rapidly than do sales (see Figure 3). This induces the fall in
the inventory-sales relationship depicted in Figure 5. Eventually, inventories build up
more rapidly, leading to overshooting and an increase relative to the initial position.
Since both inventories and sales are close to their pre-shock values after six years
(see Figure 3), the inventory relationship returns as well, as Figure 5 shows. By
contrast, a shock to the inventory equation leads to a complicated pattern displaying
more persistence. The inventory-sales relationship rises initially by construction, and
then declines erratically for eight quarters before briefly rising again and then slowly
decaying. At the end of six years, a return to the pre-shock value is not evident:
these unrestricted VAR estimates suggest great persistence in the inventory-sales
relationship.
2.2.2. A suruey o f results

Table 6 and Figures 5 and 6 suggest that there is little mean reversion in economywide inventory-sales relationships. Congruent evidence comes from two sources,
unstructured tests such as in Table 6, and structural estimates of what is called a "speed
of adjustment".
Consider first the unstructured tests. Using quarterly economy-wide data, West
(1990b, 1992b) cannot reject the null of no cointegration for the USA and for

Ch. 13: Inventories

881

Japan. Using monthly US data, Granger and Lee (1989) find only mild evidence
for cointegration in monthly two-digit manufacturing and trade series; fewer than a
third of their 27 data sets reject the null of no cointegration at the 5% level, and the
median first-order autocorrelation of the putatively stationary linear combination of
inventories and sales is about 0.99. Rossana (1993, 1998) uses similar data and allows
a vector of cost variables W t to enter the cointegrating relationship. He uses regression
techniques to search for a combination H t - OSt - otI W t that is stationary. Wt is defined
to include real wages, real materials prices, nominal interest rates and inflation. In the
end, however, he finds mixed evidence of cointegration across H t , St and Wt. (He does
not report autocorrelations o f stationary linear combinations.)
In addition, a large literature has used structural inventory models to estimate the
"speed of adjustment". We shall describe such models below. For the moment, what
is relevant is that under conditions described below, a slow speed of adjustment is
equivalent to persistence in the inventory-sales relationship.
Let p be the largest autoregressive in H t - OSt, or H t - OSt - ct~Wt, with the latter
variable the relevant one if, as in the Rossana (1993, 1998) papers cited above, a vector
of cost variables is entered into the cointegrating relationship. The large empirical
literature has estimated inventory equations, with results implying that ~ is near 1.
A typical value in quarterly data is around 0.8-0.95.
The following are some examples. Using quarterly economy-wide data for some
industrialized countries, Wilkinson (1989) found ~ - 0.75-1.0, with W t including
one or more of: sales shocks, inflation, wages, raw materials prices and capacity
utilization. Similar results have repeatedly been found using monthly or quarterly US
manufacturing data. Examples include Maccini and Rossana (1981), Blinder (1986b),
and Haltiwanger and Maccini (1989). In these papers, Wt included one or more of:
factor prices such as wages, raw materials prices and real and nominal interest rates,
other factors of production such as labor, and sales expectational errors.
Does aggregation across heterogeneous firms substantially account for this high
serial correlation? We are not aware of analytical arguments establishing genera]
conditions under which aggregate estimates of p will be higher than typical firmspecific estimates, though no doubt such arguments could be constructed. Simulations
in Lovell (1993) and a limited amount of empirical evidence suggests that aggregation
does impart a bias. Schuh (1996) reports that for monthly data for 700 manufacturing
firms, the median estimate of p is about 0.6 (Wt includes a real interest rate); for
quarterly data for some publicly owned firms, and with Wt including measures of
credit conditions, ~ is reported to be about 0.6-0.8 by Carpenter et al. (1994, 1998),
although a somewhat higher value of about 0.9 is found by Kashyap et al. (1994)10
9 The autocorrelation was computed from the Durbin-Watson statistic reported in the last column of
Table II in Granger and Lee, using 2(1 -~) = d.w.
10 A small literature has discussed how estimation ofp is affected when the decision interval for firms
is smaller than the sampling interval of the data [Christiano and Eichenbaum (1989), Jorda (1997)].
Such time aggregation does not appear capable of explaining the high persistence.

882

V.A. Ramey and K.D. West

Of course, tests for cointegration have notoriously low power. And there is
heterogeneity of estimates o f p implied by the flexible accelerator literature. But these
results suggest that there is little evidence that mean reversion of Ht - OSt towards its
mean takes place rapidly, and considerable evidence of persistence. To interpret such
persistence, as well as the procyclical behavior discussed in the previous section, we
now present a standard inventory model.

3. Linear quadratic models

3.1. Introduction

The linear quadratic inventory model dates back to Holt et al. (1960). Although this
book is written in an operations research style that suggests that its main aim was to
provide practical advice to managers, it may still be profitably reviewed by economists
interested in inventory behavior. In fact, Holt et al. (1960) develop models more general
than those in many of the applications we review here: they allow for stockout costs,
order backlogs, and stochastic variation in costs.
Early uses of a linear quadratic model to interpret macro data include Childs
(1967) and Belsley (1969). Tools developed in the 1970s and 1980s to estimate and
interpret decision rules and first-order conditions from rational expectations models
[e.g., Hansen and Sargent (1980), Hansen and Singleton (1982)] were subsequently
used by many authors to estimate one or another version of the model. Some papers
used aggregate data (sometimes economy wide, sometimes at the two-digit level); some
used data at the level of individual firms or physical products.
It is this more recent literature that we review in this and the next four sections.
The focus of this literature, and of our discussion, is on how production parameters
and constraints influence the intertemporal interaction between production, sales and
inventories. While different papers of course vary in the details of the model, there is
sufficient commonality that the model presented in Section 3.2 may fairly be described
as representative. Section 3.3 derives a first-order condition. Section 3.4 discusses
whether the model is applicable to a wide range of inventories.
Table 7 lists notation, and may be a useful reference in this and subsequent sections.
3.2. A model

We assume that a firm maximizes the present value of future cash flows. In macro
applications this will be a representative firm. In the formal statement of the model
about to be given, we omit constant, linear and trend terms for notational simplicity.
Earlier work provides tediously detailed treatment o f such terms, allowing for trends
that are either arithmetic [West (1983)] or geometric [working paper versions of West
(1988, 1990b)].

Ch. 13:

Inventories

883
Table 7
Variable and parameter definitions a

A. Definitions of basic variables

H t

inventories at end of period t

H t -H i

stationary linear combination o f l i t , S t and W t when Udt and W t have

unit autoregressive roots, but Uct does not; H t - H i = H t - ( OS t + aI W t )

H t -- OS t

inventory-sales relationship

Qt

production in period t

St

sales in period t

Uct

cost shifters, Uct = ~ W t + uct

uct

cost shock, unobservable to the economist

Udt

demand shock, unobservable to the economist

Wt

vector of observable cost shifters

B. Definitions of basic parameters

Mnemonic

Description

a0

cost o f changing production

Section b
3.2

a1

cost o f production

3.2

a2

inventory holding cost

3.2

a3

accelerator term for inventories

3.2

discount factor

3.2

inverse of slope o f demand curve

4.2

a = - ( b a 2 ) ~(1- b ) a , coefficient vector on W t in H ;

3.3

coefficient vector on W t in Uct

3.2

0c

AR(1) coefficient of Uct , uct = 0cUct_l + ect

4.2

0d

AR(1) coefficient of Udt, Udt =0dUdt-I +edt

4.2

qSw

AR(1) matrix o f coefficients of W t , Wt = ~ w Wt 1 + ewt

4.2

= a 3 [al(1-b)/ba2] , coefficient on S t in H i

3.3

:~H

an autoregressive root in H t - H i when a 0 - 0

4.2

:v t, :v2

two autoregressive roots in H a H T when a 0 ~ 0

4.3

a All variables and parameters are scalars, with the exceptions of ewt, W t , a, ~t and q~w. The variables
in panel A are introduced in Section 3.2.
b Section where parameter is introduced.

W e u s e t h e f o l l o w i n g n o t a t i o n : P t is real p r i c e (say, r a t i o o f o u t p u t p r i c e to t h e w a g e ) ,
St

real sales, Q t real p r o d u c t i o n , H t

real e n d o f p e r i o d i n v e n t o r i e s , Ca real p e r i o d

c o s t s , b a d i s c o u n t f a c t o r , 0 ~< b < 1, a n d E t m a t h e m a t i c a l e x p e c t a t i o n s c o n d i t i o n a l o n

V.A. Ramey and K.D. West

884

information known at time t, assumed equivalent to linear projections. The objective

function is
T

max l i m r ~

Et Z

bj(Pt +ySt +j - Ct +j)

j-o
subject

(3.1)

to ~ Ct = 0.5a0AQ 2 + 0.5alQ 2 + 0.5a2(Ht-i - a3St) 2 + U c t Q t ,

( Qt = St + He -

He 1.

The scalar Uct is a cost shock, and, as discussed below, may depend on both observable
and unobservable variables. The term Pt +jSt +j is revenue. The analysis in this section
does not depend on specification of demand or market structure, so we defer discussion
o f P t + j S t +j until the next section.

The cost function Ct allows two possible roles for inventories. One is a production
smoothing role, in which inventories facilitate intertemporal allocation of production.
(N.B.: in much of the inventory literature, the phrase "production smoothing"
references smoothing from demand shocks; we use it to reference smoothing from
cost shocks as well.) This role is reflected in the terms in AQ 2 and Q2. The second
role is a revenue role, in which inventories allow a firm to satisfy demand that cannot
be backlogged. This role is reflected in the " a 3 S t " term in (Ht-1 - a3St)2; (He 1 - a 3 S t ) 2
induces an accelerator motive. In our discussion o f these terms, we assume for the
moment that a~ and a2 are positive, ao and a3 nonnegative.
The first production smoothing term, aoAQ2t, captures increasing costs of changing
production and of production. This represents, for example, hiring and firing costs.
Not all authors include this term, and, as discussed in Section 7, some empirical tests
find estimates of ao insignificantly different from zero.
The second production smoothing term, a~Q 2, reflects costs of production. It can
be interpreted as the second order term in a quadratic approximation to an arbitrary
convex cost function associated with a decreasing returns to scale technology. In data
with trends, this approximation would likely be around a growth path. (Recall that
constant and trend terms are omitted for notational simplicity.)
The accelerator term a 2 ( n t - 1 - a 3 S t ) 2 embodies inventory holding and backlog
costs. Consider first when a3 = 0, so that the term becomes a2H2t 1. Then this can
be interpreted as the second order term in a quadratic approximation to an arbitrary
convex inventory holding cost function. When a3 ~ 0, the term is intended to reflect
backlog (stockout) and batch as well as inventory holding costs, and thus captures a
revenue-related motive for holding inventories. Stockout costs arise when sales exceed
the stock on hand, perhaps entailing lost sales, perhaps entailing delayed payment if
orders instead are backlogged. Batch costs vary inversely with the stock of inventories,
since fewer production runs and larger lot sizes imply larger inventory levels on
average.
Ceteris paribus, the higher the stock of inventories, the less likely is a stockout and
the lower are stockout costs. As well, higher stocks result when the number of batches

Ch. 13: Inventories

885

falls, since lot sizes rise. On the other hand, higher stocks entail higher inventory
holding costs. This quadratic term approximates the tradeoff between the two costs,
with a3 rising as stockout costs rise relative to backlog costs. Holt et al.'s (1960) formal
derivation o f this time invariant approximation to this inherently nonlinear, and timevarying, cost is presented in Section 8. Note in any case that in many applications,
inventories are strictly positive and large relative to sales in all time periods, perhaps
in some data sets because o f aggregation over heterogeneous firms. So in such data,
careful treatment of nonlinearity may have limited empirical payoff. Section 8 below
discusses alternative approaches.
The final term in the cost function is UotQt. This captures exogenous stochastic
variation in costs. (We omit terms o f the form cost shock x A Q t and cost shock H t
to avoid needless algebraic complications.) In some applications Uct = 0 and this shock
is absent [West (1986)]; in others it is not observed by the economist and follows an
exogenous process [Eichenbaum (1989)]; in still others it has both observable and
unobservable components [Ramey (1991)]. To cover all three cases, we write
Uct = a' W t + Uct.

(3.2)

In (3.2), Wt is a vector o f observable components; uot is unobservable to the economist

and follows an exogenous process. In one or another paper, Wt includes variables such
as real wages, materials prices and real and nominal interest rates. If there are no such
components, W t - 0; if cost shocks are entirely absent, Uct =- 0 as well. For convenience
we refer to uct as a "shock", even though it may be serially correlated and partially or
fully observable.
3.3. A first-order condition

A n optimizing firm will not expect to increase cash flow by producing one more
unit this period, putting the unit in inventory, and decreasing production by one unit
next period, all the while holding revenue constant. Formally, upon differentiating the
objective function (3.1) with respect to H t we obtain 11
E t [a0(AQ, - 2bAQt +1 + b 2zxQt+2) + a l (Qt - bQt+ l) + ba2 (Ht - a3S,+ 1) + Uct

b Uct+i ] = O.

(3.3)
For discussion of the second o f our stylized facts (persistence in the inventory-sales
relationship), it will be helpful to note a low frequency implication o f Equation (3.3),
namely, that inventories and sales are cointegrated if St is I(1) and Uct is I(0). [Here,

11 The first-order condition derived assuming that [O(pt+jSt+j)/OHt]- O. This assumption is not
particularly appealing, since a 3 > 0 is motivated in part by stockout costs, and presumably increases
in H t will decrease stockouts and increase revenues (increase p,St). As noted above, our modeling of
stockout costs is crude but given data constraints in some applications the gains from more sophisticated
treatments perhaps are small. See Section 8 below for alternative treatments.

EA. Ramey and K.D. West

886

we use standard time series notation: a variable that is integrated o f order 0 - I(0),
for short - is one that is covariance stationary, with a spectrum that is finite and
strictly positive at all frequencies. An "integrated" variable - I(1), for short - is one
whose arithmetic difference is I(0). I(1) variables are sometimes called "difference
stationary", or as having unit autoregressive roots (a term that we used in Section 2).]
To see the cointegration result, write the term in brackets in Equation (3.3) as xt+2,
so that (3.3) is Etxt+2 = 0. If we replace expectations with realizations, we can write
(3.4)

Xt+2 = ~ t + 2 , tlt+2 ~ (Xt+2 -- Etxt+2) ~ I(0).

Note that even if some or all o f the variables that comprise xt+2 are integrated, ~t+2 will
still be stationary. Kashyap and Wilcox (1993) observe that xt+2 may be rewritten
Xt+2 =

ao( AQt - 2bAQt+l + b2 AQt+2) - b a l ( A H t + l

Agt+l) + all'r-It

- a2a3ASt+l - ba2OASt+l + ba2(Ht - OSt) + Uct - bEtUct+b

(3.5)

al(1 - b )
O~a

ba2

Suppose U c t ~ I ( O ) but H t , S t ~ I ( 1 ) . Then A H t ~ I ( O ) and A Q t ~ I ( O ) , and Equainventories and sales are

tion (3.4) (stationarity o f xt+2) requires H t - O S t - I ( O ) :
cointegrated with cointegrating parameter 0.
We focus on St ~ I ( 1 ) for concreteness and empirical relevance, but it is worth noting
that 0 is still economically interpretable in other cases. I f St and Uct are both I(0), then
O = E H t / E S t is the inventory sales ratio evaluated at steady state values o f St and Hr.
(Recall that we have omitted deterministic terms for notational simplicity.) I f St and
H t have deterministic drift ( E A S t ~ 0) - which is consistent with Uct either I(0) or
I(1), and St either I(1) or I(0) around trend 12 _ then O = E A H t / E A S t .
Suppose there are observable cost shifters. I f Uct = ~ l W t + u c t with W t ~ I ( O )
or W t ~ I ( 1 ) [see Equation (3.2)] then from similar logic Uct~[(O) ~ H t - O S t +
(ba2) 1(1 - b ) ' a I W t z H t - O S t - o f f W t
=- H t - H t ~ I(0): after controlling for
possibly nonstationary observable cost shifters, inventories and sales are cointegrated.
(Once again, OSt + a ~W t remains economically interpretable under other conditions on
presence or absence o f unit roots.)
We summarize the preceding two paragraphs as follows: if St HI(l),
H t - H t ~ I(0),
Uot ~ I(O)
Uct ~ I(O)

~
=~

H t = OSt,
Ht -

1-b

O = a3 - al - ba2 '

OSt + a ' W t ,

a =_

(3.6)

l-b_

--a.
ba2

Observe that this result does not require parametrization of the demand curve, or
specification o f market structure. Rossana (1995, 1998) assumes exogenous revenue
12 A variable xt is 1(0) around trend if Ext = m o + m lt for some m l ~ 0 and xt -Ex~ = I(0). Such variables
are sometimes called trend stationary.

Ch. 13: Inventories

887

and uses the resulting decision rule to provide a complementary proof that Uct ~ I(O)
[Uct ~I(0)] implies cointegration between H t and St (between H t , St and Wt).
3.4. Whose inoentories?

The preceding description o f the model suggests that manufacturers' inventories o f

finished goods are a natural area for applying the model. Indeed, a large fraction of
the inventory literature focuses on manufacturers' finished goods inventories, often in
six two-digit industries that are known as "production to stock". 13 To some, in fact,
the model is not a particularly attractive one for studying any other types of inventories
[e.g., Blinder and Maccini (1991)].
In connection with our discussion of Table 4's sectoral breakdown o f US inventories,
however, we noted that manufacturers' inventories of finished goods are a small and not
particularly volatile component of total inventories. If, indeed, the model is applicable
only to finished goods inventories, then it has limited relevance for aggregate inventory
fluctuations. We conclude this section by briefly noting that this arguably constitutes
an unadvisedly narrow reading of the model.
First, works in progress inventories apparently function as a buffer in many
industries, particularly ones that are production to order [West (1988)], and thus fit
naturally into the model. More importantly, however, it is possible that an invisible
hand causes a large aggregate to solve an optimization problem such as (3.1), using
transactions not explicitly modeled in Equation (3.1) to do so. This point was first
made by Blanchard (1983), who combined data from the production and retail sectors
of the auto industry, modelling explicitly the transactions between the two sectors,
and showed that the industry as a whole solved an optimization problem such as (3.1).
This is an illustration of the equivalence between a social planning and a decentralized
equilibrium, which is well known to occur under general circumstances.
We are therefore sympathetic to the view that there has been too strong a focus on
manufacturers' inventories o f finished goods. But we feel the implication may be not
that the model is of limited relevance, but that it, or related models that capture similar
forces, should be applied more widely.

4. Decision rule
4.1. Introduction

Section 4.2 briefly reviews alternative treatments of demand, and solves for a decision
rule under a simple specification. Section 4.3 derives the process followed by the

13 "Production to stock" industries are ones that typically sell finished goods off the shelf. By contrast,
"production to order" industries are ones that maintain order backlogs, often deferring final assembly
until orders are in hand. See Abramowitz (1950) and Belsley (1969).

888

V.A. Ramey and K.D. West

inventory-sales relationship, and may be skipped without loss of continuity. Section 4.4
summarizes the implications of Section 4.3 for persistence in the inventory-sales
relationship. We present a detailed treatment o f the inventory-sales relationship
because this process has not received much direct attention in existing literature.
Discussions o f procyclicality in subsequent sections will cite analytical results in
existing literature.
4.2. Derioation o f decision rule

Derivation o f a decision rule requires specification o f revenue because current and

expected sales and output appear in the first-order conditions. We begin by reviewing
some alternatives. We then work through in detail a specification that is relatively
tractable.
In some applications, sales is taken as exogenous, with cost minimization (i.e.,
m i n E t }--~/~0 bJCt+j) the objective 14. Examples include Holt et al. (1960), Belsley
(1969) and Blanchard (1983). The use o f this assumption in industry-wide data is
valid only if the demand curve facing the industry is vertical.
In other applications, an industry equilibrium is analyzed, and a linear demand curve
is specified [e.g., Eichenbaum (1984)]. We write such a demand curve in inverse form
as

Pt = - g S t + g [ f dt ~ -gSt + Udt.

(4.1)

In (4.1), Udt and Udt are stochastic. The demand curve is written in this form so
that exogenous sales is a special case of Equation (4.1), implemented by letting the
parameter g --+ oo and specifying ~rdt as exogenous; with g ---+ oo, St = Udt. In
practice, one needs to allow for serial correlation in Udt. In principle one might want
to rationalize such serial correlation with (say) costs of adjustment on the part of
purchasers, or with observable shifters o f the demand curve [West (1992b)]. But since
the model focuses on production, and, moreover, is typically not used to study the
effects of a hypothetical intervention or change in regime, taking such serial correlation
as exogenous is a useful simplification that will be maintained here.
Finally, Christiano and Eichenbaum (1989) and West (1990b), building on Sargent
(1979, ch. XVI) derive the linear demand curve (4.1) in general equilibrium. Both
papers assume a representative consumer whose per period utility is quadratic in St
and linear in leisure. The disturbance Udt is a shock to the consumer's utility. There is
no capital; the only means o f storage is inventories. See the cited papers for detail.

14 TO prevent confusion, we note that the first-order condition (3.3) also results if one assumes cost
minimization. So if one aims to use condition (3.3) to estimate model parameters, one can motivate the
equation by reference to cost minimization without taking a stand on the how revenue is determined
(apart from the caveat stated in Footnote 11).

Ch. 13: Inventories

889

Here, we do not derive Equation (4.1) in general equilibrium but take (4.1) as given.
We do not attempt to trace the demand shock back to preferences or other primitive
sources. We therefore caution the reader that despite the label "demand", Udt should
not be thought of as literally a nominal or monetary shock, since it (like all our
variables) is real. As well, one can imagine scenarios in which Udt reflects forces
typically thought of as supply side. If the good in question is an intermediate one, for
example, one can imagine that shocks to the technology of the industry that produces
the good dominate the movement of Uat.
Whatever the interpretation of Udt, we derive an industry equilibrium assuming a
representative firm. Even so, to obtain a decision rule, we must be specific about market
structure and the structure of the demand and cost shocks. We assume here that the
market is perfectly competitive, and normalize the number of firms to one. If the firm
is a monopolist, the reduced form is identical, but with a certain parameter being the
slope of the marginal revenue curve rather than the slope of the demand curve.
We assume that Wt, Udt and Uct follow exogenous AR processes, possibly with
unit autoregressive roots. By "exogenous" we mean "predictions of Wt, Udt and uot
conditional on lagged Ws, Uas and uos are identical to those conditional on lagged
Ws, Uds, uos, and industry-wide H s and Ss: Wt, Uat and uot are not Granger-caused
by industry-wide Ht or St". (Of course in general equilibrium, such exogeneity of Wt
is doubtful.)
Finally, for notational simplicity, and to make contact with the literature on the
"speed of adjustment" (see the next section), we tentatively assume that
a0 = 0.

(4.2)

This assumption is arguably not a good one empirically, and we will relax it below.
Under the assumption of perfect competition, there are two equivalent methods for
deriving the decision rules for inventories and sales. The first method, which studies the
decentralized optimization problem, derives the individual firm's first-order conditions
and then incorporates those into the industry equilibrium. The second method, which
uses a social planning approach, derives the first-order conditions for the social planner
problem and obtains decision rules for those. Both methods yield identical answers.
We exposit here the decentralized method, and present in the Technical Appendix
the social planner approach. With a0 = O, the first-order condition for sales St for the
representative firm is
Pt - Et[alQt - a2a3(Ht-i - a3St) + Uct] = O.

(4.3)

In the absence of inventories, this would simply tell our competitive firm to
set marginal revenue Pt equal to marginal cost a l Q t + U c t . The additional term
aaa3(Ht 1 - a3St) is the effect on inventory holding costs of an additional unit produced
for sale.
Upon using Pt = - g S t + Udt in Equation (4.3) and Qt =St + A H t in Equation (4.3)
and the inventory first-order condition (3.3), we obtain a pair of linear stochastic

V.A. Ramey and K.D. West

890

difference equations in Ht and St. This two equation system is solved in the Technical
Appendix. The resulting decision rule is
Ht = YgHHt-1 + distributed lag on uct, Udt and Wt,

(4.4a)

St = ~sHt 1 + a different distributed lag on uct, Udt and Wt.

(4.4b)

In (4.4a), srH is the root to a certain quadratic equation, ]~H[ < 1. Both ~ / a n d ~s
depend on b, g, al, a2 and a3. (Note two differences from the relatively well-understood
case of exogenous sales. Even when as, a2 > 0, i f g < oc: (a) it is in principle possible
to have :v~ ~<0, and (b) the accelerator coefficient a3 affects ~/t.) The distributed
lag coefficients on Uct, Udt and Wt depend on b, g, al, a2 and a3 as well as the
autoregressive parameters governing the evolution of the uct, Udt and Wt. In the
empirically relevant case of z~H > 0, ~H increases with marginal production costs al
and decreases with marginal inventory holding costs a2. The signs of OJvH/Oa3 and
OYfH/Og a r e ambiguous.
The solution when revenue is exogenous (g --+ c~) is obtained by replac~g Udt
with gUdt [see Equation (4.1)] and letting g ~ c~. In this case, :Vs =0, St = Udt and
the solution (4.4) may be written in the familiar form
H t = ~HHt I + distributed lag on St and on measures of cost,

(4.5a)

St N exogenous autoregressive process.

(4.5b)

On the other hand, when revenue is endogenous, :rs ~ 0 and we see in Equation (4.4b) that inventories Granger-cause sales. The intuition is that forward looking
firms adjust inventories in part in response to expected future conditions. Thus
industry-wide stocks signal future market conditions, including sales. This signalling
ability is reflected in Equation (4.4b).
These same results can be obtained directly from the social planner problem that
maximizes consumer surplus plus producer surplus, which is equal to the area between
the inverse demand and supply curves. See the Technical Appendix.
In empirical application, matching the data might require allowing shocks with
rich dynamics. Such dynamics may even be required to identify all the parameters
of the model. Blanchard (1983), for example, assumes that the demand shock follows
an AR(4). For expositional ease, however, we assume through the remainder of this
section that all exogenous variables - Udt, uct, Wt - follow first-order autoregressive
processes (possibly with unit roots). Specifically, assume that
Et-1 Wt = (I-)wWt 1,

Wt = CrAwWt-1 + ewt,

Et_lewt = O,

I I - ~wZl = 0 ~ Izl/> 1,
Et l Uct = q~cuct-1,
Et-1 Udt = ~ d U d t - 1 ,

Uct = q~cUct-1 + ect,

Udt = ~JdUdt-1 + edt,

Et-leot = 0,
Et ledt = O,

[q~c[ ~< 1,

]d[

~< 1.
(4.6)

Ch. 13:

Inventories

891

(Given the growth in the number of symbols, it may help to remind the reader that
Table 7 summarizes notation.) The Technical Appendix shows that the distributed lags
in Equation (4.4) are all first order, and Equation (4.4) is
H t = YfHHt-1 +f~/w W t + f HcUct + f HdUdt,

(4.7a)

St = ~sgt-I

(4.7b)

+ f t s w W t + f scUct + f sdUdt.

See the Technical Appendix for explicit formulas for the ')"s in terms of b, g, al, a2,
a3, qJw, q~c and q~d. Of course, if ~ = 0 so that Uct =uct, thenfHw = f s w =0.
4.3. Persistence in the inventory-sales relationship

To analyze the second of our stylized facts (persistence in the inventory-sales

relationship), we now further assume that the demand shock and the observable cost
shifters follow random walks:
(bd = 1, Udt = Udt 1 + edt, qDw = I , W t = Wt-1 + ewt.

(4.8)

Recall that if Uct is stationary, H t - OSt is stationary as well, where the cointegrating
parameter 0 is defined in Equation (3.5).
When there are no observable cost shifters (~ = 0 ~ fHw = f s w = 0), tedious
manipulation o f Equation (4.7) yields
H t - H t =~ H t - OSt = ~ H ( H t - l

- OSt-1) + mocuct -t- mlcUct l + modedt,

(4.9)

where moo, ml~ and m0d depend on O, f H o , f H d , f S c and f S d (see the Technical
Appendix). Let "L" be the lag operator. Since ( 1 - ~ c L ) u c t = e c t , it follows from
Equation (4.8) that
(1 - ~,vL)(1 - (bcL)(Ht - H t ) = vt,
vt = mocect + m~cect-i + mOdedt -- ~)cmOdedt-1 ~ MA(1).

(4.10)

Thus, H t - H t ~ ARMA(2, 1) with autoregressive roots Jr/4 and ~bc. (This presumes that
the moving average root in vt does not cancel an autoregressive root in H t - H i, which
generally will not happen.) Note that the innovation edt, rather than the shock Udt,
appears in Equation (4.9) and thus in Equation (4.10). With q~d ~ 1, however, the right
hand side of Equation (4.10) would include a linear combination of Udt and Udt-I
that would not reduce to a linear function of edt, and ~d would also be one of the
autoregressive roots of H t - H i . In this case, if ~d ~ 1, then Ht - H i would also have a
moving average root that would approximately cancel the autoregressive root of ~bd.
Similarly, when there are observable cost shifters (a ~ 0), it may be shown that
Equations (4.6) and (4.7) imply
H t - H i = H t - OSt - TIWt = :rH(Ht-i - OSt-1 - a1Wt-1) + disturbance,

disturbance

= m~owewt + mocUct + mlcUct-i + mOdedt.

(4.11)
Once again, persistence in H t - H 2 is induced by ;r,q and q~c.

892

V.A. Ramey and K.D. West

We close this subsection by re-introducing costs of adjusting production a0.

Suppose
a0 ~ 0.

(4.12)

It is well known that when revenue is exogenous (g ---+ oc), costs of adjusting
production put additional persistence in inventories [Belsley (1969), Blanchard
(1983)]: in this case Equation (4.5a) becomes
H t = Y g H I H t I + J~H2Ht 2 q- distributed lag on S t and on measures of cost,

(4.13)
with Y~H2~ 0. Unsurprisingly, inventory decisions now depend on Qt-1 =St-1 +Ht-1 H t - 2 and thus on Ht-2, even after taking into account Ht-t and the sales process.
As one might expect, the presence of costs of adjusting production has a similar
effect even when sales and revenue are endogenous, and on the inventory-sales
relationship as well as inventories. The Technical Appendix shows that a0 ~ 0 puts an
additional autoregressive root in Ht - H t , which now follows an ARMA(3, 2) process.
One autoregressive root is Oc. We let Jrl and Y~2 denote the two additional (possibly
complex) roots. These are functions of b, a0, al, a2, a3 and g. Intuition, which
is supported by the simulation results reported below, suggests that increases in a0
increase the magnitude of these roots.

4.4. S u m m a r y

on persistence

in t h e i n v e n t o r y - s a l e s

relationship

We summarize the preceding subsection as follows: assume the shocks follow the
AR(1) processes given in Equation (4.6), with the additional restriction (4.8) that the
demand shock and observable cost shifters follow random walks. Then
ao = 0 ~

H t - H t = H t - OSt - ct ~W t ~ ARMA(2, 1),

with AR roots : r t / a n d 0c.

(4.14)

The root ~H is a function of b, g and the ai, but not the autoregressive parameters of
the shocks, and is increasing in the marginal production costs at. In addition,
ao ~ 0 ~

Ht - Ht

=-- H t - OSt - a t W t ~

with AR roots ~1, ~2 and c;

if

0c=0,

Ht-H

ARMA(3, 2),
(4.15)

t~ARMA(2,1)

with AR roots Z~l and z~2.

The roots ,TgI and JL"2 are functions of b, g and the ai, but not the autoregressive
parameters of the shocks; both analytical manipulations of the formulas in the

Ch. 13: Inventories

893

Technical Appendix and simulations reported in Section 6 indicate that the modulus
o f the larger o f the roots increases with a0 and al 15
Thus the persistence documented in Section 2.2 above follows i f there are sharply
increasing production costs (a0 and/or al are sufficiently large) and/or serially
correlated cost shocks. In addition, it is important to observe that qualitatively similar
reduced forms are implied b y the following two scenarios: (1) serially correlated cost
shocks with no costs o f adjusting production, and (2) serially uncorrelated cost shocks
and sharply increasing costs o f adjusting production. We shall return to this point
below.
O f course persistence m a y also follow if we put different dynamics into the shocks
Wt, Uct and Udt.

5. The flexible accelerator model

We now derive (4.10)-(4.11) from another optimization problem. This optimization
problem is one that underlies empirical work motivated by the flexible accelerator
model. In this model, pioneered by Lovell (1961), firms solve a static one period
problem, balancing costs o f adjusting inventories against costs o f having inventories
deviate from their ffictionless target level H i. Specifically, the firm chooses H t to
minimize
0.5(Ht - H~) 2 + 0 . 5 v ( H t - Ht-l)2 + utHt.

(5.1)

In (5.1), v > 0 is the weight o f the second cost relative to the first, and ut is an
exogenous unobservable disturbance 16. The first-order condition is then
Ht-Ht-1

= [1/(1 + v ) ] ( H ; - H t - 1 ) -

[1/(1 + v)]ut.

(5.2)

The coefficient 1/(1 + v) is the fraction o f the gap between target and initial inventories
closed within a period. I f v is big (cost o f adjusting inventories is big), the fraction o f

~5 Under the present set of assumptions, then, the parameter called "p" in Section 2.2 is max{~H, $c}
if a 0 = 0, max{l~ l I, 1~2I,Oc} if a 0 0.
16 Ht and St are sometimes measured in logs [e.g., Maccini and Rossana (1981, 1984)], and the
variable ut is sometimes split into a component linearly dependent on the period t surprise in sales
and a component unobservable to the economist [e.g., Lovell (1961), Blinder (1986b)]. We slur over
differences between regressions in levels and logs, which in practice are small (see Footnote 8), and omit
a sales surprise term in the inventory regression, which in practice has little effect on the coefficients
that are central to our discussion.

V.A. Ramey and K.D. West

894

the gap expected to be closed is, on average, small. To make this equation operational,
target inventories H~ must be specified. Let
(5.3)

H t = OS, + a ' W t .

Here, Wt is a vector of observable cost shifters [as in Section 2.2.2 and Equation (3.2)].
Notation has been chosen because of link about to be established with 0 and a ~W t as
defined earlier. Suppose
S t = St-1 + edt,

W t = W t - 1 + ewt,

(5.4)

= 0. (In practice, Et-lSt is usually approximated as a linear function

of a number of lags of S, the actual number dependent on the data, and similarly
for Wt [e.g., Maccini and Rossana (1984)]. The single lag assumed here is again for
simplicity.) Then with straightforward algebra, the first-order condition (5.2) implies

Et-1 edt = O, Et l ewt

H t - OSt - a ' W t = :rH(Ht 1 - OSt-1 - a~Wt_l) + disturbance,

:vH = [v/(1 + v)],

disturbance = [1/(1 + v)](Oed, + a'ew, -- ut),

(5.5)

which is in the same form as Equation (4.11).

We have thus established that in the simple parameterization of this section, in
which sales follows an exogenous random walk, high serial correlation in a stationary
linear combination of inventories and sales is the same phenomenon as slow speed of
adjustment of inventories towards a target level.

6. Dynamic responses
To develop intuition about how the model works, and what the two stylized facts
suggest about model parameters and sources of shocks, this section presents some
impulse responses. Specifically, we present the industry equilibrium response of (1) H t ,
St and Qt, or (2) H t , St and H t - OSt, to a shock to Udt or Uct, for various parameter
sets, with no observable cost shifters (a = Wt = 0). While the parameter values we use
are at least broadly consistent with one or another study, we choose them not because
we view one or more of them as particularly compelling, but because they are useful
in expositing the model.
Table 8 lists the parameter sets. It may be shown that the solution depends only
on relative values o f g, ao, al and a2; multiplying these 4 parameters by any
nonzero constant leaves the solution unchanged. [This is evident from the first-order
conditions (3.3), (B.4) and (B.5): doubling all these parameters leaves the first-order
conditions unchanged, apart from a rescaling of the shocks.]
Our choice of a2 = 1 is simply a normalization. We fix g = 1 in part because some
of the properties documented below can be shown either to be invariant to g [see
West (1986, 1990b) on procyclicality of inventories] in part because a small amount of

Ch. 13:

895

Inventories

Table 8
Parameter sets a
(1)
Mnemonic

(2)
g

(3)
a0

(4)
a1

(5)
a2

(6)
a3

(7)
~c

(8)
~d

n.a. b

0.7

n.a.

0.7
0.7

-0.1

n.a.

AI

n.a.

An

0.7

n.a.

n.a.

n.a.

a See Table 7 for parameter definitions. The behavior of the model depends only on the scale of the
parameters g, a0, a~ and a2; doubling all these leaves behavior unchanged. The discount factor b is set
to 0.99 in all experiments.
b "n.a." means that the autoregressive parameter is irrelevant for the impulse responses plotted in
Figures 7-13: the response is for a shock to the other variable, whose AR(1) parameter is given.
e x p e r i m e n t a t i o n indicated little sensitivity to g. To p r e v e n t possible confusion, we note
explicitly that the p a r a m e t e r a3 is identified in absolute terms and not just relative to
other parameters. Throughout, w e set the discount factor b = 0.99, and interpret the t i m e
p e r i o d as quarterly. To facilitate discussion, in the graphs we set vertical tick marks
labelled " - 1 " , " 1 " , "2", and so on, but this (or any other) choice o f traits to measure the
response is arbitrary. [In actual application, the units u s e d w o u l d o f course be m o n e t a r y
(e.g., billions o f 1992 dollars in the impulse responses in Section 2 above)].
The p r o d u c t i o n s m o o t h i n g aspect o f the m o d e l is m o s t clearly e v i d e n t w h e n shocks
are m e a n reverting. We therefore begin with three p a r a m e t e r sets illustrating the
response to an innovation in a stationary A R ( 1 ) d e m a n d shock Ud~, w i t h A R parameter
~d = 0 . 7 . Since q~d = 0 . 7 is probably far e n o u g h f r o m unity to m a k e the notion o f
cointegration b e t w e e n H t and St unappealing, we plot the responses o f Qt, St and H t
but not those o f H t - O S t 17.
Parameter set A illustrates the production s m o o t h i n g model. F i g u r e 7 presents the
response to a d e m a n d shock. A s may be seen, w h e n there is a , p o s i t i v e innovation to
demand, sales o f course rise. But part o f the increase in sales is m e t by drawing d o w n
inventories, thereby b u f f e r i n g production f r o m the d e m a n d shock. A s sales return to

17 Naturally, even though we do not include the plots here we did examine them ourselves. As it
turned out, H t - O S t showed persistence. From Equation (B.11) in the Technical Appendix, we see
that H t - OSt has an autoregressive root of Od that is cancelled by a moving average root only when
0d --4 1. This autoregressive root apparently explains the persistence. In our view such persistence is not
particularly interesting: in a stationary model, 0 = a3 - [al (1 - b)/ba 2 ] is not the parameter corresponding
to a projection o f H t onto St, and thus H t - OS t does not correspond to the quantity displaying persistence
in, for example, Table 6.

896

V.A. Ramey and K.D. West

I

5
43-

"-1

2.t-

O-

~,

inventories
quarter

Fig. 7. Response to a stationary demand shock; parameter set A.

the steady state, inventories are gradually built back up. It may be seen in the graph
that production is smooth relative to sales.
The intuition is straightforward: given increasing marginal costs (al >0), it is
cheaper to produce at a steady rate than to produce sometimes at a high rate, sometimes
at a low rate. So the increased demand is met partly with inventories, and production is
smoothed relative to sales. (Note that this logic applies even for a competitive firm that
can sell as much as it wants at the prevailing market price.) Inventory movements are
countercyclical, in the sense that they covary negatively with sales. It may be shown
analytically that such cotmtercyclical behavior will obtain when a l > 0, a3 = 0 and there
are no cost shocks [West (1986) for a stationary model, working paper version o f West
(1990b) for a model with unit roots].
One can obtain procyclical movements when costs are convex if the accelerator
term is operative (a3 > 0) and is sufficiently strong to offset the production smoothing
motive. In Figure 8, which shows results when a3 = 1 rather than a3 = 0, inventories
initially rise along with sales when there is a positive innovation to the stationary
demand shock. So production rises even more than does sales, and is more variable.
All three variables then fall smoothly back towards the steady state.
Some algebra may help with intuition: if ao=a] =0, and Uct=O, the firstorder condition for Equation (3.1) is simply Ht=a3EtSt+l. Thus inventories will
covary positively with expected sales, and thus with sales themselves since St is
positively serially correlated in equilibrium. With a0 0, al ~ 0, inventory movements
will reflect a balance of accelerator and production smoothing motives. I f the

Ch. 13." Inventories

897
I

-t-I
e-

0
I

quarter

Fig. 8. Response to a stationary demand shock; parameter set B.

accelerator motive dominates, as it does in this parameter set, inventories will move
procyclically IS.
Another way to obtain procyclical movements in response to demand shocks, is with
nonconvex production costs [Ramey (1991)]. Parameter set C captures this with a small
negative value for al. [The linear quadratic problem will still be well-posed, and lead
to an internal solution, as long as the nonconvexity is not too marked; in the present
context, this essentially demands that a2 and g be sufficiently large relative to ]al I.
See Ramey (1991).] We see in Figure 9 that a positive innovation to demand causes
inventories to rise (though by a small amount - an artifact o f our choice o f parameters):
with al < 0 it is cheaper to bunch rather than smooth production. Thus, firms build up
inventories when sales are high. If there is a cost o f changing production (a0 ~ 0),
marginal production costs are (1 +b)ao +al. Ramey (1991) has noted that al < 0 may
induce a tendency to bunch production even if (1 + b)ao + a~ > 0 [see West (1990b) for
a particular set o f parameters for which this happens].
We now turn to parameter sets with a unit root in the demand shock (q~d= 1).
Figure 10 plots the response o f inventories, sales and the inventory-sales relationship

18 Recall that the accelerator term is motivated in part by stockout costs. Kahn (1987) rigorously shows
that when nonnegativity constraints are imposed, demand uncertainty (which implies uncertainty about
whether a stockout will occur) will lead to procyclical movements if demand is serially correlated.

898

V.A. Ramey and K.D. West

I

~.2
10
8

4
2
0

2_

_'~-~_ 2 _

_"-2"~-_ _ - _ ' _

_ _-_,_

_ ~ =

4
quartsr

Fig. 9. Response to a stationary demand shock; parameter set C.

H t - O S t , with the technology parameters matching those in parameter setA. As

with a stationary shock, firms draw down inventory stocks when demand increases
(though the fall is slight in our figure). They will replenish stocks in response to a
negative shock (not depicted). Thus inventories buffer production. With our choice of
parameters, the transition to the new steady state is quite rapid 19. In parameter sets
B and C, a demand shock with a unit root leads to procyclical inventory movements
(not depicted): with or without a unit root in the demand shock, inventories buffer
production.
Figure 10 also plots the response o f the inventory sales relationship H t - OSt. To
understand the pattern it exhibits, some mechanics may be helpful. Since a3 = 0, 0 < 0
and ( - 0 ) > 0 [see Equation (3.5)]. In Figure 10 we see that the response o f Ht is
negative but small in absolute value, that of St positive and relatively large; in the end,
the net response of (-O)St > 0 is greater than that o f Ht < 0, and Ht - OSt increases
in response to a demand shock. The inventory-sales relationship has little persistence,
however; it has a first-order autocorrelation coefficient o f a little under 0.3.
When we computed impulse responses for parameter sets B and C with a unit root
demand shock (not depicted), the sign o f the initial response of l i t - OSt happened to
be negative for parameter set B, positive for parameter set C: the sign o f the initial
response to a demand shock is sensitive to exact parameter values. A characteristic

19 To prevent confusion: sales and revenue are endogenous in this experiment (g<ec). Although
St looks like a random walk in the figure, in fact ASt does have a little bit of serial correlation,
and is Granger-caused by inventories.

Ch. 13. Inventories

899
I

sales

3
e-

]
inventory-sales relationship
/ J_/

inventories

quarter
Fig. 10. Response to a unit root demand shock; parameter set A ~.

of all three parameter sets, however, was rapid mean reversion in H t - OSt. The
autoregressive root x~/ [see Equation (4.9)] was 0.270 (parameter set A), 0.269 (B)
and -0.148 (C).
The negative sign of xH in parameter set C perhaps deserves a word of mention.
Recall that al < 0 in this parameter set, and that downward sloping marginal costs
induces production bunching. So bunching generates a negative autocorrelation, since
high activity in one period tends to be followed by low activity in the next.
In parameter set A", we continue to use the same technology parameters, but now
plot responses to a cost rather than demand shock. The cost shock is stationary, with
an AR parameter of q~o= 0.7. We see in Figure 11 that inventories move procyclically
in response to a negative cost shock: the shock causes both inventories and sales to
rise, and makes production (not depicted) more variable than sales. (Recall that we are
studying industry equilibrium, and sales of course change as costs change.)
The intuition once again is straightforward: a firm with a convex cost function will
use periods of low cost to produce a lot and to build up inventory stocks (as in the
figure), and use periods of high cost (not depicted) to produce little and instead sell out
of inventory stocks that have already been built up. In this case, inventories serve to
buffer production from cost shocks. (Reminder: the phrase "production smoothing" is
conventionally used only to describe smoothing from demand shocks but not, as in the
present paragraph, smoothing from cost shocks.) Inventory movements are procyclical.
It may be shown analytically that such procyclical behavior will obtain when al > 0,

900

V.A. Ramey and K.D. West

I

4
sales

=~1
r-

4
quarter

Fig. 1i. Response to stationary cost shock; parameter set A".

a3 = 0 and there are no demand shocks [see the working paper version o f West (1990b)].
We see that there is now persistence in H t - OSt 2o.
We showed above that when a0 = 0 , persistence in H t - OSt results even in the
absence o f cost shocks i f production costs a l are sufficiently large relative to inventory
costs a2. W h e n sales are exogenous (g ~ oe), it is straightforward to establish
analytically that persistence also increases as ao increases relative to al and a2. We use
the final two parameter sets to document via simulation that large values o f ao also
cause persistence when sales are endogenous. Parameter set D varies from A ~ only by
introducing a0 = 3 instead o f a0 = 0. Figure 12 plots responses o f H i , S t and H t - OSt
to a positive innovation in a unit root demand disturbance. From the perspective o f
buffering, there are no new results: sales increase and inventories are drawn down
to buffer production. But now there is persistence in the inventory-sales relationship
H t - OSt, which has an autocorrelation a little above 0.7. The intuition is that i f costs
o f adjusting production are large, and i f there is a (say) jump in demand, firms only
very gradually increase production to build the stock up.
Finally, parameter set E varies from D by allowing the accelerator motive, setting
a3 = 1 (as in parameter set B). In Figure 13 we see that inventories now move
procyclically in response to demand shocks, and that there continues to be persistence
in the inventory-sales relationship.

20 Of course, for the computed response of H t - OSt to give us insight into the empirical behavior
of H t - OSt, there must be unit roots or near unit roots in H t and St, and hence this experiment and
parameter set cannot provide the whole explanation for the two stylized facts.

Ch. 13:

901

Inventories
I
5

43-

B
.H
t--

2~.-

~--i

n_7_nt__r_Y- sa~e_s_5 e1.ati nshi P

O-

....

inventories
I

quarter
Fig. 12. Response to a unit root demand shock; parameter set D.

5
4

/ ~

inventories

3
2
i
-I

/
-2

-3

\//

inventory-sales relationehlp

quarter
Fig. 13. Response to a unit root demand shock; parameter set E.

Table 9 s u m m a r i z e s the discussion in this section. Evidently, we m u s t consider

e m p i r i c a l e v i d e n c e on: the accelerator motive, the relative values o f a0, al and a2,
and cost shocks.

902

V.A. Ramey and K.D. West

Table 9
Possible explanations of stylized facts a
Inventories
procyclically

Persistence in
inventory sales
relationship b

no

yes

yes
yes

i"10

yes

yes

Inove

In response to demand shocks:

(1) Marginal production costs rise very rapidly relative to marginal

inventory holding costs (a2 small relative to al and/or ao)
(2) Declining marginal production costs (al < 0)
(3) Strong accelerator motive (aza3 large relative to a 0 and a a )

no

In response to cost shocks;

(4) Increasing marginal production costs

a The parameters are defined in Table 7.

b The implications for persistence in the inventory-sales relationship apply if there is a unit root in the
demand shock [explanations (1) (3)] and persistence in the cost shock [explanation (4)].
c The reference to "declining marginal production costs" abstracts from costs of changing production
(from ao). With a0 * 0, marginal production cost is a0(1 + b) + a I. But even if a0(1 + b) + at > 0, inventory
movements may be procyclical if a 1 < 0.

7. Empirical evidence
7.1. I n t r o d u c t i o n

The analytical results in West (1986, 1990b) and Section 4 and the simulations in
Section 6 suggest at least two different ways o f rationalizing the procyclicality o f
inventory movements and the persistence o f the inventory-sales relationship. One is
a demand-driven model with rapidly increasing marginal production costs (marginal
production costs a0 and/or al are large relative to marginal inventory holding costs a2),
together with a strong accelerator motive (a2a3 large relative to a0 and a 0 . The second
is a cost-driven model, with increasing marginal production costs; such a model may
or may not have a role for the accelerator. For simplicity we somewhat loosely refer to
these as our d e m a n d - d r i v e n and our c o s t - d r i v e n explanations. We do so with some
reservations: please recall that our demand shock Udt may in some data basically
reflect supply side forces.
These two do not exhaust the possibilities, and many economists (including us)
would expect both cost and demand shocks to be important over samples o f reasonable
length. Our own work, for example, has emphasized the possibility o f declining
marginal production costs [Ramey (1991)]. In combination with highly persistent
cost shocks, both procyclicality o f inventories and persistence o f the inventory-sales
relationship m a y result. A n d West (1990b) finds both stylized facts explicable with a
model with strong costs o f adjusting production and a substantial role for both cost
and demand shocks, but with no accelerator.

Ch. 13: Inventories

903

But our demand-driven and cost-driven explanations have the virtue of simplicity,
and both have support from a number of papers: as summarized in this section and the
next, most aggregate studies, and the limited microeconomic evidence available, do not
point to declining marginal cost, and do find a role for the accelerator. In citing such
support we do not cast a wide net but instead selectively cite representative papers.
In addition, after some introductory remarks on papers using the flexible accelerator
model (Section 7.2), we focus on papers that explicitly use the linear quadratic model,
for ease of exposition.
Section 7.2 reviews parameter estimates from the linear quadratic literature,
Section 7.3 discusses sources of shocks, and Section 7.4 provides an interpretation.
We remind the reader that the behavior of inventories depends only on the relative
values of g, a0, al and a2. All statements referencing "large" values of one of these
parameters should be understood to mean "large relative to another parameter or
linear combination of parameters". The normalization involved will be clear from the
context.

7.2. Magnitude of cost parameters

Our discussion will focus on estimates of the linear quadratic model. We begin,
however, with a brief discussion of results from less structured studies, including those
using the flexible accelerator. We record two results.
The first is that in flexible accelerator studies, actual or expected sales is generally
found to be an important determinant of inventory movements, with a positive
relationship between the two series. See, for example, Maccini and Rossana (1981,
1984) or Blinder (1986b). In terms of the model in Section 5, a positive relationship
may be interpreted as 0 > 0, where 0 is the coefficient on sales in the expression for
target inventories [see Equation (5.3)]. As well, in direct estimation of a cointegrating
parameter, Granger and Lee (1989) do obtain 0 > 0 in all 27 of their US two-digit
manufacturing and trade series.
To interpret this with the linear quadratic model, recall that under certain conditions,
the decision rule from the flexible accelerator model (5.1) can be mapped into that
of the linear quadratic model (3.1). Under those conditions, 0 = a3 - [al (1 - b)/(ba2)]
[see Equations (3.5), (4.11) and (5.5)]. Thus a3 > 0 is necessary for the cointegrating
parameter 0 to be positive, as noted by Kashyap and Wilcox (1993). [This holds
even when Uct is present (although cointegration requires Uct-I(0)).] Thus here and
in linear quadratic studies (see below) there is support for a nontrivial role for the
accelerator motive - a result that may be unsurprising or reassuring to some, but
in any event is not particularly helpful in discriminating between our two candidate
explanations.
The second result from the flexible accelerator literature concerns the structure
of production costs. As discussed in Section 2, this literature has found large
autoregressive roots in H t - H i, which implies slow adjustment of Ht towards H i.
In quarterly data, a typical estimate of the root is around 0.8-0.9, implying that about

904

V.A. Ramey and K.D. West

10-20% o f the gap between actual and target inventories is closed in a quarter. Ever
since Carlson and Wehrs (1974) and Feldstein and Auerbach (1976), many observers
have found such estimated speeds puzzling and perhaps not well-rationalized by the
flexible accelerator model. One reason is that even the largest quarterly movements
in inventories amount to only a few days production. This suggests to Feldstein and
Auerbaeh (1976, p. 376) and others that costs o f adjusting inventories [v, in the
notation o f Equation (5.1)] cannot be very large 21 .
To interpret this second result with the linear quadratic model, recall that we set
a0-= 0 when we established a mapping from the flexible accelerator to the linear
quadratic model (3.1). With a0-= 0, an arbitrarily slow speed o f adjustment results
when al is arbitrarily large. It is not clear to us how large a value o f al is implausibly
large. But we take from the flexible accelerator literature the message that many find
this simplest version o f the model unappealing [see Blinder and Maccini (1991) for a
recent statement].
Accordingly we consider the other sources o f persistence isolated above: costs of
adjustment (discussed in this subsection), and serial correlated cost variables (discussed
in the next subsection). To focus the discussion o f costs of adjustment, we highlight
estimates from some recent linear quadratic studies using two-digit manufacturing data
from the USA. Different studies present estimates o f a0, al and a2 relative to different
parameters or linear combinations o f parameters. To display results from various
studies in consistent form, we restate published estimates of ao, a~ and a2 relative
to a c o m m o n linear combination o f the published estimates of those parameters. This
linear combination is
c ~ (1 + 4 b + b 2 ) a o + ( 1 + b ) a l +ba2,

(7.:)

with b ~ 0.99. Here, "c" is the second derivative o f the objective function (3.1) with
respect to Ht; the Legendre-Clebsch condition states that e > 0 is a necessary condition
for an optimal solution. [See Stengel (1986, p. 213) or Kollintzas (1989, p. 11).]
Note that the estimates we discuss will therefore not be comparable to those used
in the simulations in the previous section and in Table 8, and often are not as easily
interpreted as those expressed relative to a single parameter. We nonetheless use this
normalization since studies sometimes report negative estimates o f a0, al or a2, which
can make interpretation o f estimates relative to one o f those parameters problematic.
Most authors examine more than one specification. Table 10 presents results for a
specification that seemed to be preferred by the author(s). For the preferred specification, columns 2-6 present the median point estimate o f ao/c, a l/c, [(1 + b)ao + a l ]/c

21 The logic apparently is that it should be easy to make inventory movements rapid if firms are
beginning from a starting point in which current movements are small relative to production. But small
inventory movements seem to be exactly what one would associate with slow adjustment speeds, if costs
of adjustment determine both the size of movements and the adjustment speeds; if, instead, the slow
adjustment speeds were accompanied by large movements in inventories, there would be a puzzling
contrast between regression results and basic data characteristics.

Ch. 13:

905

Inventories

Table 10
Median point estimates of model parameters a-d

(1) Reference e

(2)
ao/C

(3)
al/c

(4)
[(1 +b)a 0 +al]/
c

a2/c

(5)

(6)
a3

(7)
Number
of
industries

Models with serially correlated cost variables:

(1) Durlauf and Maccini (1995)

0.

0.43

0.43

0.15

0.55

(2) Eichenbaum (1989)

0.

0.21

0.21

0.58

1.15

-0.16

0.83

0.64

-0.09

1.14

0.15

-0.63

-0.43

1.69

0.40

(3) Kollintzas (1995)

(4) Ramey (1991)

Models without serially correlated cost variables:

(5) Fuhrer, Moore and Schuh (1995)

0.13

0.12

0.38

0.00

0.67

(6) West (1986)

0.05

0.34

0.44

0.01

1.12

10

a In the column definitions, e -- (1 + 4b + b2) a 0 + (1 + b) a 1 + ba2, b =- 0.995. Note that the magnitudes
in columns 2-4 are therefore not comparable to those in columns 4-6 in Table 8.
b Different papers expressed point estimates relative to different linear combinations of parameters. For
each paper, the reported point estimates were restated relative to c. The Legendre-Clebsch condition
states that c > 0 is a necessary condition for an interior solution of the optimization problem. The table
reports the median of the restated estimates. When a0 = 0 (lines 1 and 2), or when there is only one
industry (line 5), the column 4 entry for marginal production cost is by construction equal to: (1 +b)
times column 2, plus column 3.
c All the studies used two-digit manufacturing data from the USA. The exact data, sample period,
specification and estimation technique vary from paper to paper.
d Most papers present more than one set &results. We chose the specification that seemed to be favored
by the author(s).
e Sources by reference: (1) Table 7 (p. 85), entries labelled "Table 3"; (2) Table 2 (p. 861); (3) Tables 1 6
(pp. 77-80), columns labelled "random walk"; (4) Table 1 (p. 323), excluding autos; (5) Table 4 (p. 128),
entry labelled "FIML-endogenous sales"; (6) Table 4 (p. 391).
( = m a r g i n a l production cost, taking into account costs o f adjusting production), a 2 / c
a n d a3. The m e d i a n is c o m p u t e d across the datasets considered b y the author; the
n u m b e r o f datasets is given i n c o l u m n 7.
A skim o f the table suggests a broad consensus on a3 ( c o l u m n 6). A s well, there
is relatively little d i s a g r e e m e n t on the sign o f the slope o f marginal production costs
( c o l u m n 4); with the exception o f R a m e y (1991), the studies find a n upward slope to
m a r g i n a l production cost. There is, however, some variation in the extent to which the
cost o f adjustment a0 contributes to this upward slope. Consistent with the d e m a n d driven explanation, F u h r e r et al. ( t 9 9 5 ) (line 5) and to a lesser extent West (1986)
(line 6) find that a0 contributes to the upward slope.
Some studies with other datasets have found an even stronger role for the cost o f
adjustment a0, with a0 positive and significant but with estimates o f the production
cost al negative [consistent with R a m e y (1991)], or e c o n o m i c a l l y or statistically

906

V.A. Ramey and K.D. West

indistinguishable from zero. For example, Kashyap and Wilcox's (1993) study of the
automobile industry in the 1920s and 1930s yielded median estimates of parameters
as follows:
ao/c
al/c
[(1 + b)ao + al]/c
a2/c
a3
(7.2)
0.20
-0.11
0.29
0.03
0.72"
Similar results are reported for the modern automobile industry by Blanchard (1983)
and Ramey (1991), and for US aggregate inventories by West (1990b).
On the other hand, we see in lines 1 and 2 that the preferred specifications in the
Eichenbaum (1989) and Durlauf and Maccini (1995) set the cost of adjustment to
zero. In these two papers, the estimates of al tended to be positive but perhaps not
so large as to imply a speed of adjustment that Feldstein and Auerbach (1976) would
find implausibly slow. In part these papers set a0 to zero - because in a setup similar
to that of Kollintzas (1995) in line 3, negative and insignificant point estimates of a0
tended to result.
Rounding out the cost-driven story requires finding substantial persistence from
stochastic variation in costs. This is discussed in the next subsection.
7.3. Shocks
There is much circumstantial evidence that serially correlated cost shifters have
important effects on inventory behavior. In particular, the data often seem happy with
specifications in which the unobservable disturbance uct is highly autocorrelated [e.g.,
Eichenbaum (1989), West (1990b), Ramey (1991)].
One's confidence that this unobservable disturbance really reflects stochastic
variation in production costs would be increased if inventories could be shown to
respond aggressively to observable measures of costs. Unfortunately, this appears not
to be so. In practice, factor prices and interest rates usually are insignificant (in both
economic and statistical terms), and sometimes have effects opposite of the theoretical
predictions. For statistical significance, Table 11 shows a selection of results using cost
variables, from studies of two-digit manufacturing in the USA, and now including
flexible accelerator as well as linear quadratic studies.
It may be seen in columns 1-4 that a finding of a statistically significant effect of
observable measures of costs is rare: only 2 entries are "y"s, indicating that in only
two of the 21 studies did significance at the 5% level characterize at least three-fourths
of the coefficients estimated in a given study. 11 entries are "n"s, indicating that in
these 11 studies fewer than one-fourth of the coefficients were significant. On the other
hand, in column 5 it may be seen that for the unobservable disturbance, three of the
6 entries are "y"s, and that two of these "y"s are for studies that also included some
observable measures of costs (lines 6 and 8); none of the 6 entries are "n"s.
7.4. Interpretation
We showed in Section 4 that the demand-driven and cost-driven explanations put
two large autoregressive roots in the inventory sales relationship H t - O S t ; in fact,

Ch. 13: Inventories

907
Table 11
Statistical significance of cost variables ~c

Reference d

Wage

Materials
prices

(1) Blinder (1986b)

(2) Durlauf and Maccini (1995)

Energy
prices

Interest
rate

Unobservable
shock

(3) Eichenbaum (1989)

(4) Kollintzas (1995)

(5) Maccini and Rossana (1981)

(6) Maccini and Rossana (1984)

(7) Miron and Zeldes (1988)

(8) Ramey (1991)

(9) Rossana (1990)

n
y
?

a This table is an updated version of a table in West (1995).

b All the studies used two-digit manufacturing data from the USA. The exact data, sample period,
specification and estimation technique vary from paper to paper.
c A "y" entry indicates that the coefficient on the variable in a given column was significantly different
from zero at the 5% level in at least three-fourths of the datasets in a given study, a "n" that it was
significant in at most one-fourth of the datasets, a "?" that it was significant in more than one-fourth
but fewer than three-fourths of the datasets. A blank indicates that the variable was not examined.
d Sources by reference: (1) Table 1 (pp. 360 61); (2) Table 3, inst. set. 4; (3) Table 2 (p. 861);
(4) Tables 1-6 (pp. 77-80), columns labelled "HP filter" and "quadratic trend"; (5) Table 1 (p. 20);
(6) Table 3 (p. 231) and discussion on p. 227; (7) Table I1 (p. 892); (8) Table 1 (p. 323); (9) Tables 3 and
4 (pp. 26-27), with the cost of capital variable "ce" and "cp" interpreted as interest rate variables.

u n d e r certain conditions, b o t h i m p l y A R M A ( 2 , 1) p r o c e s s e s o f l i t - OSt. Specifically,

this happens w h e n q~c= 0 in the d e m a n d - d r i v e n explanation [see E q u a t i o n s (4.14) and
(4.15)1.
That the similar A R M A structures might allow both m o d e l s to fit a g i v e n b o d y o f
data is illustrated by Kollintzas (1995). Kollintzas' results in line 3 o f Table 10 were for
a specification w i t h a r a n d o m w a l k (q~c= 1) cost shock (i.e., Kollintzas differenced the
first-order condition b e f o r e estimating). A m o n g other specifications, Kollintzas allowed
for an i.i.d, u n o b s e r v a b l e cost shock. In the specification with i.i.d, cost shocks, the
m e d i a n estimates o f the p a r a m e t e r s were:

ao/c

al/c

0.03

0.42

[(1 + b)ao + al]/C

0.47

a2/c

a3

0.01

2.51'

(7.3)

W h i l e the estimate o f m a r g i n a l production costs was n o t wildly different (0.47 with

i.i.d, shocks vs. 0.64 w i t h r a n d o m walk shocks [line 3, c o l u m n 4 o f Table 10)], the

908

V.A. Ramey and K.D. West

median estimate of a0 was higher. In fact, the estimate o f a0 was higher in 5 o f the 6
datasets 22.
An interpretation is that a model that fits his data would imply two autoregressive
roots. When serial correlation in the cost shock was suppressed, the positive values
for a0 rationalized a second autoregressive root; when serial correlation in the cost
shock was imposed, large (or even positive) values o f a0 would imply an autoregressive
structure too elaborate for the data, and accordingly the regression yielded diminished
values o f a0.
Discriminating between the two explanations thus means distinguishing between
costs o f adjustment [when a0 0 and the serial correlation of the cost shock is zero
(~bc= 0)] and exogenous serial correlation (when a0 = 0 and q~c is near one). In principle
this may be done, using either cross-equation restrictions, or additional variables such
those in the Wt vector. But in both inventory and non-inventory contexts this has
proved difficult [e.g., Blinder (1986b), McManus et al. (1994), Surekha and Ghali
(1997)].
And in any case, our discussion so far perhaps has understated the extent o f conflict
across empirical results. There is a range of estimates of most parameters (including
some wrong-signed or otherwise implausible ones), and we have pushed papers into
one o f just two camps in the interest o f summarizing a complex set o f results: while
in principle it may be possible to pin down important macroeconomic parameters and
sources o f shocks by simply estimating linear inventory models with aggregate data,
this tantalizing idea has not proved true in practice so far.
The conflict across papers, or the range o f estimates, may be no worse than in
empirical work in other areas. For example, those familiar with the real business
cycle literature will probably not be surprised that it is difficult to find observable
counterparts to unobservable cost shocks. And Lovell (1994) shows that the estimated
speed o f adjustment o f Ht towards H~ is in fact no slower than those o f some other
variables. As well, part o f the conflict across papers no doubt results from econometric
problems related to sample size or estimation technique [West and Wilcox (1994,
1996), Fuhrer et al. (1995)]. Finally, it may be that careful analysis would reveal that
seemingly disparate conclusions in fact result mainly from the use o f different sample
periods, datasets, and observable cost shiflers ("Wt", in the notation o f the previous
sections).
But pointing out (perhaps unfairly!) that other literatures have similar problems will
not advance our knowledge about inventories. Nor, most likely, will sharp estimates
be produced by even the most refined econometric technique, at least when applied to
familiar data. We therefore suggest some alternative approaches.

22 Such statements potentially are sensitive to how the parameters are expressed (relative to "c", as in
Table 10, or some other linear combination of parameters). But in this case the statement applies not
only with respect to the normalization we have used, but also with respect to the normalization used by
Kollintzas, which was relative to a0(1 + b)+ a l.

Ch. 13: Inventories

909

8. Directions for future research

8.1. Introduction

In this section we offer what we believe to be fruitful directions for future research.
Sections 8.2 and 8.3 describe alternative modelling strategies. Some of our suggestions
are based on alternatives to the basic linear quadratic production smoothing model;
others extend the basic model. All build on the insights delivered by the basic model:
that procyclical movements result when inventories facilitate sales (a force captured
in the basic model with the accelerator term), and that the shape of production
costs influences both the character of cyclical movements and the persistence of
the inventory-sales relationship. In addition, all seem intuitively capable of helping
explain either or both of our stylized facts (procyclicality of inventories, persistence
o f the inventory-sales relationship), although, of course, research to date involving
these suggestions has its share of blemishes (e.g., wrong-signed parameter estimates).
Finally, Section 8.4 describes how the use of different data may help understand
inventory behavior.
8.2. Inventories in production and revenue functions

The potential importance of the accelerator term (a3) in explaining both the business
cycle and long-run behavior of inventories suggests that the relationship between
inventories and sales deserves more study. Consider first Holt et al.'s (1960) original
motivation for this formulation as az(Ht-a3St+l) 2. As discussed on pp. 56-57 of
their book, their initial model of optimal inventory holdings used lot-size formulas,
where the optimal batch size, the number of batches and optimal inventory levels all
increase with the square root o f the sales rate. They used two approximations to capture
the costs and benefits associated with inventory holdings. First, they approximated
the square-root relationship with a linear relationship between inventories and sales
(e.g., H 7 =a3St+l). Second, they approximated all costs and benefits associated with
inventories with a quadratic in which costs rise with the square of the deviation of
inventories from the optimal level. This generates the accelerator term a 2 ( H t - H t ) 2.
While this tractable formulation provides a plausible mechanism for procyclical inventory movements, there are two potential problems with it. First, the approximations
may be inadequate. As we will discuss below, the approximations used imply that the
cost of a marginal reduction in inventories is linear in the stock of inventories, whereas
at least one paper found significant convexities. Second, inventories may directly affect
revenue in a way that is not well captured by including the accelerator term in the cost
function.
One alternative strand of the literature has modelled inventories as factors of
production, or considered interrelationships between inventories and other factors of
production. Christiano (1988), Ramey (1989), Galeotti et al. (1997) and Humphreys
et al. (1997) are examples. Ramey (1989) argues that since inventories at all stages

910

V.A. Ramey and K.D. West

of production facilitate production and shipments, they should be considered factors

of production. She includes three stages of inventories in the production function, and
estimates factor demand relationships. This approach obviously has the potential to
make inventories move procyclically, since factor usage fluctuates with output. The
results from the linear quadratic model suggest if costs of adjustment are allowed,
persistence would result as well.
A second line of research has considered the revenue role of inventories. Kahn
(1987, 1992) develops a theory of a stockout avoidance motive for holding inventories
and tests some of its implications using automobile industry data. Kahn argues that
demand uncertainty and a nonnegativity constraint on inventories can explain several
important patterns in the data. Bils and Kahn (1996) extend this line of research by
assuming that the demand function is a (nonlinear) function of the stock of goods
available for sale. They apply the model to two-digit manufacturing data with mixed
success. Rotemberg and Saloner (1989) offer another potential role for inventories
in revenue, arguing that inventories may be accumulated to deter deviations from
an implicitly collusive arrangement between firms. The nature of the equilibrium
implies that inventories will be high when demand is high. They show empirically
that the correlation between inventories and sales is higher in concentrated industries,
as predicted by their model.
A third line of research studies uses more general functional forms for the
relationship between inventories and sales. [The work by Kahn (1992) and Bils and
Kahn (1996) also fits into this category.] Pindyck (1994) studies the convenience yield
of inventories for three commodities. Augmenting the usual production, sales and
inventory data with futures prices, he provides evidence that the marginal convenience
yield is very convex, increasing sharply as inventories approach zero. This indicates
that the approximation embodied in the basic Holt et al. (1960) model may miss some
important aspects of inventory behavior.

8.3. Models with fixed costs

We next consider arguments and evidence that a key shortcoming of the linear
quadratic model is that it fails to account for fixed costs facing firms. Blinder (1981),
Caplin (1985), Mosser (1988), Blinder and Maccini (1991), and Fisher and Hornstein
(1996) all argue that fixed costs of ordering may be very important for understanding
the behavior of retail and wholesale inventories as well as manufacturers' materials and
supplies. In some environments the aggregation argument presented in Section 3.4 will
not apply, and research to date has shown that under certain conditions such fixed costs
may lead to (S, s) type of decision rules. In their review article, Blinder and Maccini
(1991) recommend that future inventory research concentrate on the (S, s) model. This
will require resolution of difficult problems of aggregation, perhaps partly through
the use of simulations [Lovell (1996)]. While the results look suggestive at the level
of a single-product firm, the implications for a multi-product firm, let alone for an

Ch. 13: Inventories

911

industry or economy, have been harder to obtain because of difficulties of aggregating

(S, s) rules.
The studies by Bresnahan and Ramey (1994) and Hall (1996) show that fixed
costs are an important determinant of production costs in the automobile industry.
Bresnahan and Ramey follow some fifty assembly plants on a weekly basis from 1972
to 1983, and uncover important lumpiness in the margins for varying production.
Hall studies fourteen assembly plants from 1990 to 1994. Both studies isolate two
important methods for varying production, which appear to involve some sort of
nonconvex costs. First, they find that complete shut-down of a plant for a week at
a time is an important method for temporarily decreasing output rates. Second, the
adding and dropping of extra shifts (each of which doubles or halves production)
are an important source of output variability, and appear to involve fixed costs and
lumpiness of production levels. Thus, costs in the automobile industry deviate from
the linear quadratic production smoothing model in two important ways. First, there
appear to be fixed costs of adjusting production, not convex costs as postulated in the
production smoothing model. Second, the lumpiness of the margins, accompanied by
the fixed costs, leads to a nonconvex cost function. It is important to point out that
the nonconvexity is due not to declining marginal costs [as Ramey (1991) originally
posited], but rather to the existence of large fixed costs at key points in the cost curve.
Thus, both the (S, s) literature and the limited amount of factory evidence available
suggests that fixed costs may be very important. Furthermore, the types of fixed
costs highlighted can potentially explain both the procyclicality of inventories and
the persistence of the inventory-sales relationship. For example, the lumpiness of
the shifts margin in the automobile industry can explain why an increase in sales
might lead to a more than proportional increase in production. Also, the importance
o f fixed adjustment costs can explain why significant deviations in the inventory-sales
relationship are allowed to occur before production responds.
It is not yet clear, however, how general are the results from the automobile industry.
And more generally it is not well understood how and whether fixed costs at the plant
or firm level translate into industry- or economy-wide behavior. Thus, the role of these
types of fixed costs in explain aggregate inventory fluctuations remains an important
topic for future study.
8.4. The value o f more data

Finally, we discuss how the addition of more data may help narrow the estimates
obtained from the linear quadratic model, as well as shed light on the unobserved
cost shocks. We will argue that there are several available sources of data that have
the potential to clear up ambiguities.
One possible explanation for the range of estimates obtained from the production
smoothing model is the data are not sufficient for distinguishing the relative values
of the parameters. One way to glean more information from macroeconomic data
is to use information contained in prices, something done in a handful of papers

912

V.A. Ramey and K.D. West

including Eichenbanm (1984), Blanchard and Melino (1986) and Bils and Kahn
(1996). Pindyck's (1994) results using futures prices provides additional evidence of
the information contained in prices.
A second possible use of new data is to measure the stochastic variation in cost. As
Table 11 indicates, a number of authors have experimented with several observable cost
shifters, but generally do not find effects. Another possible source of cost shocks that
has been studied in a few papers is credit conditions. We remarked in Section 2.2 that
Kashyap et al. (1994) and Carpenter et al. (1994, 1998) still find persistence in the
inventory-sales relationship after including measures of credit conditions. But they
also regularly find that credit conditions affect inventory holding behavior of small
firms, across various specifications. If these credit conditions are serially correlated
(which they are likely to be), and if small firms are important enough to substantially
affect industry- and economy-wide aggregates, credit conditions may ultimately help
explain our two stylized facts.
Finally, we advocate more plant and firm-level studies, although gathering such data
requires substantial work. Schuh (1996), for example, uses panel data from the M3LRD
to calibrate biases from aggregation. And consider Holt et al.'s (1960) study o f six
firms ranging from a paint producer to an ice cream maker and Kashyap and Wilcox
(1993) and Bresnahan and Ramey's (1994) studies of the automobile industry. They use
not only firm-level data on production, inventories and sales, but also company reports
and industry press, which provide valuable insights into the cost structure facing firms.
For example, Bresnahan and Ramey (1994) were able to categorize the cause of every
plant shutdown using information from Automobile News, which chronicled drops in
demand and cost shocks such as strikes and model year change-overs.

9. Conclusions

We conclude by briefly reiterating several points we have made in this chapter. We

began by asserting that inventories are a useful resource in business cycle research.
The theoretical dependence of the comovements o f sales, production, and inventories
on important parameters such as the slope of marginal costs, and on the nature of the
underlying shocks, indicates that inventory models can in principle be used to identify
these important macroeconomic features. The two stylized facts we highlight - the
procyclicality of inventories and the persistence of the inventory-sales relationship are intimately linked to other aspects of business cycle fluctuations. Thus, inventory
movements have valuable business cycle information.
To consider explanations for the two facts, we presented a linear quadratic model. We
showed that the model can rationalize the two facts in a number of ways, but focused
on two stylized explanations have the virtue of relative simplicity and support from a
number of papers. Both assume that there are persistent shocks to demand for the good
in question, and that marginal production cost slopes up. The first explanation assumes
as well that there are highly persistent shocks to the cost of production. The second

Ch. 13: Inventories

913

assumes that there are strong costs of adjusting production and a strong accelerator
motive.
Our review o f the empirical evidence, however, indicates that the range of estimates
of key parameters and of the relative importance of cost versus demand shocks is
too wide to allow us to endorse one of the two or some third explanation. But while
the literature has not reached a consensus, it has identified mechanisms and forces that
can explain basic characteristics of inventory behavior. We believe that several research
strategies, and use of different data, promise to continue to improve our understanding
of inventory movements and therefore of business cycle fluctuations.

Appendix A. Data Appendix

Data sources for annual G7 data: all data on inventory changes were obtained
from International Financial Statistics, mostly from the 1996 CD-ROM. From the
CD-ROM, we obtained nominal and real GDP and the nominal change in aggregate
inventories. The GDP deflator was used to convert the inventory change from nominal
to real. For the Canada, France, the UK and the USA, 1955 data were available to
compute AQ and AS in 1956. For all other countries an observation was lost in
computing the initial AQ and AS. Additional sources were used for West Germany
and Italy.
West Germany: (a) 1957-1978: the IFS data used in West (1990a), rebenchmarked
to a 1990 from a 1980 base, and output measured with GNP instead of GDR (b) 19791994: in both the CD-ROM and in recent hardcopy versions of IFS, the figures on the
annual change looked suspicious: they were uniformly positive and large relative to
1957-1958, bore no obvious connection to the figures on the levels reported in the
Statisches Bundesamt publication cited below, and in recent years bore no obvious
connection to the average of the reported quarterly figures. So for 1979-1990, we
used the annual change reported in the hardcopy IFS, obtaining a given year's data
from the April issue three years later (e.g., the 1990 figure came from the April 1993
issue of IFS). (For 1980 we used the May 1983 issue, because the April 1983 issue
was missing.) For 1991-1994, we used the average of the quarterly figures from the
April 1995 hardcopy version of IFS.
Italy: 1993 and 1994 real GDP came from OECD Economic Surveys, Italy, 1996,
rebenchmarked to a 1990 from a 1985 base. We checked the US data against the
Department of Commerce's 1992 chain-weighted NIPA data, and while there were
notable differences, overall the two perhaps were tolerably close: the correlation
between inventory investment as constructed here and the Department of Commerce
measure was 0.96.
Data sources for non-US data on inventory levels: Canada: private communication
from Statistics Canada gave a nominal 1995:IV inventory figure for all nonfmancial
industries of 140.8 billion Canadian dollars, which we deflated with the GDP deflator. West Germany: Statisches Bundesamt, Volkswirtschafiliche Gesamtrechnungen,

914

V.A. Ramey and K.D. West

Table 3.2.9. Agriculture (line 2) was subtracted from total (line 1), and the result
was deflated by the GDP deflator. Japan: Economic Planning Agency, Annual Report
on National Accounts, 1997, table on "Closing Stocks". The nominal figure for
total stocks was deflated by the GDP deflator. United Kingdom: Office for National
Statistics, United Kingdom National Accounts: The Blue Book, 1996, Table 15.1.
Agriculture (series DHIE) and government (AAAD) were subtracted from total
(DHHY), and the result was deflated by the GDP deflator.
Data sources for sectoral distribution of US inventories: broad sectoral categories
were obtained from Citibase, and manufacturing inventories by stage of processing
were obtained from the BEA. The stage of processing inventories were converted from
monthly to quarterly data by sampling the last month of the quarter.

Appendix B. Technical Appendix

This appendix discusses the following: (1) solution of the model 23; (2) Computation of
E(Q 2 - S 2) in Table 4; (3) Estimation of 0 in Table 5; (4) the social planning approach
to derivation of the first-order conditions.
B. 1. Solution o f the model

We assume throughout that al, a2, g > 0 and a0, a3/> 0. See Ramey (1991) for solutions
when al < 0.
We begin by working through in detail the solution discussed in Section 4, when
a0 = 0 and the forcing variables follow first-order autoregressions. For simplicity, for the
most part we set ~ ---- 0 as well. Thus Uot =Uct [see Equation (3.2)], Et-luct =(&u~t-l
and Et 1Udt = (9,JUdt-l. To insure a unique stable solution, we assume that either (B.la)
or (B.lb) holds:
g > a2a3(1 - a3),
a2a3(1 - a3) > g >

(B.la)
2(1 + b 1)ala2(a3 - 0.5)(a3 - b(1 + b) -1)
a2 +2al(1 + b 1)

(B.lb)

Note that the right-hand inequality in (B. l b) follows if a3 falls outside (b(1 + b) -I , 0.5),
a narrow range when b ~ 1. There will also be a stable solution when a2a3(1 - a 3 ) = g .
But to allow us to divide by g - a2a3(1 - a 3 ) at certain stages in the derivation, we rule
this out for conciseness.

23 We thank StanislavAnatolyevfor assistancein the preparationof this part of the TechnicalAppendix.

915

Ch. 13.. Inventories

When a0 = 0, differentiating the objective function (3.1) with respect to St gives

Pt - Et[al Qt - a2a3(Ht-1 - a3St) + Uct] = 0.

Use P t = - g S t + U d t ,
(B.2) becomes

(B.2)

and our tentative assumption that Uct=Uot.

Qt=St+AHt,

- a l H t - (al + a2a~ + g ) S t + (al + a2a3)Ht-1 - Uct + Udt = 0.

(B.3)

al
St = - ~ H t

(B.4)

al + a2a3 .
+ ~ - - H t

l-~Uct+

1
~Udt'

d ---- (al + a2a~ + g).

Use (B.4) and (B.4) led one period to substitute out for St and St+l in H t ' s first-order
condition (3.3) (with a0 =- 0). After some rearrangement, the result may be written
0 = bEtHt+i - (1 + b + m ) H t + H t 1 + gtlcuct + grid

Udt

bEtHt+ - ~lHt + H t - I + gHcUct + gHdUdt,

m=

a2[b(al + g) + ala3(1 - b)]

a l [ g +a2a3(a3 - 1)]

'

(B.5)

g + a2a 2 - bOc[g + a2a3(a3 - 1)]

gHc =-

grid --

al [g + a2a3(a3 - 1)]

al - bq~d(al + a2a3)
a l [ g + a2a3(a3 - 1)]'

It can be shown that inequality (B. 1) guarantees that there is exactly one root less than
one to the polynomial
bx 2 - t/x + 1 = 0.

(B.6)

Call this root ~H, where

/2]

if

~/>0,

0 . 5 b - 1 [ ~ l + ( t 1 2 - 4 b ) 1/2]

if

~/<0.

=0.5b-l[r]-(r]2-4b)
~z4

(B.7)

Using techniques from Hansen and Sargent (1980) it follows that the solution to
problem (B.5) is
H t = ~ H H t - 1 + f HcUct + f Hd Udt,
f Hc =-- [YgH/(1 --b~14Oc)]gHc,

f Hd =~ [~H/(1 --bYgHOd)]gHd.

(B.8)

Upon substituting Equation (B.8) into Equation (B.4) and rearranging, we obtain
St = ~ s H t - I + f scUct + f sdUdt,
fSc =

1 + alfHc
2
'
al + a2a 3 + g

~S =~

al(1 - ~ H ) + a2a3
al + a2a 2 + g

(B.9)

1 -- a l f H d
f S d =-

al + a2a~ + g

916

V.A. Ramey and K.D. West

Let L be the lag operator, "adj" the adjoint of a matrix. From Equations (B.7) and (B.8),
a representation for the bivariate (Ht, H t - O S t f =-- Y t process is
Yt = AYt-I +BUt,

Jr.
A ----

C14 - 0Cs

fH
BI ~

0 '

Yt = (I-AL)-IBUt

file--

c0
f Sc

fHd
f Hd -- O f sd

adj ( I - A L ) ~ .
~

(B.lO)

t~t-/t

1I - A L l Yt : a d j ( I - A L ) B U t .

This m a y be used to solve for the univariate process for H t - OSt, which is
(1 - CHL)(Ht - OSt) = ( f Hc - O f so) uct + O ( : V H f Sc -- Y f S f Hc)Uct-1

03.11)

+ ( f H d -- O f s d ) Udt + O(gHfSd -- ~ S f H o ) U d t - 1 .

Suppose that Udt follows a random walk, so that Cd = 1 and ( f H d - O f s d ) U d t =

( f H d -- O f s d ) ( U d t 1 + edt). Upon using the definition of 0 in Equation (3.5), and in
light o f the quadratic equation used to obtain ZrH, tedious manipulations reveal that
( f Hd -- O f sd) + O ( : r H f Sd -- : r S f HO) = 0. It follows that
Od = 1

:=k

(1 -- : r H L ) ( H t - OSt) = ( f n c - O f sc) uct + O(~mf Sc -- ~ S f Hc) Uc,-I + ( f e o -- O f sd) edt

=- mocUct + mlcUct-i + mOdedt

(1 -

:rilL)(1 - (bcL)(Ht - OSt) = v - moce~t + m1~e~t-1 + m0dedt - OcmOdedt 1

~ MA(1).

(B.12)
Thus, when Od = 1, H - OSt N ARMA(2, 1) with autoregressive roots eVIl and 0c.
Now suppose that a 0, so that Uct = "aIWt + Uct, with E t a Wt = q)wWt 1. Algebra
similar to that used above may be used to conclude that the first-order condition (B.5)
and the decision rules (B.8) and (B.9) become
/

0 = E t ( b H t + l - r]Ht + H t - t + g , w W t +gHeUct + gmdUdt),

H t = Z~HHt 1 + f ~ w W t

+ f HcUct + f HdUdt,

S t = YgsHt-1 + f s w W t + f scuct + f Sd Udt,

gHw ~

(B.13)

( g + a 2 a 2 ) I -- b [ g + a2a3(a3 - 1)]q~/w ~,
al [ g + aza3(a3 - 1)]

f H w ----:rH(I -- bZCHq)/w)-1 gHw,

f S w --

"a + a l f i-lw
2

al + a2a 3 + g

Ch. 13:

Inventories

917

with the other parameters unchanged. It follows that when ~bd= 1

(1 - ~ , L ) ( H t - OSt)
= ( f g w -- O f s w f W t + O(~HfSw -- Y ~ S f H w f W t 1
+ (fI4c -- Ofsc)Uct + O ( ~ g f S c -- YgSfHc)Uct-I + (fHd -- Ofsd)edt.

(1 - :vHL)(Ht - OSt - a' Wt)

= (fh'w - Ofsw - a ) ' W t + [O(gHfsw - arsfHw) + YgHa]'Wt-1
+ ( f i l e -- Ofsc) Uct + O(~14fSc -- ~ S f H c ) Uct t + OCHd -- Ofsd)
__

edt

= mow Wt + [ O ( ~ H f s w - arsf14w) + :rHa]'Wt_l + mo~uct + ml~Uct i + modedt.

(B.14)
When q~w = I and Wt = Wt 1 +ewt, it may be shown that mow + O ( : r H f S w - - : r S f , w)+
ZCHa = 0. Then (B.14) implies
(1

x14L)(Ht-OSt

--

a ' W t ) - --

(B.15)

m o' w e w t + mocUct + m l c U c t - 1 + mOdedt.

Now allow ao ~ 0, as well as arbitrary autoregressive processes for Wt, Uct, and Udt.
When a0 ~ 0, the first-order condition for St (B.2) becomes
-gSt

+ Udt -

Et[(aoAQt - baoAQt+l ) +

alQt

- a2a3(Ht-l

- a 3 S t ) + U c t ] = O,

(B.16)
where Pt = - g S t + Udt has been used to substitute out for Pt. The solution is most
concisely derived if one uses St = Q t - A t t t to remove the St from the first-order
condition (equivalently, if one makes Qt and H t rather than St and H t the choice
variables). After so doing, Equations (B.16) and (3.3) may be written
Et[bAtlXt+l + A o X t +A1Xt-1 +BoUt +BlUr+l] = O, X t = (Ht, Q t f .

(B.17)

The (21) vector Ut is (Udt, U c t f . The matrices A1, Ao and Bo and B1 are (2 2),
with

Ao =A 1 =--

(1 + b)g + a2a~ + ba2(1 - a3) 2

- ( g + a2a 2)

-[g-a2a3(1-a3)]
[ g - a2a3(1 -

~'
0

Vt~CVt.

--a0

Bo =

B1 =

--

'

I:l
0

"
(B.18)
Suppose that Vt ~ (uet, Udt, W~) f N AR(p) (possibly with unit autoregressive roots),
Et 1Vt =q)lVt l + ' " . + ~ p V t ~ . (There may be many zeros in the q)i if there is lots
more dynamics in say Wt than in either uct or Ud). Note for the future that
Ut = 10 01

a3)]

- ( g + a2a23)
g + a~ + a2 a2 + (1 + b)ao '

(B.19)

918

V.A. Ramey and K.D. West

Guess a solution of the form

Xt

(B.20)

R Y t - l -]- GoVt + ' . . + Gp 1Vt~+l =- RXt_~ + G(L)Vt.

In Equation (B.20), the Gi are 2 (2 + dimension o f Wt). In Equation (A.17), use

(B.20) led once to substitute out for EtXt+l, and then substitute out for X t using (B.20).
For condition (B.17) to hold, we must have
(bAil R2 + AoR + A l ) X t - l = 0,

(B.21a)

bA'1 { R G ( L ) V t + [EtG(L)Vt+I]} + AoG(L)Vt + B o C V t + B~ CEt Vt+l = O.

(B.Zlb)
Equation (B.21a) requires bA'l R2 +AoR+A1 =0. Given model parameters, and thus
knowledge o f A1 and A0, this equation may be used to solve for a stable matrix R.
(The matrix equation will have multiple solutions, just as does the scalar quadratic
Equation (B.5). Restrictions similar to those in (B. 1) will insure that there is a unique
stable solution.) It may help to note that the solution matches the earlier one if we
reimpose the assumption that there are no costs o f adjusting production. With a0 = 0,
the second column o f A1 is zero, from which it follows that the second column o f R is
zero. Further, R(1, 1) ~ rl 1 = JrH, r21 = JrH + ;rs - 1 for JrH and ;rs defined in Equations
(B.7) and (B.9).
Whether or not a0 = 0, once R is recovered from Equation (B.21 a), Equation (B.2 lb)
may then be used to solve for the Gi. For example, suppose that Wt and the shocks
are first-order autoregressive, so that p = l : q~l is block diagonal with ~bc in its
(1, 1) element, Cd in its (2, 2) element and q~w in the block in its lower right hand
corner. Then Equation (B.21b) implies
bA'I (RGo + Goq~l) + AoGo + BoC + B1C ~ I = 0,

(B.22)

which can be used to solve linearly for Go in terms o f the model parameters and q~l.
Return to the solution (B.20). Let R = [r/j]. Transform from a solution in (Ht, Qt)'
to one in (Ht, St)' =- Zt, using Qt = St + A H t . The result is
Zt = 111Zt-I + H2Zt-2 + Fo Vt + " + Fp 1Vt p+l,

//1 =

rll +r12
1 +r22+r21 - ( r l l +r12)

Fi = MGi,

M =

lO
1 1

r12
r22-r12

112 =
'

-r12
-(r22-r12 )

0
0 '

"

(B.23)
Thus St 2 does not appear in the reduced form, and the first column o f / / 2 is the
negative o f the second column o f H~. To repeat an earlier point: if ao = 0, then
rl2=r22 =0, rl~ = ~ H , and 1 + r 2 ~ - r l l = ~ s .
Finally, suppose we use Equation (B.23) to derive the autoregressive process for
(Ht, H t - OSt)', and then solve for the univariate process for H t - OSt, using the method

Ch. 13.

919

Inventories

that led to Equation (B.11). When a0 s 0 , the relevant determinant [the analogue
of ] I - A L I in Equation (B.10)] is a second-order polynomial in the lag operator.
Specifically, for/'/1 defined in Equation (B.23), let II1 = [~/j]. Then this second order
lag polynomial is
1 - (Jr11 + 3g12)L+ (3"gl13"g22-}-,7112 -- gg213"gi2)L 2.

(B.24)

The roots to this polynomial are called ~l and :r2. Equation (B.22) may be used to
show that the moving average component of H t - OSt is first order when q)c = 0 and
Od = 1.

B.2. Computation of E(Q 2 - S 2)

The computation of E ( Q 2 - S 2) follows West (1988). In the stationary case, and
ignoring deterministic terms, E(Q 2 - S ] ) v a r ( A H t ) = 2EStAHt = 2cov(S, AHt) =
2 cov[(ASt + ASt-1 + ASt 2 - t - ' ' '), z~LIt] = 2[cov(ASt, AHt) + cov(ASt_l, AHt) + - . . ] .
It may be shown that even in the case S~I(1): (1) under regularity conditions,
Y'~-o cov(ASt4, AHt) is finite and may be consistently estimated; (2) the implications
of the model for the sign of E(Q 2 - S 2) are the same as those for var(Q)-var(S)
when St (and Ht) are I(0) [see the working paper version of West (1990b)]. Let "~j
be an estimate of cov(ASt_j, AHt), which we computed as ~j = T -t ~ t r=j +1 Ast-jAht,
where As and Ah are residuals produced by demeaning or detrending. When St ~I(1),
consistent nonparametric estimation of ~ 0
cov(ASt_j, AHt) involves computing
}-~ii' ~j and letting m ~ oo as T ~ ec. In the computations in Table 4, we let the
number of lags m be 5 for the full samples, 4 for post-1973 samples.

B.3. Estimation of~O

The cointegrating parameters were estimated using dynamic OLS, as advocated by
Stock and Watson (1993). We regressed inventories on a constant and sales (with no
deterministic trend), and included current plus up to two years (or eight quarters)
of leads and lags of the change in sales. We successively eliminated variables with
t-statistics less than 1.65 in absolute value. Heteroskedasticity and autocorrelation
consistent standard errors were computed using a Bartlett kernel with two years (or
eight quarters) of lags.

B. 4. Social planning derivation of the model's first-order conditions

The area under the inverse demand curve is just the integral of the inverse
demand (4.1), and is given by

fo

CX~(udt gXt) dXt

-

UdtS, - 0.5gS~.

(B.25)

The area under the supply curve is equal to the cost function presented as part of
Equation (3.1). Thus, the competitive equilibrium solution is equivalent to the solution

920

V..A. Ramey and K.D. West

to the following social planner problem that maximizes the difference between these
two functions:
MaxH,s V = E, ~_~ b j IUdt+jSt+j - 0.5gSet+j j-O
O.5aoAQ2/ - O.5al Q~+j - O.5a2 (Ht +j-i - a3St +j)2
- U c t +jQt +j]
03.26)
subject to the inventory identity that Qt +j = St +j + A H t +j. The first-order c o n d i t i o n for
inventories is identical to the one o b t a i n e d from the firm-level problem. The first-order
c o n d i t i o n for sales is identical to the one obtained w h e n the industry d e m a n d curve is
substituted into the firm-level first-order c o n d i t i o n for sales.

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V.A. Ramey and K.D. West

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Ch. 13:

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Review 33:181-194.

Chapter 14

RESUSCITATING REAL BUSINESS CYCLES *

ROBERT G. KING
University of Virginia and NBER
SERGIO T. REBELO
Northwestern University and NBER

Contents
Abstract
Keywords
1. Introduction
2. Stylized facts o f a g g r e g a t e activity
2.1. Measuring business cycles with the HP filter
2.2. Some stylized facts of US business cycles
2.3. Some stylized facts of economic growth
2.4. Implications of stylized facts
3. The basic neoclassical m o d e l
3.1. The structure
3.2. Steady-state growth and transforming the economy
3.3. Optimal capital accumulation
3.4. The nature of the steady state
3.5. Transitional dynamics
3.6. The (Un)importance of capital formation
3.7. Constructing dynamic stochastic models
4. The Real Business C y c l e s h o c k
4.1. The driving process
4.2. Calibrating and solving the model
4.3. Business cycle moments
4.3.1. Simulations of US business cycles
4.4. The importance of capital accumulation
4.5. Early successes and criticisms

928
928
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931
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934
941
941
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942
944
946
947
948
950
951
952
952
953
956
958
960
960

* We benefited from the comments of the editors as well as from those of Rui Albuquerque, Robert
Barro, Marianne Baxter, Satyajit Chatterjee, Aubhik Khan, Daniele Coen Pirani, Henry Siu, Julia
Thomas, and Michelle Zaharchuk. Dorsey Farr provided detailed comments and excellent research
assistance. Support from the National Science Foundation is gratefully acknowledged.
Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford
1999 Elsevier Science B.V. All rights reserved
927

928
5. The central role o f productivity shocks
5.1. Productivity shocks must be large and persistent
5.2. The influence of productivity persistence
5.3. Why not other shocks?
6. Extensions o f the basic neoclassical model
6.1. The supply of labor
6.1.1. Estimated and assumed labor supply elasticities
6.1.2. Implications of varying the aggregate labor supply elasticity
6.1.3. Modeling the extensive margin
6.2. Capacity utilization
7. Remeasuring productivity shocks
8. Business cycles in a high substitution economy
8.1. Specification and calibration
8.2. Simulating the high substitution economy
8.3. How does the high substitution economy work?
8.4. What are the properties of the shocks?
8.5. How sensitive are the results?
9. Conclusions
Appendix A. Dynamic theory
A.1. Assumptions on preferences and technology
A.2. The dynamic social planning problem
A.3. A dynamic competitive equilibrium interpretation
A.4. The welfare theorems
References

R.G. King and S.T. Rebelo

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Abstract
The Real Business Cycle (RBC) research program has grown spectacularly over the last
decade, as its concepts and methods have diffused into mainstream macroeconomics.
Yet, there is increasing skepticism that technology shocks are a major source o f
business fluctuations. This chapter exposits the basic RBC model and shows that it
requires large technology shocks to produce realistic business cycles. While Solow
residuals are sufficiently volatile, these imply frequent technological regress. Productivity studies permitting unobserved factor variation find much smaller technology
shocks, suggesting the imminent demise o f real business cycles. However, we show that
greater factor variation also dramatically amplifies shocks: a RBC model with varying
capital utilization yields realistic business cycles from small, nounegative changes in
technology.

Keywords
macroeconomics, business cycles
JEL class~cation: El0, E32

Ch. 14:

Resuscitating Real Business Cycles

929

1. Introduction

Business cycle research studies the causes and consequences of the recurrent
expansions and contractions in aggregate economic activity that occur in most
industrialized countries. Over the last century, exploration of real business cycles the idea that economic fluctuations are caused primarily by real factors - has itself
undergone periods of intense activity and relative dormancy. In the 1920s, real theories
played a leading role: economists sought to use new microeconomic tools to learn
about the aggregate consequences of shifts in demand and supply of goods and
productive factors. However, the Great Depression of the 1930s had a dramatic effect
on business cycle research. Economists began to believe that microeconomic theory
was an inadequate basis for understanding business cycles. Real factors came to be
less stressed, with greater weight given to monetary conditions and the psychology of
households and firms. Government management of the economy came to be seen as
not only desirable but essential.
The rise of Keynesian macroeconomics to a position of orthodoxy in aggregate
economics meant that it took half a century for a revival of interest in equilibrium
business cycle models. The breakdown in the performance of macroeconometric
models in the 1970s and the associated rational expectations revolution pioneered
by Lucas (1976) set the stage for a vigorous recovery, since the logic of rational
expectations ultimately required general equilibrium analysis 1. Kydland and Prescott
(1982) and Long and Plosser (1983) first strikingly illustrated the promise of this
approach, suggesting that one could build a successful business cycle model that
involved market clearing, no monetary factors and no rationale for macroeconomic
management. It is now perhaps hard to recall that this idea was met with surprise and
disbelief.
By the end of the 1980s there was a central and controversial finding of real business
cycle (RBC) research, as this line of work came to be called. Simple equilibrium
models, when driven by shifts in total factor productivity measured using Solow's
(1957) growth accounting approach, could generate time series with the same complex
patterns of persistence, comovement and volatility as those o f actual economies.
Writing a survey of RBC research at that time, it was difficult to find sufficient material
so we settled for expositing the basic model and forecasting future developments 2. A
decade later, our task in this chapter is substantially different: it is time to take stock
of a decade of research, to assess criticisms, and to evaluate the health of the research
program.
The first observation is that it has been a decade of spectacular growth: so many
theoretical and empirical articles use the RBC approach that a full bibliography would

Sargent (1982).
2 King,Plosserand Rebelo (1988a,b) surveyedthis area when a single conferenceprogram could include
most participants in the RBC research program.

930

R.G. King and S.T. Rebelo

likely exhaust the generous page constraint on our contribution to this volume. 3 Real
business cycle analysis now occupies a major position in the core curriculum of nearly
every graduate program. 4 At a recent NBER conference, a prominent Cambridge
economist of the New Keynesian school described the RBC approach as the new
orthodoxy of macroeconomics, without raising a challenge from the audience.
Continuing on the positive side of the ledger, the methods of the RBC research
program are now commonly applied, being used in work in monetary economics,
international economics, public finance, labor economics, asset pricing and so on. In
contrast to early RBC studies, many of these model economies involve substantial
market failure, so that government intervention is desirable. In others the business
cycle is driven by shocks to the monetary sector or by exogenous shifts in beliefs. The
dynamic stochastic general equilibrium model is firmly established as the laboratory
in which modern macroeconomic analysis is conducted.
At the same time, there has been increasing concern about the mechanism at the
core of standard RBC models: the idea that business cycles are driven mainly by large
and cyclically volatile shocks to productivity, which in turn are well represented by
Solow residuals as in the provocative study of Prescott (1986). A key difficulty is
that typical estimates of Solow residuals imply a probability of technical regress on
the order of 40%, which seems implausible to most economists. Recent studies have
corrected the Solow residual for mismeasurement of inputs - notably, unobserved effort
and capacity utilization - and inappropriate assumptions about market structure. These
remeasurements have produced technology shocks with more plausible properties:
notably, productivity growth is much less likely to be negative. In effect, these
studies have caused productivity shocks to grow smaller and less cyclically volatile
by introducing elements which respond sympathetically to economic activity [see, for
example, Burnside, Eichenbaum and Rebelo (1996)].
Since the standard RBC model requires large and volatile productivity shocks, this
remeasurement research is typically interpreted as indicating that our chapter should
be a first draft of the obituary of the RBC research program. In fact, most of our survey
does read like a chronicle of the life and death of RBC models. We begin in Section 2
by discussing the measurement of the business cycle as well as reviewing facts about
growth and business cycles that have motivated the construction of aggregate models.
We next turn in Section 3 to the basic neoclassical model of capital accumulation, as
initially developed by Solow (1956) and others for the purpose of studying economic
growth but now used more widely in the study of aggregate economic activity. We
then celebrate the early victories of the RBC program in Section 4 and discuss early
criticisms.

3 One valuable monitor of this ever-expanding literature is provided by Christian Zimmermann's web
page (http : //ideas. uqam. ca/QMRBC/index, html).
4 One manifestation of the breadth of this intellectual impact is that Hall (1999) cites Berkeley's
David Romer (1996) and Harvard's John Campbell (1994) for authoritative presentations of the basic
RBC model.

Ch. 14: Resuscitating Real Business Cycles

931

There has been a substantial amomlt of research on real business cycles, but we
organize our discussion around three main points in the next three sections. The central
role of large and persistent productivity shocks in the basic model is discussed in
Section 5. Important improvements to the basic RBC framework are highlighted in
Section 6. The remeasurement of productivity shocks, which has fostered concern
about the health of real business cycles, is reviewed in Section 7.
In Section 8 we argue that the incipient demise o f the real business cycle is
hardly as likely as suggested by conventional wisdom. In fact, rather than weaken
the case for a real theory of the cycle, our view is that the recent remeasurement
of productivity actually strengthens it. To make this point, Section 8 describes a
very simple variant of the basic RBC model, but one that is different on two key
dimensions. The economy has indivisible labor, which is one of the key improvements
reviewed in Section 6, and has costly variation in capital utilization, which is
one of the structural features that makes the standard Solow residual depart from
productivity. There is a substantial remeasurement of productivity shocks mandated
by this economy: when we do the necessary correction, the standard deviation of
productivity growth drops to less than one-fifth of the standard deviation of the growth
rate of the Solow residual. Productivity regress occurs in less than 1% of the postwar quarterly observations, even though the measured Solow residual shrinks 37% of
the time. Yet these small shocks can generate empirically reasonable business cycles
because our model features substantial amplification o f productivity shocks: readily
variable capital utilization and a highly elastic labor supply lead small changes in
productivity to have major effects on macroeconomic activity. When we drive our
model with such small measured productivity shocks, there is a remarkable coincidence
between actual US business cycles and simulated time paths of output, consumption,
investment, and labor input. The same structural features that lead the Solow residual
to dramatically overstate productivity fluctuations also lead the economy to greatly
amplify productivity shocks.

2. Stylized facts of aggregate activity

In the 1930s, Burns and Mitchell began to document the existence of a remarkable set
of business cycle regularities. This research program culminated in their 1946 treatise
on Measuring Business Cycles. Burns and Mitchell's arcane methodology led many
economists to view their findings with skepticism [see e.g. Koopmans (1947)] and their
methods fell into disuse 5. But when Hodrick and Prescott (1980) employed modern
time series tools to re-examine the empirical regularities of the business cycle, they

s However,there is some recent interest in these methods. Watson (1994) uses the Burns and Mitchell
methodology to contrast inter-war and post-war US business cycles. Simkins (1994) and King and
Plosser (1994) show that RBC models produce artificial data that the Burns and Mitchell methods
would recognize as having similar characteristics to US data.

932

R. (7. King and S.T. Rebeto

found the Burns-Mitchell facts intact, lurking underneath almost half a century of
accumulated dust. As stressed by Lucas (1977), the finding that "business cycles are
all alike" suggested that the nature o f macroeconomic fluctuations does not hinge on
institutional factors or country-specific idiosyncrasies, so that one can hope to construct
a unified theory of the business cycle.
2.1. M e a s u r i n g business cycles with the H P f i l t e r

Most real quantities, such as US real national output in the top panel o f Figure 1,
grow through time. Hence, the statistical measurement o f business cycles necessarily
involves some way o f making the series stationary, which is most commonly done by
the removal o f a secular trend. In their study o f quarterly post-war US data, Hodrick
and Prescott (1980) detrended their variables using a procedure now widely known as
the HP filter. In essence, this method involves defining cyclical output y~ as current
output Yt less a measure o f trend output yg, with trend output being a weighted average
o f past, current and future observations:
J
Y; = Yt - Yg = Yt - Z ajyt4.
j=-j

(2.1)

Figure 1 displays how cyclical output is constructed. In the first panel, the logarithm
o f current output is the more variable series and trend output is the smoother series.
The HP cyclical component o f output is the dotted line in the second panel, defined
from the elements o f the first panel as y~ = Yt - Y t g except that we have multiplied by
100 so that cyclical output is a percentage 6. Aggregate output displays business cycles
in that there are alternating periods o f high and low output, but these episodes are of
unequal duration and amplitude.
To see how the cyclical output measure produced by the HP filter compares with
those from other detrending methods, we can look at the second and third panels of

6 The HP filter is derived by solving the following minimization problem:

min

{(Yt _yg)2 + it [(yg+, yg)_ (yg _ygl)]2}.

t=l
g oc

{y, },=0
For quarterly data, the standard value chosen for the smoothing parameter it is 1600. When it = oo
the solution to this problem is a linear trend, while with it = 0 the trend coincides with the original
series. In a finite sample context, the weights aj in Equation (2.1) depend on the length of the sample,
so that the text expression is a simplification. King and Rebelo (1993) discuss additional properties of
this detrending procedure, including derivation of filter weights and frequency response fimctions for
the case in which the sample is infinitely large. They establish that the HP filter has strong detrending
properties, in the sense that it can make stationary series up through four orders of integration.

Ch. 14: Resuscitating Real Business Cycles

8.8 -

933

Output

and

HP Trend

8.6-

8.4-

i
o,

............... Output
o

HP Trend

7.8-

7.6-

7.4-

f
7.2

47

I
52

I
57

',

:
62

:
67

',

:
72

l
77

~
82

I
87

I
92

Date

HP and

6.

Band

Pass

(6,32)

Cyclical

Components

42-

~. -2.
-4.

i.J

~'

,.~

~'~. . . . . . .

HP

-6-8 ,
47

',

',

',

',
52

',

',

',
57

',

',

',
62

',

',

',

',
67

',

1
72

t
77

',

',
82

',

',

',
87

',

',

',
92

',

',

',

',

',

',

Date

HP

15

/
-10 ~t
-15 I
47

Growth

Component

and

Linear

Trend

'~

...... Output [~ss Linear Trend

~
-- -- -- HP Trend less Linear Trend

~/
I

I
52

I
57

Residual

i
62

I
67

',
72

',

',

',

',
77

',

',

',

',
82

',

',
87

',

',

',

',
92

Date

Fig. 1. Trend and business cycle in US real output. Sample period is 1947:1-1996:4.

934

R.G. King and S.T. Rebelo

Figure 1. First, if we simply subtract a linear trend from the log o f output, the resulting
business cycle component would be the solid line in the third panel o f Figure 1. This
alternative measure o f cyclical output is much more persistent than the HP measure:
for example, output is high relative to its linear trend during most o f the 1960s and
1970s. The dashed line in the third panel is the gap between the HP trend and a linear
trend, thus indicating that the HP filter extracts much more low frequency information
than a simple linear trend.
It is also useful to compare the HP cyclical component with the business cycle
measures resulting from the band-pass (BP) filter procedure developed by Baxter and
King (1995), since such measures are presented by Stock and Watson (1999) in their
extensive compilation o f business cycle facts elsewhere in this volume 7. In the second
panel o f Figure 1, the HP measure o f cyclical output is accompanied by a BP measure
o f cyclical output: this procedure makes the cyclical component mainly those parts
o f output with periodicities between 6 and 32 quarters. For series like output, which
contain relatively little high frequency variation, Figure 1 shows that there is a minor
difference between these alternative cyclical measures.
There has been some controversy about the suitability of the HP filter for business
cycle research. Prescott (1986) notes that the HP filter resembles an approximate highpass filter designed to eliminate stochastic components with periodicities greater than
thirty-two quarters. Adopting that perspective, we are simply defining the business
cycle in a fairly conventional way: it is those fluctuations in economic time series that
have periodicity o f eight years or less s. At the same time, the third panel o f Figure 1
reminds us that there are slow-moving stochastic components o f economic time
series omitted by this definition, which may have substantial positive and normative
significance.

2.2. Some stylized facts of US business cycles

Making some selections from the data set that Stock and Watson (1999) investigate
more extensively, we apply the HP filter to produce cyclical components for key US
macroeconomic variables 9. Figures 2, 3 and 4 provide graphs of the HP business cycle
components o f major US aggregates. We use the cyclical component of output as a
reference variable, placing it in each panel of each figure, so as to allow the reader to

7 Since an exact bandpass filter contains an infinite number of moving average terms, a practical
bandpass filter cannot be produced exactly but involves approximations. Baxter and King (1995) derive
the relevant formulas, imposing the constraint that the sum of the filterweights must be zero; they also
compare the BP filter to several other detrending methods including the HP filter.
8 Eightyears corresponds to the longest reference cycle that Burns and Mitchell (1946) tmcoveredusing
very different methods. Stock and Watson (1999) adopt an alternative view of the interesting business
cycle periodicities (six to twenty four quarters), but this is a difference of degree rather than kind.
9 This data set covers the period 1947 (first quarter) to 1996 (fourth quarter).

Ch. 14: Resuscitating Real Business Cycles

935

Nondurables

2|

i, i '

.,I

.
sD

~
!X

'

~i~

-8,
:
47

Consumption

and Output

i~"
~,

~':"
in!

ii

"d(

..

ki
xj ....
- - -

~6

: :
52

: :
57

: :
62

: :
67

: :
72

: :
77

: :
82

Output
Consumption (ND)
: :
87

: :
92

Date

30

Durables

Consumption

and Output

20

Output

....

15.L

I~

o[~t
/ .p,(~,
!/\.!,k
p l , l ' , # i { i "~,"J
I J
IJ

!,lA
1/.1 " / i . q "
l'I

-5

i?

....

j~.<,h,,~,~
I"
""i

t,,?i
/

'. . . . . . . . . . . . . .

47

52

57

62

67

/,/i'~ . . . .
7. j~
IJ

7""~

72

c .....

pt~on ( D )

ft,i'l.IJll~NY't\

....
i'J.\
f
I t" e l

77

f:4't,.,.~,~

I'"

82

-;d"

87

"

92

Date

Investment

15-

and Output

105-

if'<./

~0

+, .

i\

zJ

<<1"!,

,,N~

i,,

~ ~

.... .,

~ -5-10

-154

.....
,,

,,

', :
52

', ,, :
57

', ,, ,, ,, ,, :
62
67

', :
72

v .--7W y ont

. . . . . . . . . . . . . . . . . .
77
82
87

92

-20 -

Government

1510-

Spending

and Output

i~

50

k,v:'li i

m-1O

,g

'71

-5-

,l

,jv'i ~

,~/.-..-~

""','<l

" ; ':'

,.~A/.~

-254
-25

Output
-- -- - - Gov't Spending

!~

-15 :
'

-vv ,.;.--,'w-v

. . . . . . .

; ;
52

', ;
57

: :
62

; ;
57

: :
72

: :
77

: :
82

: :
87

: :
92

Date

Fig. 2. Cyclical components of US expenditures. Sample period is 1947:1-1996:4. All variables are
detrended using the Hodrick-Prescott filter.

R.G. King and S.T. Rebelo

936
6

Total Hours

and Output

4.

2.

"<

!f

-..

'!d

-; ;--~ 2',,?'.o~

~I

-6-8,

47

: :
52

: :
57

: :
62

', :
67

',

: :
72

: :
77

: :
82

: :
87

: :
92

Date

Capital

:t

i~ ~!

'ii

"

and Output

i:

"

i t

i '

, :.,:

lJ

47

: ',
52

; :
57

: :
82

: :
67

I I
72

!, i

i/

i I
77

/
............. pu,

~I

..........

I I
82

I I
87

I I
92

Date

Capital

10-

Utilization

and Output

5-

J',~

:'~,,~

! ~' t;i

t I

~'4

;I

t'l

"~1

-lO -15,

fl, h

i,!

:%2

it "v'~e

VI

.D

/jl

\,-/

W7

II

I/J

W/

'~ ~,, t

I ,

57

62

67

72

-" "

~V'

~ I

~,I

~l

52

m ....

'~ .t

:,

"~,..d u
'~ u

"

Out ut
- - -- - - Capital UtilizaSon

77

82

87

92

Date

!4

Productivity

1.',J

J. ~-

47

"~/

~/

[J

it

.o

(Solow

,t

"

residual)

'(.,'~Lt

/b/

?!

52

57

and Output

~,

62

67

72

I*:

'~/

.............o=,

~"

77

82

- - - - - - Productivity

87

92

Date

Fig. 3. Cyclical component of US factors of production. Sample period is 1947:1-1996:4. All variables
are detrended using the Hodrick-Prescott filter.

Ch. 14." Resuscitating Real Business Cycles

937

Hours per Worker and Output

it

o ~

~t

~.i<

~,

._,~,,i.~

~"

iv;

.,

t I
~

'~

7
i;

tY

i,

,ok.

; .,,,

~ ,,

"

"v"

,.A!,,,x.<,~

~ . ~ ^ ]

;~"

i/

~,

I >

t;

,1

\ f
........................
Output
- - - - - - Hoursper Worker

Date

Employment and Ouput

,~',

:-

-4

V~

-6

47

i. 7 '

52

(;

iY

kV'

","

ij

57

62

67

72
Datll

77

o.o.,
Employment

----

82

87

92

Average Product and Output

,
,,

,:,

P.

h,,>, ,2,~v.,~,"
~l\w.

.D ,j,,],k{"~ .,w), t~ ,.~,h:

t /

i l;~ .ACd~,..."~_,

i, ii

- -

h~..- .,

A,e,.g. P,odoot

7
-8

47

52

57

62

67

72
Date

77

82

87

92

Real Wages and Output

V'UI ~"," W"

~.-2.
4-

i"'"v',d'".'hv '-'v"

i!
t 7
/ i
I}

t/
{/
I'

. 47
. . . . . . 52
. . . . . . 57. . . . . 62

'..~; '4,;',41
"i'/

ti

t~

6]i 7I

~/
/ )
7
V

712 . . . . 77
. . .

v.>.-/'- ~.~'>,",-./"
/

i
" ~
\,J

," .4
......... Output
-- - - - Rea Wages

812111817

I 912111

Date

Fig. 4. Cyclical component of US labor market measures. Sample period is 1947:1-1996:4. All variables
are detrended using the Hodrick-Prescott filter.

R.G. King and S.T. Rebelo

938
Table 1
Business cycle statistics for the US Economy
Standard deviation

Relative standard
deviation

First-order
autocorrelation

Contemporaneous
correlation with output

1.81

1.00

0.84

1.00

1.35

0.74

0.80

0.88

5.30

2.93

0.87

0.80

1.79

0.99

0.88

0.88

Y/N

1.02

0.56

0.74

0.55

0.68

0.38

0.66

0.12

0.30

0.16

0.60

-0.35

0.98

0.54

0.74

0.78

a All variables are in logarithms (with the exception of the real interest rate) and have been detrended
with the HP filter. Data sources are described in Stock and Watson (1999), who created the real rate
using VAR inflation expectations. Our notation in this table corresponds to that in the text, so that Y is
per capita output, C is per capita consumption, I is per capita investment, N is per capita hours, w is
the real wage (compensation per hour), r is the real interest rate, and A is total factor productivity.

easily gauge the relative volatility o f the series i n question and its c o m o v e m e n t with
output. S u m m a r y statistics for selected series are provided in Table 1 10
Volatility: Economists have long b e e n interested in understanding the e c o n o m i c
m e c h a n i s m s that underlie the different volatilities o f key m a c r o e c o n o m i c aggregates.
The facts are as follows, working sequentially w i t h i n each figure and using the notation
panel 2-1 to denote panel 1 o f Figure 2 and so forth:
C o n s u m p t i o n o f non-durables is less volatile t h a n output ( p a n e l 2-1);
C o n s u m e r durables purchases are m o r e volatile t h a n output ( p a n e l 2-2);
I n v e s t m e n t is three times more volatile than o u t p u t ( p a n e l 2-3);
G o v e r n m e n t expenditures are less volatile than output ( p a n e l 2-4);
Total hours worked has about the same volatility as output ( p a n e l 3-1);
Capital is m u c h less volatile than output, b u t capital utilization in m a n u f a c t u r i n g is
more volatile than output ( p a n e l s 3-2 and 3-3)11;
E m p l o y m e n t is as volatile as output, while hours per worker are m u c h less volatile
than output (panels 4-1 and 4-2), so that most o f the cyclical variation in total hours
worked stems from changes in employment;
Labor productivity (output per m a n - h o u r ) is less volatile than output ( p a n e l 4-3);

10 For a discussion of open economy stylized facts see Baxter and Stockman (1989), Back-us and Kehoe
(1992) and Baxter (1995).
1~ This measure of capacity utilization, constructed by the Federal Reserve System, is subject to
substantial measurement errol, see Shapiro (1989).

Ch. 14.. Resuscitating Real Business Cycles

939

The real wage rate is much less volatile than output (panel 4-4).
Comovement: Figures 2 through 4 show that most macroeconomic series are
procyclical, that is, they exhibit a positive contemporaneous correlation with output.
The high degree of comovement between total hours worked and aggregate output,
displayed in panel 3-1, is particularly striking. Three series are essentially acyclical wages, government expenditures, and the capital stock - in the sense that their
correlation with output is close to zero 12.
Persistence: All macroeconomic aggregates display substantial persistence; the firstorder serial correlation for most detrended quarterly variables is on the order of 0.9.
This high serial correlation is the reason why there is some predictability to the
business cycle.
In presenting these business cycle facts, we are focusing on a small number of
empirical features that have been extensively discussed in recent work on real business
cycles. For example, in the interest of brevity, we have not discussed the lead-lag
relations between our variables. In choosing the series to study, we have also left
out nominal variables, whose cyclical behavior is at the heart of m a n y controversies
over the nature o f business cycles 13. However, we do report the cyclical behavior
of a measure of the expected real rate of interest from Stock and Watson (1999) in
Table 1. This real interest rate is constructed by subtracting a forecast o f inflation
from the nominal interest rate on US treasury bills. There is a negative correlation
of the real interest rate with real output contemporaneously and, indeed, this negative
relationship is even stronger between real output and lagged real interest rates. Many
modern macroeconomic models, including real business cycle models, have difficulty
matching this feature of business cycles ~4

12 The observation that the real wage is not tightly related to the business cycle goes back to Dunlop
(1938) and Tarshis (1939) who stressed that this was at odds with Keynesian models. This finding is
somewhat dependent on precisely how the real wage is constructed,depending on whether the numerator
(the wage) includes various compensation items and on the index in the denominator (the price level).
Two particular features of wage measurement that affect its cyclical behavior are as follows. First, firms
pay for overtimehours in an expansion and layoffregular hours in a recession. Second, there is a cyclical
composition bias in the labor force lowerquality workers are hired in expansions - which suggests
that the real wage per efficiencyunit of labor effort is procyclical.
13 See Stock and Watson (1999, Sections 3.4, 3.6, and 4.1) for a discussion of literature and empirical
results.
14 King and Watson (1996) find this negative "leading indicator" relationship between the real interest
rate and real activity, using BP filtered data. They also show that a number of modem macroeconomic
models, including the basic RBC model, are unable to match this fact even when driven by complicated
forcing processes that allow them to match most other features of the business cycle. However, while this
result is provocative, it is important to stress that the behavior of this real interest rate involves assuming
that the inflation forecasting equation is temporallystable and that agents know this forecasting structure
in advance.

R.G. King and S.T. Rebelo

940
0.6.

L a b o r ' s Share of O u t p u t

0.575.
s',
/ t
k/
'. / ~j/
,,~

0.65

0.525-

~i

> ?

"W

<'j

i~ ;

=~" j

i l t!j

b!

.... 4 7

"2

'

. . 62
. . .

7~

67

'

"

'

'2

'

"

'

92
'

'

Date

0.25 -

Investment - Output Ratio

0.2-

0.15 -

0.1-

0.o5 -

oi

'

47

'

52

'

"~

'

'

"2

'

7,

'

"2

'

6',

72

'

Daia

6>75

Consumption - Output Ratio

0.7
\J'lt.

0.65

,,.#

0.6
0.55

o%

.
52

. . .

57

'2

'

'

'
72

'

7,

. . .82 .

"2

87

Date

11oo

Hours per Person

/ i~

j~

1000

~J

<ji

660

\/

000

850
. . . . .

47

52

62

72
Date

77

67

Fig. 5. Growth facts: great ratios and hours per person.

'

Ch. 14: ResuscitatingReal Business Cycles

941

2.3. Some stylized facts of economic growth

While the US time series for many aggregates grow overtime, there are many '~great
ratios" that appear to be relatively constant, suggesting that there are a small number
of common forces which give rise :to trend growth. As with the systematic patterns
of business cycles, this finding :is also consistent across many countries and .time
periods, suggesting that there may be a coherent theoretical explanation of its origin.
These stylized facts of economic growth were uncovered as applied researchers such as
Kuznets (1973)assembled long time series on economic growth. 'They are sometimes
called the "Kaldor facts" of growth because Kaldor (1957) drew attention to them: in
addition to the constancy o f great ratios, he stressed that the growth-process seemed
to involve growth rates and interest rates that were stationary'even'though the'level of
economic aggregates were not.
The great ratios. Panels 1-3 of Figure 5 illustrate that the .process ,of:sustained
growth appears to leave many of the shares of income components and output
components relatively unaffected 15. The ratios of investment to output and labor
income to output appear to fluctuate around constant means. The ratio of consumption
to output does increase from 1952 onwards, but there is nothing like the 'large trend
that we saw in output in Figure 1. Stability of the great ratios implies that most ~series
have a similar rate o f growth, .so that there is no deterministic trend in the ratios, and
that factors causing permanent changes in the 'level of economic activity do so in a
way that makes their effects proportional across series.
Labor and growth. During long-term economic growth, which most economists
believe occurs mainly due to population growth and technical progress, measures 'of
labor input per person are also relatively constant asdocumented inpanel 4 of Figure 5.
This relative constancy of hours per capita is remarkable given the rise in real wages
that accompanies economic growth. Over our sample period, the real wage measure
previously studied in panel 4 of Figure 4 grew at 1.76% per year, but there is little
evidence of a trend in hours worked per person.

2.4. Implications of stylized facts

Some of the facts just described have been influential .in shaping the views of
economists about of how the economy operates. In terms of the business cycle
facts, the high volatility of investment no doubt underlies Keynes' famous assertion
that investors have "animal spirits". At the same time, the low cyclical volatility of
capital is often taken to imply that one can safely abstract from movements in capital
in constructing a theory of economic fluctuations. The remarkably high correlation

15 Klein and Kosobud (1961) produced an early test of the stability of the "great ratios" in the USA.
More recently, King, Plosser, Stock and Watson (1991) drew attention to how the constancy of these
great ratios was a cointegration implication about the logarithms of the variables, which they tested for
the USA. Evidence on cointegration for other OECD countries is contained in Neusser (1991).

R.G. King and S.T. Rebelo

942

between hours worked and aggregate output has led some economists to believe that
understanding the labor market is key to understanding business fluctuations. Finally,
the relatively small variability of real wages and the lack of a close correspondence of
wages with aggregate output, has led some economists to conclude that the wage rate
is not an important allocative signal in the business cycle. The growth facts suggest the
importance of building models that feature a common trend in most real aggregates.

3. The basic neoclassical model

In the 1950s and 1960s, aggregate economic activity was analyzed with two very
different types of dynamic macroeconomic models. The trend components of aggregate
economic activity were studied with "growth models" that stressed three sources
of dynamics: population growth, productivity growth and capital formation. The
business-cycle components were studied with Keynesian macroeconomic models,
which stressed the interaction of consumption and investment but downplayed the
importance of capital accumulation and productivity growth. While there were attempts
to synthesize these developments towards the end of this period, the study of growth
and business cycles most frequently involved very disparate models. Relative to this
traditional macroeconomic approach, the real business cycle literature took a very
different point of view. Its core is a neoclassical growth model of the form developed
by Solow (1956), Cass (1965) and Koopmans (1965). It then follows Brock and
Mirman (1972) in making this growth model stochastic, by positing that the production
technology is buffeted by random aggregate shocks to productivity.
Our introduction to RBC analysis thus naturally begins by reviewing the "basic
neoclassical model", which has implications for both growth and business cycles. In
this section, we focus on the structure of the model, trace some of its implications for
capital accumulation, and discuss Solow's work on productivity measurement. In the
next section, we discuss its business cycle properties.

3.1. The structure

The basic neoclassical model is built on assumptions about preferences, endowments
and technology that are designed to capture key features of growth and business cycles,
while building a model economy that is readily amenable to economic analysis.
Preferences: The economy is populated by a large number of infinitely lived agents
whose expected utility is defined as
O<3

Eo ~

btu(Ct, Lt),

b > 0,

(3.1)

t=O

where b denotes the discount factor, Ct represents consumption and Lt leisure. The
symbol E0 denotes the expectation of future values of C and L based on the information

Ch. 14: Resuscitating Real Business Cycles

943

available at time zero 16. The infinite horizon assumption, which greatly simplifies the
mathematical analysis o f economic growth and business cycles, is usually justified
by appealing to the presence o f altruistic links across generations [Barro (1974)].
However, it can be viewed as an approximation to an economy with many long-lived
agents 17. In our exposition o f this model, we treat the population as constant for
simplicity, although we discuss the consequences of relaxing this assumption at various
points below.
The momentary utility function u(Ct, Lt) in Equation (3.1) is assumed concave and
obeys regularity conditions discussed in the Appendix. It implies a preference for
smooth profiles o f consumption and leisure. It also implies a willingness to substitute
across time if interest rates and wage rates imply differing costs of consumption and
leisure at different dates. Thus, the neoclassical model imbeds a form of the permanent
income hypothesis of Friedman (1957).
Endowments: The fundamental endowment that individuals have is their time, which
can be split between work (Nt) and leisure activities (Lt). Normalizing the total amount
o f time in each period to one, the time constraint is:

Nt + Lt = 1.

(3.2)

We abstract from other endowments of resources since the production from unimproved
land and from nonrenewable resources is a small fraction o f output in most developed
countries.
Technology: The output o f the economy is assumed to depend on a production
function that combines labor and capital inputs. To capture the upward trend in output
per capita that is shown in Figure 1, the basic neoclassical model incorporates secular
improvement in factor productivity. In particular, output (lit) depends on the amounts o f
capital (Kt) and labor (Nt) according to a constant returns to scale production function
which satisfies regularity conditions discussed in the Appendix.

Yt = AtF(Kt, NtXt),

(3.3)

where At is a random "productivity shock" variable, whose law of motion will be

described further below, and Xt represents the deterministic component o f productivity.
This latter component of productivity is assumed to expand at a constant rate,
Xt+ 1 = yXt,

y > 1.

(3.4)

16 TO simplify, we adopt a dating convention that does not distinguish between "planning time" for the
individual and "calendar time" for the economy. Alternative presentations that emphasize this distinction
would write the objective as E t }-~)~obJu(Ct+j,Lt+j), where t is calendar time andj is planning time.
17 Rios-Rull (1994) finds that an overlapping generations model calibrated to the age structure of the
US population has business cycle properties that are similar to an infinite horizon model.

R.G. King and S.T. Rebelo

944

The output o f the e c o n o m y c a n be used for consumption or investment (It) so that an

additional resource constraint is:

(3.5)

I1, = c , + 1,1

This equation corresponds to the basic national i n c o m e accounting identity for a closed
economy with no government. The stock of capital evolves according to:
Kt+ l = It + (1 - 6)Kt,

(3.6)

where 6 is the rate o f depreciation. This formula coincides with the one used in practice
to estimate the stock o f capital according to the "perpetual inventory method ''18.
The form o f the production function (3.3) is motivated by the growth facts and
was widely employed in growth models after Phelps (1966) showed that steady-state
growth - a situation in which all variables grow at a constant rate - required that the
deterministic component o f technology be expressible in labor augmenting form in
economies with Equations (3.5) and (3.6) 19~ In fact, in the feasible steady states of
this model consumption, investment, output and capital all grow at the same rate - the
rate o f trend technical progress - so that the great ratios are stationary.
Initial conditions: The economy starts out with a capital stock K0 > 0. It also
begins with a level o f the technology trend X0 > 0, which we set equal to unity for
convenience, and an initial productivity shock A0 > 0.

3.2. Steady-state growth and transforming the economy

Our assumptions on the production side o f the. model ensure that a steady-state path
is feasible in the face o f the trend productivity expansion in X~. However, additional
assumptions are necessary to make such a steady state desirable. In the standard fixed
labor version o f the basic neoclassical model momentary utility has to take the form
1

u(C) = ~-L-~[C

1-o

- 1],

(3.7)

where cr > 0. This utility function insures that the marginal rate o f substitution between
consumption at dates t and t + 1 depends only on the growth rate o f consumption.
18 In practice the perpetual inventory method allows the depreciation rate to vary through time according
to empirical measures of economic depreciation schedules. Ambler and Paquet (1994) study a RBC model
with depreciation shocks.
19 Three types of technical progress frequently discussed in the literature can be represented in a general
production function:

Yt = X y F (KtXK, NtX,).
The variable X'tH represents total factor augmenting (Hicks-neutral) technical, progress, YtK capital
augmenting technical progress, and Xt labor augmenting (Harrod-neutral) technical progress,. When
the production fimction is Cobb-Douglas these different forms of technical progress are interchangeable
and, hence, they are all consistent with balanced growth. For all other production functions, the only
form of technical progress consistent with steady-state growth is labor augmenting,

Ch. 14:

Resuscitating Real Business Cycles

945

In the basic neoclassical model of growth and business cycles, which features
endogenous labor supply, a steady state also requires that hours per person be
invariant to the level of productivity. King, Plosser and Rebelo (1988a,b) show that
the momentary utility function must be expressible as
b/(C, L) = ~

{ [ C v ( L ) ] 1-g _ 1},

(3.8)

which also implies exactly offsetting income and substitution effects of wage changes
on labor supply 2. The function v(.) satisfies regularity conditions discussed in the
Appendix.
When these restrictions are imposed, it is possible to transform the economy - so
that steady-state growth is eliminated - by scaling all of the trending variables by the
initial level of X: Using lower case letters to denote these ratios, for example yt = Yt/Xt,
we can then write the optimal growth problem as maximizing the transformed utility
fimction:
C~

(3.9/

~-~/3tu(ct,Lt)
t=0

with/3 = by 1-~ being a modified discount factor satisfying 0 < /3 < 1. Utility is
maximized subject to the transformed constraints:
Nt

= 1 - Lt,

(3.1 O)

Yt

= AtF(kt,Nt),

(3.11)

Yt

= Ct + it,

(3,12)

ykt+ l = it (1 - 6)kt.

(3.13)

Relative to an economy in which there is no growth due to X, this transformed

economy involves an altered discount factor and a slight modification of the capital
accumulation equation. Given this close correspondence, RBC analyses sometimes
omit growth all together or simply start with the transformed economy 21.

20 That is, suppose that Equation (3.8) is maximized subject tothe static budget constraint C <~ w(1 -L).
The equality of the real wage with the marginal rate of substitution between leisure and consumption
implies
CDv(L) _ [w(1-L)]Dv(L)
W

v(L)

v(L)

'

with the latter equality following from eliminating consumption using the budget constraint. Changes in w
have no effect on the optimal level of leisure and labor supply.
21 By leaving out population growth, we have essentially proceeded in this manner. However, since
productivity is labor-augrnenting~ we can reinterpret the stationary transformation as.one that involves
dividing through by both the population and the productivity of labor. Under this interpretation, ~' is the
growth rate of population and productivity.

946

R.G. King and S.T. Rebelo

Constraints (3.11), (3.12), and (3.13) can be summarized by the equation

ct + ykt + ~ = A t F ( k t , N t ) + (1 - 6)kt.

(3.14)

3.3. Optimal capital accumulation

The optimal path of capital accumulation can be obtained by choosing sequences for
consumption {ct}~0, leisure {Lt}~0, labor {Nt}~-0 and the capital stock {kt+ l}~0
to maximize Equation (3.9) subject to conditions (3.10) and (3.14). For this purpose,
we form the "Lagrangian"
O<3

L = Z

fitu(ct'Lt)

t=O

+ ~ffXt[AtF(kt,Nt)

+ (1 - b)kt - ct - 7kt+ 1]

t=O
oG

t=O

The first-order conditions include

ct

: DlU(Ct,Lt) = L ,

Lt

: D2u(ct,Lt) = cot,

Aft

: L A t D 2 F ( k t , N t ) = cot,

kt+l : [3)~t+l[At+lD1F(kt+l,Nt+l)+ 1 - 6 ] = yAt,

(3.15)
(3.16)
(3.17)
(3.18)

where we use the notation Diu(c, L) to denote the partial derivative of the function
u(c,L) with respect to its ith argument. The first pair of these efficiency conditions
dictate that the marginal utility of consumption be set equal to its shadow price
[associated with the constraint (3.14)] and that the marginal utility of leisure be set
equal to its shadow price (associated with the time constraint Nt + Lt = 1). The
second pair of efficiency conditions dictate that the utility value of goods produced
with a marginal unit of work (the marginal value product &tAtD2F(kt, Nt)) equal its
utility denominated cost (cot) and that the present value of the future product of capital
([~t+ 1[At+ 1DlF(kt+ 1,Nt+ 1) + 1 - 6]) equal its current utility cost (T),t). An optimal
consumption, leisure, work and capital plan - sequences {ct}~0, {Lt}~0, {Nt}~0,
and {kt}~ 0 - satisfies these first-order conditions, the original constraints, the initial
condition requirement on kt and the transversality condition, l i m t ~ fit,~tkt +j = O.
Optimal capital accumulation in the basic neoclassical model is a "general
equilibrium" phenomenon in three ways. First, the choices of consumption, labor
and capital accumulation are interdependent at each point in time and across time:

Ch. 14: ResuscitatingReal Business Cycles

947

a solution for optimal capital accumulation involves specifying sequences for all three
of these variables. Second, the requirement that the optimal decisions must respect the
resource constraints of the economy is signalled by the shadow prices (cot and )~t). An
optimal capital accumulation plan thus also involves specification of sequences of these
prices. Third, if these shadow prices were market prices for individual households,
then they would similarly signal these agents to supply and demand the optimal
quantities. That is, there is an equivalence between the optimal quantities chosen by
the social planner and those in a dynamic competitive general equilibrium in the basic
neoclassical model. We will thus move between optimal and market outcomes in our
discussion of the basic model as it seems useful in the next several sections. We will
return later to discuss how work on real business cycles relates to other developments
in dynamic stochastic general equilibrium modeling.

3.4. The nature of the steady state

There is a unique stationary state that occurs in the transformed economy when At = A
for all t. The first-order conditions can be used to describe this stationary state in a
recursive manner. First, the capital accumulation efficiency condition implies that

AD1F(k, N) = (r + 6),

(3.19)

where r = ~ - 1 is the stationary state real interest rate and r + 0 is the stationary
state rental price of capital. Given that the production function is constant returnsto-scale, the marginal product of capital depends on the capital-labor ratio k rather
than on the levels of the factors. Accordingly, Equation (3.19) determines the capitallabor ratio as a function of productivity and the rental rate. Second, given this capitallabor ratio and the level of A, the marginal product of labor is also determined, since
ADzF(k, N) = ADzF(~, 1). Thus, there is a real wage rate w = co/;. that is determined
independently o f the total quantity of labor:

w=~=AD2F(k,1).
Third, there are unique levels of work, consumption and the shadow price of
consumption that satisfy the remaining equations.
We know that the variables in the original, untransformed economy are related to
those of the transformed economy by a simple scaling procedure, Yt = ytXt, etc. Hence,
if the transformed economy is in a stationary state, then the original economy will be
in a steady state with many variables - including, consumption, capital output and real
wages - growing at the same rate. Other variables will be constant, notably work effort
and the real interest rate.

R.G. King and S, T. Rebelo

948

Output

Capital

0-

0.

-0.05'-

-0.2.

-0.1 -0.4.

~=~o ~ j

-0.15 ~

-0.6.
-0.0

,o.25 -

~'~

. . . . . . .

-0.3 :

-0.351

-t.2,

3 4

2 0 4

5 6 7 8 9 10 11 12 13 14 15 16 ~7 ,18 19 20

',

0,1.

-0.2 -

O.6

0.

1.2

Consumption

and Labor

1.4

0.8

Quarters

Quarters

Investment

5 0 ? 8 9 1011121314151617181020

.... c,

"" ~

~0.3

~ -0,4.

0,4

4/.5

0.2,
-O.6

2
2

9 10

14 15 ~6 17 18 19 20

5 0

7 8 9 10 11 1213 14 15 16 17 18 19 20

-O.7.

Quarters

Real Interest Rate

16

Real Wage

14
.

12

-0.1

.-0.05
... I
-0.15

~
~,~

~8

" ~

-0.2

O~

9 10 11 12 13 14 15 16 17 18 19 20

Quarters

9 10 11 12 13 14 15 16 17 18 19 20
Ouartem

Fig. 6. Transitional dynamics: Basic RBC model (stars); fixed labor model (circles); dashes in mid
left-hand panel represent labor response.

3.5. Transitional dynamics

Transitional dynamics arise whenever the intitial capital stock is different from its
steady-state value 22. For stationary versions of the fixed labor model, Cass (1965) and
Koopmans (1965) established that it is always optimal for the economy's capital stock
to move monotonically toward the stationary level from any positive initial level o f

22 In the transformed economy, this is the movement from an initial level of capital k0 to the stationary
level k.

Ch. 14: Resuscitating Real Business Cycles

949

capital. Working to establish this stability theorem, Cass and Koopmans were hampered
by the absence of an explicit solution to the model, which stemmed from the presence
of many interdependent choices for consumption and capital at different dates. Thus,
they were able to establish the stability property, rather than ascertaining how the pace
of the transition process depended on the underlying preferences and technology.
More precise descriptions required the detailed specification of preferences and
technology, with near steady-state linear approximations sometimes being used to
evaluate the nature of the global transitional dynamics. Figure 6 illustrates the nature of
these local transitional dynamics of capital, as well as the related movements in output,
investment and consumption. There are two sets of paths in each of the panels: the
' o ' path describes the fixed-labor model used by Cass and Koopmans and the ' . ' path
describes the variable-labor model used in RBC analysis. In these panels, all variables
are displayed as percentage deviations from their corresponding stationary values. For
both models, the economy is assumed to start off with a capital stock that is one percent
lower than its stationary value, so that both of the paths in the upper left panel have
an entry o f - 1 at the first date.
Looking first at the 'o' paths that describe the transitional dynamics of the CassKoopmans model, we see that capital accumulates through time toward its stationary
level, i.e., the (negative) deviation from the stationary level becomes smaller in
magnitude through time. Since capital is low relative to the steady state, the second
panel shows that output is also low relative to the stationary state. Capital is built up
through time by individuals postponing consumption. In a market economy, a high real
rate of return is the allocative signal that makes the postponement of consumption
occur, with the rate of return given by rt = [ A D 1 F ( k t + I , N ) - 6] in the fixed labor
economy. Using the preference specification (3.7), in fact, one can show that the growth
rate of consumption is given by
l o g \( O ct
r + ' j) -- - ~1 log ( ~ t l )

~ -1~ [ r t - r ] ,

(3.20)

so that a high real interest rate fosters consumption growth along the transition path 23.
The initial level of consumption is set by the wealth o f individuals or, equivalently,
so that the efficient path of consumption will ultimately be at the stationary level.
In general, as the economy saves to accumulate the new higher stationary level of
capital, net investment it - 6kt is positive along the transition path. In this figure
gross investment is also higher than its stationary level during the process of capital
accumulation.
23 In fact, the value of cr used in constructing Figure 6 is one, so that consumption growth and the rate
of return are equal. The time unit of these graphs is a quarter of a year, however, and the interest rate
is expressed at an annual rate, so that the slope of the consumption path is one fourth of the annualized
interest rate shown in the next to last panel. A basis point is one hundredth of a percentage point, so that
an annual interest rate that is 0.10 percentage points above the steady-state level causes consumption to
grow from about -0.600 to about -0.575 in the second panel.

R.G. King and S.T. Rebelo

950

When work effort is endogenous, as in the ' , ' path of Figure 6, these transitional
dynamics change significantly, although there is still a period of capital accumulation
toward the stationary level. The extra margin matters for the speed of the transition.
When capital is initially low individuals work harder and produce more output that is
used for capital accumulation. This extra effort occurs despite the fact that the real
wage (wt = AD~F(kt,Nt)) is low relative to its stationary level. Again, the allocative
signal is a high rate of return that makes it desirable to forgo leisure (as well as
consumption) during the transition process. In fact, there is a subtle general equilibrium
channel that enhances the magnitude of the effect on the rate of return. With more
future effort anticipated, the rate of return rt = [ADtF(kt+I, Nt+ 1) - 6] is higher than
in the fixed labor case, because additional effort raises the marginal product of capital.
Further, this higher rate of return stimulates current work effort. On net, variable effort
raises the speed of transition and mitigates the effects of initially low capital on output
and consumption, while enhancing the investment response.
3.6. The (Un)importance o f capital formation

The capital accumulation mechanism at the heart of the basic neoclassical model
is sometimes viewed as relatively unimportant for growth and business cycles. In
the growth area, Solow followed his (fixed saving rate) growth model (1956) with
a celebrated demonstration that productivity was much more important to economic
growth than was capital formation. It is easiest to exposit this result if we assume that
the production function is Cobb-Douglas:
Yt = AtK~t-a(NtXt) a,

(3.21)

with the parameter a being measurable as labor's share of national output (an idea
which we discuss more below) and thus being constrained to be between zero and
one 24. Then, using time series for output, labor and capital, we can compute the Solow
residual as:
logSRt = log Yt - a logNt - (1 - a) log Kt.

(3.22)

Abstracting from measurement error in outputs or inputs, the Solow residual can be
used to uncover the economy's underlying productivity process,
log SRt = log(At) + a log(Xt).

(3.23)

To evaluate the importance of capital accumulation to economic growth, Solow

(1957) looked at how the average growth rate of output per unit of labor input
24 Our depiction of Solow's (1957) procedure is impressionistic rather than literal. Solow worked in
changes rather than levels and incorporated time varying, rather than constant factor shares. Moreover,
in ways which anticipate recent developments, he also sought to correct for changes in the utilization
of capital.

Ch. 14: Resuscitating Real Business Cycles

951

(the average of log(Yt/Nt) - log(Yt 1/Nt-l)) was divided between growth in productivity
(the average of log(SRt) - log(SRt_l)) and growth in capital per unit of labor input
(the average of log(KJNt) - log(Kt i/Nt 1)). The result was a surprising one and must
also have been disappointing in view of his just completed work on the dynamics
of capital accumulation [Solow (1956)]: capital accumulation accounted for only one
eighth of the total, with the remainder attributable to growth in productivity. Thus,
the transitional dynamics of capital formation turned out to be not too important for
understanding economic growth.
Moreover, the transitional dynamics of Figure 6 do not display the positive
comovement o f output, consumption, investment and work effort that take place during
business cycles. Labor and investment are higher than in the steady state when capital
is low while consumption and output are below the steady state. Further, consumption
is much more responsive to a low capital stock than either labor or output, which is
inconsistent with the evidence on relative volatilities reviewed earlier.
Sometimes these results are interpreted as indicating that one should construct
macroeconomic models which abstract from capital and growth, since the introduction
of these features complicates the analysis without helping to understand business
cycle dynamics. However, real business cycle analysis suggests that this conclusion is
unwarranted: the process of investment and capital accumulation can be very important
for how the economy responds to shocks.
3.7. Constructing dynamic stochastic models

In this section, we have concentrated on describing the steady state and the transitional
dynamics of the basic neoclassical model, as an example of the type of dynamic general
equilibrium model now used in RBC analysis and other areas of macroeconomics.
There is now a rich tool kit for studying the theoretical properties of stochastic
equilibrium in these models, such as the advances described by Stokey, Lucas and
Prescott (1989). A systematic analysis of the Brock and Mirman (1972) stochastic
growth model, modified to include variable labor supply as above, calls for the
application of these methods. We review these developments in the Appendix, using
the basic RBC framework to highlight two important issues. First, we characterize
the optimal decision rules for consumption, capital, output, investment and labor
using dynamic programming. Second, we demonstrate that the outcomes of the
optimal growth model are the same as the outcomes of a dynamic stochastic general
equilibrium model, in which firms and workers trade goods and factors in competitive
markets. This equivalence requires that firms and workers have rational expectations
about future economic conditions. Another notable result for this stochastic model,
first established by Brock and Mirman (1972), is that the stationary state is replaced
by a stationary distribution, in which the economy fluctuates in response to shocks.
We have also discussed the local transitional dynamics of the basic neoclassical
model illustrated in Figure 6. The development of real business cycle models and
dynamic stochastic general equilibrium theory has also heightened interest in methods

952

R.G. King and S.T. Rebelo

for solving and simulating dynamic equilibrium models. In this survey, we rely on
now-standard loglinear approximation methods for solving the various real business
cycle models that we construct 25. These methods have been shown to be highly
accurate for the basic RBC model 26. The application of these methods contains
essentially two steps. First, it is necessary for us to specify the utility function, the
production fixnction, the depreciation rate and so forth so that we can solve for
the steady state of the model economy, working much as we did in Section 3A.
Second, we take loglinear approximations to the resource constraints (3.10)-(3.13)
and the efficiency conditions (3.15)-(3.18). We then assume that these approximate
equations hold in expected value - a certainty equivalence assumption - and solve the
resulting expectational linear difference equation system. This yields a system of linear
difference equations forced by random shocks, f r o m which moments and simulations
can b e easily computed.

4. The Real Business Cycle shock

The stark simplicity of the analysis of Prescott (1986) provided a dramatic demonstration of the empirical power of RBC models. His results were surprising because
the neoclassical model - even with stochastic productivity - was widely viewed as
suitable for long-run analysis, but not for the study of business cycles. In particular,
Prescott (1986) showed that a simulated version of the basic neoclassical model could
generate business cycle statistics like those in Table 1 when driven by productivity
shocks. To make these shocks "realistic", Prescott required that they have the same
statistical properties as the actual residuals from an aggregate production function
computed using the method of Solow (1957). Building on this idea, Plosser (1989)
showed that empirical Solow residuals constructed from post-war US data produced
model time series for macroeconomic activity that appeared visually close to the actual
business cycle fluctuations on a period-by-period basis. In this section, we display these
moment and time-path results as an introduction to real business cycles.
4.1. The drioing process

The crucial assumption in RBC analysis is that the stochastic component of

productivity can be extracted from the empirical Solow residual using Equation (3.23),
log(SRt) = log(At) + a log(Xt). Then, assuming that log(At) follows an AR(1) process,
log(At) = p log(At-O + et,

(4.1)

and exploiting the fact that log(Xt) = log(Xt_l)+ log(y), it is possible to estimate the
stochastic process for productivity and, in particular, the persistence parameter p and
25 There are versions of the basic RBC model that can be solved analytically but require restrictive
assumptions on preferencesand technology. See, e.g., Radner (1966), Long and Plosser (1983), Devereux,
Gregory and Smith (1992), and Rebelo and Xie (1999).
26 See, e.g., Danthine, Donaldson and Mehra(1989), Christiano (1990), and Dotsey and Mao (1992).

Ch. 14: ResuscitatingReal Business Cycles

953

the standard deviation of the innovation et. Todo this, one fits a linear trend to logSRt
in order to compute y. Then, one uses the residuals from this regression to estimate p
and standard deviation of~t. For our quarterly data set, the resulting point estimates
are 0.979 for p and .0072 for the Standard deviation o f et. The high estimated value of
p reflects the substantial serial correlation in panel 4 o f Figure 3, where the variable
described as productivity is the Solow residual.

4.2. :Calibrating and solving the model

The work of Kydland and Prescott (1982) and Long and Plosser (1983) illustrated the
value of exploring the workings of stochastic dynamic models by using a "reasonable"
set of parameter values. Following the methodological recommendations of Lucas
(1980) in his influential "Methods and Problems in Business Cycle Theory," Kydland
and Prescott relied on microeconomic empirical studies and on the long-run properties
of the economy to choose parameter values. To explore the operation of their multiple
sector business cycle model, Long and Plosser (1983) drew parameters from inputoutput tables for the US economy. This new approach, which came to be known
as "calibration" has at times been controversial. This partly reflects the fact that
most research in macroeconomics followed one of two other routes prior to the
rational expectations revolution 27. First, many authors explored qualitative features of
theoretical models and compared them informally with empirical evidence. Second,
many researchers formally estimated and tested models.
To see how the calibration approach works, let us apply it to our basic neoclassical
model. There are broadly two parts of calibration. One must begin by choosing
functional forms which imply that certain parameters are important and then one must
assign parameter values.
The great ratios in the steady state: From our discussion in Section 3.4 above,
we know that the production side of the model determines nearly everything about
the steady State. We choose the discount factor so that the steady-state real interest
rate coincides with the average return to capital in the economy. This is 6.5% per
annum, if we equate it with the average return on the Standard and Poor 500 Index
over the period 1948-1986. Since we are interested in a quarterly model, we choose the
discount factor b so that the quarterly real interest rate is 0.065/4. In the Cobb-Douglas
production function (3.21), there are three parameters a , X and A. We set a equal to

27 This calibration approach is commonlyassociated solelywith the RBC program, but it was also used
in the early 1980s by researchers studying the effects of nominal contracting on economicfluctuation,
such as Blanchard and Taylor. The calibration approach had been previously used in other areas of
economics, such as public finance and international trade, which employedcomplicated, though static,
general equilibrium models. Calibration is now routine in a wide range of macroeconomicareas, although
it was controversial in the late 1980s because of Kydland and Prescott's (1991) insistence that it should
be used instead of standard econometricmethodology.A nontechnical review of the interaction between
the quantitative theory approach and econometricsis provided by King (1995).

R.G. King and S.T. Rebelo

954

two-thirds which is a standard value for the long run US labor income share 28. Both
X0 (the initial level o f technical progress) and the m e a n value o f A are parameters
which affect only the scale o f the economy, and hence can be normalized to one.
The growth rate o f technical progress is chosen to coincide with the average growth
rate o f p e r capita output in the U S A during the post war period (1.6% per annum),
which implies a quarterly gross growth rate o f technical progress o f 7 = 1.004 29.
The rate o f depreciation is chosen to be 10% p e r annum (6 = 0.025) 3. Taking all
o f this information together, we can solve for the capital-labor ratio k/N, using the
requirement that r + 6 = A D 1 F ( k , N ) . In the C o b b - D o u g l a s case we obtain:
k

[ r+6

"

In turn, this implies that the steady-state value o f the capital-output ratio is
k/y = ( k / N ) / ( y / N ) since the average product o f labor y / N = A ( k / N ) l-a. We also thus
compute the steady-state ratios i/y = ( y - 1 + 6 ) ( k / y ) and c/y = 1 - (i/y), as well as the
steady-state real wage rate w = aA(k/N) l-a.
P a r a m e t e r i z i n g utility: The constant elasticity class o f utility functions (3.8) is
motivated b y having steady-state growth in productivity lead to steady-state growth
in consumption and a constant average level o f hours per person. In our discussion o f
this basic model, we use the momentary utility function
u ( c t , L t ) = log(ct)+ _1- ~ 0 (L~- r l - 1),

(4.2)

Once we specify the parameter which governs the labor supply elasticity (r/) we
choose 0 to match steady state N , which is about 20% o f the available time in the
U S A in the postwar period 31 . The studies o f Prescott (1986) and Plosser (1989) used
the " l o g - l o g " case, which makes utility u(Ct, Lt) = l o g ( C t ) + 0 log(Ll), motivating this
form b y arguing that a range o f microeconomic and asset-pricing evidence suggests a
coefficient o f risk aversion o f ~r = 132. We begin with this case (in which ~/= 1) and
then consider some alternative values in Section 6 below.
28 This is higher than the value of a = 0.58 used in King, Plosser and Rebelo (1988a,b). This number
is somewhat sensitive to the treatment of the government sector and of proprietor's income. See Cooley
and Prescott (1995) for a discussion.
29 Many calibration studies ignore growth all together, as we ignore growth in population. Incorporating
population growth would raise the appropriate value of 7 to 1.008.
30 Here we use a conventional value for 6, but there is some evidence that it should be lower. The ratio
of capital consumption allowances to the capital stock (excluding consumer durables and government
capital) for the USA in the post war period takes values of the order of 6 percent [see Stokey and
Rebelo (1995, Appendix B)]. The average investment share is very sensitive to y and 6, but the near
steady-state dynamics are not.
c which can be solved for 0.
3~ That is, the condition w = D2u(c,L)
Dlu(c.r) = ~Oc implies that a = - ~ - ~ON;,
32 There is substantial uncertainty about ~r, which tends to be estimated with a very large standard error,
see Koeherlakota (1996).

955

Ch. 14: Resuscitating Real Business Cycles

Table 2
Calibration of baseline model
~r

~/

ge

0.984

3.48

1.004

0.667

0.025

0.979

0.0072

Collecting these results, we have Table 2 listing the parameters that are used in the
baseline model in the remainder o f this section.
Loglinearizing the model economy: The next step in solving the model is to
approximate its various equations, which is most frequently done so as to produce
log-linear relations. Sometimes, as with the utility specification (4.2), it happens that
the relations o f interest are exactly log-linear to start. For example, the consumption
efficiency condition (3.15) is At = DlU(Ct,Lt) = (ct) -I and the leisure efficiency
condition (3.16) is cot = ~twt = D2u(ct,Lt) = L t ~, so that:
-ct

= ,

-t/Lt = (~t + ~t).

(4.3)
(4.4)

In these expressions, a circumflex ("hat") over a variable represents proportionate

deviations o f that variable from its steady-state level, ~t = log(ct/c), etc.
The C o b b - D o u g l a s production function also implies that the efficiency condition
(3.17) - which can be rewritten as an equality between the real wage rate and the
marginal product o f labor - is exactly loglinear,
wt = At + (1 - a ) ( L - N t ) ,

(4.5)

i.e., the real wage is raised by productivity and by increases in the capital labor ratio.
Other equations o f the m o d e l are not exactly log-linear and so must be approximated.
The time constraint is Nt + Lt = 1 so that small changes in labor and leisure satisfy
dNt + dLt = 0 and thus )~"v d NN' + L @ = 1. Since log(-~) ~ ~dNt
- , we conclude33:
(N)Nt + (L)Lt = 0.

(4.6)

33 An alternative derivation of this and other results involves assuming that the behavioral equation
depends on A/t = log(Nt/N) etc. and then taking a linear approximation in the hatted variables. For
example, the time constraint is
N exp()~,)+ L exp(I,t) = 1,
so tha~t is approximately Equation (4.6), given that a first-order Taylor series approximation to exp(~t)
about Nt = 0 is Nt.

956

R.G. King and S.T. Rebelo

A 1.(1 a)~'t
7tra so that a
Since the constraint on uses of goods takes the form ct + it = ~t'~t
mixture of the two methods used above yields
(4.7)
Other equations such as (3.6) and (3.18), which contain variables at different dates,
can be similarly approximated. The result is a loglinear dynamic system that can be
solved numerically.
Interpreting aspects o f the model economy: One benefit of this solution strategy is
that the researcher maybe able to interpret certain aspects of the model economy prior
to obtaining its numerical solution. For one example; Equation (4.5) can be interpreted
as a description of "labOr demand", so as to discuss the influence of productivity,
the real wage rate and the stock of capital on the quantity of labor. For another,
combining Equations (4.4) and (4.6), we arrive at a "labor supply schedule" that relates
the quantity of labor to the real wage and the shadow price of goods, Le.,
L

so that a higher value of r/ lowers the labor supply elasticity. Individually, these
equations describing "labor supply" and "labor demand" can be used to evaluate
the consistency of the macroeconomic model with microeconomic evidence. Taken
together, they provide an explanation of how the quantity of labor and the real wage
rate respond to variations in productivity, the capital stock, and the shadow price.
4.3. Business cycle moments

One way of evaluating the predictions of the basic RBC model is to compare moments
that summarize the actual experience of an economy with similar moments from the
model. On the basis of such a moment comparison, Prescott (1986) argued that the
basic RBC model predicts the observed "large fluctuations in output and employment"
and, more specifically, that "standard theory.., correctly predicts the amplitude o f . . .
fluctuations, their serial correlation properties, and the fact that investment is about six
times as volatile as consumption."
Table 3 reports summary statistics on HP cyclical components of key variables
for simulations of the basic neoclassical model driven by productivity shocks. These
statistics are comparable to those reported in Table 1 for the US economy.
Volatility o f output and its components: Productivity shocks produce a model
economy that is nearly as volatile as the actual US economy. More specifically,
comparing the ratio of model and empirical standard deviations, Kydland and Prescott
(1991) have argued that the real business cycle model explains the dominant part

Ch. 14: Resuscitating Real Business Cycles

957

Table 3
Business cycle statistics for basic RBC model a,b
Standard deviation

Relative standard
deviation

First-order
autocorrelation

Contemporaneous
correlation with output

Y
C
I

1.39
0.61
4.09

1.00
0:44
2.95

0.72
0.79
0.71

1.00
0.94
0.99

N
Y/N
w
r
A

0.67
0.75
0.75
0,05
0.94

0.48
0.54
0.54
0.04
0.68

0.71
0.76
0.76
0.71
0.72

0.97
0.98
0.98
0.95
1.00

All variables have been logged (with the exception of the real interest rate) and detrended with the
HP tilter.
b The moments in this table are population moments computed from the solution of the model. Prescott
(1986) produced multiple simulations, each with the same number of observations available in the data,
and reported the average HP-filtered moments across these simulations.
a

o f business cycles 34. For the numbers in Tables 1 and 3, the Kydland-Prescott
variance ratio is 0.77 = (1.39/1.81) 2, suggesting that the RBC model explains 77%
o f business fluctuations. Using a variation on the basic m o d e l which introduces costs
o f moving labor out o f the business sector, Kydland and Prescott (1991) argued that
"technology shocks account for 70 percent o f business cycle fluctuations". Using a
slightly different version o f the model Prescott (1986) h a d previously attributed 75%
o f output fluctuations to productivity shocks.
The real business cycle m o d e l is consistent with the observed large variability o f
investment relative to output, as indicated by the relative standard deviations reported
in the second columns o f Tables 1 and 3. In particular, investment is about three times
more volatile than output in both the actual economy (where the ratio o f standard
deviations is 5.30/1.81=2.93) and the model economy (where the ratio o f standard
deviations is 2.95). Consumption is substantially smoother than output in both the
model and actual economies. In our basic model, however, consumption is only about
one-third as volatile as output while it is over two thirds as volatile as output in the
US economy. We return to discussion o f this feature o f the economy in Section 6
below.
Persistence and comovement with output. Business cycles are persistently high or
low levels o f economic activity: one measure o f this persistence is the first-order serial
correlation coefficient. Table 3 shows that the persistence generated by the basic model

34 See Eichenbaum (1991) for a criticism of this interpretation of the variance ratio.

958

R.G. King and S.T. Rebelo

is high, but weaker than in the data (see Table 1). The relative standard deviations
also provide a measure of the limited extent to which the basic RBC model amplifies
productivity shocks: in terms of its business cycle behavior, output is 1.48 times as
volatile as productivity.
Business cycles also involve substantial comovement of aggregate output with inputs
(such as labor) and the components of output (such as consumption and investment).
Accordingly, Table 3 reports the contemporaneous correlation of output with the other
four measures. All of these correlations are quite high, indicating the basic RBC
model captures the general pattern of comovement in the data. However, the empirical
correlations of output with labor, investment and productivity are substantially smaller
than their model counterparts.
From this battery of statistics, we can see that the RBC model produces a
surprisingly good account of US economic activity. However, there are also evident
discrepancies. Notably, consumption and labor input in the basic model are each much
less volatile than in the data. Further, the basic RBC model produces a strongly
procyclical real wage and real interest rate, which does not accord well with the
US experience summarized in Table 1.
4.3.1. Simulations o f US business cycles

Figure 7 depicts US data together time series generated by simulating the model with
the innovations to the actual US Solow residual. On the basis of results similar to
those in this figure, Plosser (1989) argued that "the simple (RBC) model appears to
replicate a significant portion of the behavior of the economy during recessions and
during other periods" 35. Indeed, looking at the first panel of Figure 7, it is clear that
the basic RBC model gives quite a good account of the quarter-to-quarter variation
in the output time series. The correlation between these series is 0.79; the model also
works well in all major recession and expansion episodes.
Turning to the individual components of output, the performance of the RBC model
is also surprisingly good for such a simple model. Consumption in the model and
the data are strongly positively associated (the contemporaneous correlation is 0.76),
although the model's series in the bottom panel of Figure 7 is much less volatile than
the actual experience, as suggested by the previous discussion of moments above.
Investment in the model and the data also move together in the third panel of
Figure 7, although model investment appears to lead actual investment by one to two
quarters. One measure of this lead is that the contemporaneous correlation of model
and actual investment is 0.63 and the correlation between actual investment and past
model investment is 0.73 at one lag and 0.69 at two lags. While the volatility of labor is

35 This section uses a model that is essentially the same as that in Plosser (1989), but our simulated
time series are slightly different due to (i) differences in data; and (ii) differences in filtering. Plosser's
use of the first-differencefilter emphasizes higher frequency components of time series relative to our
use of the HP filter.

Ch. 14." Resuscitating Real Business Cycles

959

6-

Output

g--2-

51

56

61

66

71

76

81

86

91

96

Date

Labor

2.

~-2

Input

l' l V 1 -

g.

i tf

"I/

V"

-6.

, ; ,1 , , , o , ,

-8.

, 1, , , , o ,6, , ,

"

"

___~2~o,

. . . . . 76. . . . . . . .81. . . . . . .86. . . . . . .91. . .

96

Date

Investment

2,;t

-15 ~-

.....

51

56

61

66

71

76

81

86

91

96

Date

Consumption

654,

Data

3i
2-

7,-

~- o
-1-2-

-3 i
I

I I
51

I I
56

I I
61

] I
66

I I
71

I I
76

I :
81

',

',

: :
86

',

', ',
91

',

:
96

Date

Fig. 7. Basic model: simulated business cycles. Sample period is 1947:2-1996:4. All variables are
detrended using the Hodrick-Prescott filter.

R.G. King and S.T. Rebelo

960

broadly similar in the data and in the model, there is much less of a period-to-period
correspondence between labor and output in the simulations in the second panel of
Figure 7 than there is in the US economy.
4.4. The importance of capital accumulation
The process of capital accumulation is central to business cycles in the RBC
framework. To highlight this importance, consider the effect of a positive productivity
shock under the assumption that investment is zero at all dates. Then, higher
productivity would raise the level of the production function and the marginal product
of labor schedule, with each increasing proportionately. From the standpoint o f the
representative individual, this would work just like a secular rise in the real wage
rate, with exactly offsetting wealth and substitution effects on labor. Thus, hours per
worker would be invariant to productivity, with consumption moving one-for-one with
output 36. By contrast, in the RBC framework, investment increases in response to a
positive productivity shock, i.e., the representative household optimally saves some
fraction of the higher current output. Thus, it is also efficient to lower consumption
and raise work effort relative to the fixed investment case, producing the cyclical
comovements that we see in the actual economy.
However, the introduction of capital as a factor of production in the basic model
tends to make it difficult to match the behavior of output and labor input that we saw
in the first panel of Figure 3, where labor is nearly as volatile as output. Fundamentally,
this reflects the fact that capital is not particularly variable over the business cycle (see
the second^panelof Figure 3). More specifically, the Solow decomposition indicates
that 33t At + aNt + (1 a)tct, so that we expect a one percent change in labor to
produce an a = ~ per cent change in output. It also works to mitigate the volatility
of labor input, since it makes the marginal product of labor decline with the quantity
of labor, given that the capital stock is essentially fixed over the business cycle. That
is, despite substantial business cycle changes in investment, these do not have a large
effect on the capital stock.
=

4.5. Early successes and criticisms

The results of Table 3 and Figure 7 illustrate why the last decade has witnessed an
explosion of research on real business cycles. The basic RBC model holds the promise
of being a coherent framework that integrates growth and business cycles. At the same
time, there were clear areas in which the model needed to be improved, so that there

36 With a total factor productivity shock, this exact offset requires that there be a Cobb-Douglas
production function, although it holds for any production function if the shock is labor augmenting.
While it clearly holds if there is no capital, it also holds if capital is present, as may readily be verified
using the line of argument in footnote 20. A key part of this more general result is that capital income
increases with the productivity shock.

Ch. 14: Resuscitating Real Business Cycles

961

clearly was important additional work to done. Prescott (1986) summarizes moment
implications as indicating that "the match between theory and observation is excellent,
but far from perfect". Plosser ('1989) summarizes the model simulations as indicating
that "the whole idea that such a simple model with no government, no market failures
of any kind, rational expectations, no adjustment costs could replicate actual experience
this well is very surprising". Rogoff (1986) warns of the potential power of the RBC
model: " T h e . . . real business cycle results.., are certainly productive. It has been said
that a brilliant theory is one which at first seems ridiculous and later seems obvious.
There are many that feel that (RBC) research has passed the first test. But they should
recognize the definite possibility that it may someday pass the second test as well."
One notable part of the RBC program is its insistence on the construction of
dynamic stochastic general equilibrium models, which is now the accepted approach
to macroeconomic analysis across a wide range of research areas and perspectives.
Even those who are skeptical o f the central role of productivity shocks have accepted
the idea that "the basic methodological approach ... (is) ... relevant to models in
which monetary disturbances play a greater role" as Rogoff (1986) forecasted that
they would.
But it is the other component of the RBC approach that was immediately
controversial and remains so to this day: that technology shocks are the dominant
source of fluctuations. The striking performance of the basic RBC model drew a
strong critical reaction from macroeconomists working in the Keynesian tradition
[Summers (1986), Mankiw (1989)]. Their criticisms focused on three main points.
First, they questioned some of the parameter values used in the calibration of
the model. In particular, they stressed that the model's performance required an
empirically unreasonable degree of intertemporal substitution in labor supply. Second,
they emphasized the model's counterfactual implications for some relative and absolute
prices. The critics observed that the strongly procyclical character of the model's real
wage rate was inconsistent with the findings of numerous empirical studies. They
also pointed to Mehra and Prescott's (1985) earlier finding that standard preferences,
such as Equation (4.2), are incompatible with the equity premium, i.e. the difference
between the average rate of return to equities and the risk free rate. 37 In addition,
t h e y suggested that a productivity shock theory of the cycle should imply a strongly
countercyclical price level. Third, they argued that the use of the Solow residual was
highly problematic, leading to excessively volatile productivity shocks.
In retrospect, the first two criticisms of RBC analysis had a small impact on the RBC
program. Rather than being fragile, the model's performance is surprisingly resilient
to variations in its parameters. Much of the model's performance is anchored on three
single ingredients: a highly persistent technology shock that is sufficiently volatile,
a sufficiently elastic labor supply, and empirically reasonable steady-state shares of

37 See John Campbell (1999) for a detailed discussion.

962

R.G. King and S. T Rebelo

consumption and investment in output 38. The RBC model does not need to rely on a
high degree of intertemporal substitution in labor choice. In fact some RBC models
[e.g. Greenwood, Hercowitz and Huffman (1988)] assume that this elasticity is zero.
However, either intertemporal or intratemporal substitution must be strong enough to
produce realistic labor movements, a point to which we will return in Section 6 below.
RBC researchers have produced a battery of models that lead to a relatively high
elasticity of labor supply. The model's predictions for the real wage can be improved
if we step away from the assumption of spot labor markets and incorporate contracts
between firms and workers that allow for wage smoothing [Gomme and Greenwood
(1995), Boldrin and Horvath (1995)] or other forms of labor contracts [Danthine and
Donaldson (1995)]. It is hardly surprising that the assumption of spot labor markets
produces unreasonable implications for the real wage. And while research on the equity
premium puzzle continues, we now have models that are consistent with some aspects
of the equity premium while maintaining the business cycle performance of the basic
model 39. Lastly, the studies of Kydland and Prescott (1990) and Cooley and Ohanian
(1991) have concluded that the price level is indeed strongly countercyclical during
most time periods.
It is the final criticism - that the Solow residual is a problematic measure of
technology shocks - t h a t has remained the Achilles heel of the RBC literature. The key
issues in this area involve quantitative rather than qualitative disagreements. With the
exception of the two oil shocks, it is hard to identify the macro shocks that produce the
productivity variations suggested by the Solow residual. If these shocks are large and
important why can't we read about them in the Wall Street Journal? Also, the Solow
residual often declines suggesting that recessions are caused by technological regress.
Finally there are several measurement problems that can make the Solow residual a
bad measure of productivity at cyclical frequencies. Summers and Mankiw emphasized
the importance of labor hoarding, that is, unmeasured variation in labor effort over
the business cycle. Perhaps even more important than labor hoarding is the cyclical
variability in capital utilization. Solow-residual based measures of technology shocks
that do not account for unmeasured variations in labor and capital will tend to be more
volatile and procyclical than true shocks to technology.
These difficulties arose as well in the earlier literature on growth accounting, where
the Solow residual had its origins. The stated goal of that literature was to measure the
long run evolution of disembodied technical progress, not the short run behavior of
productivity. Its hidden agenda was to make the Solow residual negligible, that is, to
measure production inputs well enough that all growth in output could be accounted for
by movements in factors of production. For this reason the residual was often referred
38 Given the high correlation between investment and output it is not surprising that the model cannot
display enough investment volatility if its share is unreasonably high. As the steady-state investmentoutput ratio increases the volatility of investment has to converge to that of output.
39 See Boldrin, Christiano and Fisher (1995) and Christiano and Fisher (1995). These models employ
a two-sector structure and use preferencesthat feature habit formation.

Ch. 14: Resuscitating Real Business Cycles

963

to as a "measure of our ignorance". Growth accountants were horrified when they saw
the measure of their ignorance recast as the main impulse to the business cycle. For
now we will put the problems associated with the Solow residual as a measure of
technology shocks on the back burner. But we return to them in Sections 7 and 8.

5. The central role of productivity shocks

In the standard RBC model, productivity shocks are central to the nature of business
cycles. In this section, we will discuss three major aspects o f this relationship. First, we
explain that the standard RBC model requires large and persistent productivity shocks,
by considering how the comparative dynamics of the model change as productivity
persistence is altered. Second, we show how the assumption that agents have rational
expectations matters to the nature of real business cycles. Third, we discuss why other
shocks cannot easily generate real business cycles in the standard model.

5.1. Productivity shocks must be large and persistent

The simple driving process for productivity used by Prescott (1986) and Plosser (1989)
provides a natural basis for discussing the volatility and persistence of productivity.
These authors modeled the stochastic component of productivity as a first-order
autoregressive process, log(At) = plog(At 1) + et. Under this specification, the
statistical behavior of the productivity process is influenced by the serial correlation
parameter p and the standard deviation of the zero mean "innovations" et. A standard
result from time series textbooks [e.g., Hamilton (1994)] is that the autocovariance
of log(At) with its own value lagged by j periods is ,,J
/-" var(et)
l _ p 2 This autocovariance
expression reveals that increases in the variability of the innovations directly raise the
variability of productivity. Increases in the parameter p also increase the variability
of the time series, since the variance of log(At) is var(Et)
1_p2 However, an increase in p
produces this additional variability by raising the persistence of the productivity series,
since the jth-order correlation of log(At) is pJ. Thus, when we say that the standard
RBC model requires that there must be large and persistent variations in productivity,
we are making several related statements. Mathematically, these can be summarized
by saying that the model requires large values of var(et) and o f p .
Why does the standard model require large shocks? When we say that the
model requires large shocks, we mean that there must be considerable variability in
productivity. This statement is based on understanding how output, consumption, and
other variables respond to shifts in e in the basic model. In all of the models that
we study in this section, for example, output responds to a one percent increase in
productivity by rising by no more than two percent: there is not much amplification
of the productivity shock by the model.
To illustrate the effect of smaller productivity shocks, we recomputed the simulation
of the basic RBC model using an alternative series of productivity shocks, which have

964

R.G. King and S.T. Rebelo

an innovation standard deviation that is 0.0012 or about ~ times as large as the Solow
residual. The result of this is shown in panels 1 and 2 of Figure 8: real business cycles
explain a very small fraction of output and labor volatility. Since the standard RBC
model is approximately linear, changes in the standard deviation of the innovations,
std(e), simply work to rescale the model's fluctuations. We will return later to discuss
more of the details of the computation of these alternative shocks, but at present
it is sufficient to note that they were not chosen arbitrarily. Rather, they arise from
correcting the Solow residual for the effects of varying capital utilization in ways that
we will discuss further in Sections 6-8 below.
Why does the standard model require persistent shocks? By saying that the
variations in productivity must be persistent, we mean that the series generated from
the standard RBC model will display autocorrelation similar to the US data only if
p is near one. To discuss this, we consider in detail how the standard RBC model's
implications depend on the extent of serial correlation in productivity. We begin by
discussing the response of the economy to a serially uncorrelated productivity shock,
i.e., the solution of the model when p = 0. While the dynamic responses to this
shock shown in Figure 9 are the result of a complex set of factors - the preferences
of households for consumption and labor supply, the production function and the
mechanism for accumulating capital, and the interaction of households and firms in
general equilibrium - the key mechanisms can be easily described.
Productivity is assumed to increase by one percent (e = 1) in the initial period
(date 1). Given the rise in the marginal product of labor resulting from the increase in
productivity, the representative household faces an unusually high opportunity cost of
taking leisure in this initial period. While there are offsetting income and substitution
effects, the model's preferences were chosen so that a permanent increase in the
real wage (such as the one associated with the trend in technical progress) generates
exactly offsetting income and substitution effects so that labor and leisure are left
unchanged. An implication of this result is that N has to rise in response to a temporary
productivity increase. With a temporary shock, there is a much smaller income effect
and there is greater incentive to substitute intertemporally, since the current wage is
high relative to expected future wages. On net, the positive labor response amplifies the
productivity shock: the impact effect on output in Figure 9 is 2%. Half of this response
is due to the direct effect of the productivity shock and half due to the increase in
labor.
The representative agent must choose what the economy will do with all this
additional output. One possibility is to consume it all in period one 40. However, this
would be inefficient given that the marginal utility of consumption is decreasing,
thus inducing a preference for smooth consumption paths. It is optimal to increase
consumption both today and in the future. In fact, given that there are many future

40 Our figures make the impact date of the shock period 1, while the earlier theoretical analysis made
the initial period zero. The discussion in the text follows the dating conventionin the figures.

Ch. 14." Resuscitating Real Business Cycles

965

Output with small A shocks

64-

2"E o

"?

g.-~,
-4-

~T'W"

-651

56

61

66

71

76

81

86

91

96

Date

4T

Labor Input w i t h s m a l l A s h o c k s

Date

O u t p u t w i t h s m a l l e r labor elasticity

6,
4
2

~o
~.-2.

51

56

61

66

71
Date

76

81

86

91

96

L a b o r Input w i t h s m a l l e r labor elasticity

2

it

TI ? qI ~ ~
V

" w "?'

"T/" w -

~
51

56

....
61

66

71
Date

76

81

o"='
86

91

96

Fig. 8. Consequences of smaller shocks and smaller labor elasticity. Sample period is 1947:2-1996:4.
All variables are detrended using the Hodrick-Prescott filter.

King and S.T. Rebelo

R.G.

966
1.2-

productivity

Capital

1~ 0.8-

~o.~.
0.40.20
Quartem

Quarte~

9.

Investment

8.
7.

co:
~. 0.06
~04
0.02

_;

Quarters

10 11 12 13 14 15 16 17 18 19 2 o
Quarters

1.6.

Output

Labor

Input

IA.
1.2.
1,
0,8,

g. o.o.
0.4.
0.2,
0

Quaae~
Quar~

Real Wages

0.6

0-

Real Interest

Rate

-0.5,

0.5

-1
0,4

-ili

o.~

g.
0.2

10

11

Quarte~

12 13

:
14

15 16

17

18

~I

~...................
~ ; ~ ~ '~ ~ ~ ;o ;~ ,'~;~ ;~ ;~ ;~ ;~ ;~ ;o~'o

19 2 0
Qua~e~

Fig. 9. Comparative dynamics to purely temporary productivity shock.

Ch. 14: ResuscitatingReal Business Cycles

967

periods, only a small fraction of the output windfall will be consumed at time 1; most of
it will be invested. Thus investment rises by 8% in response to a 2% increase in output.
It is interesting to note that the high volatility of investment, which Keynes ascribed
to "animal spirits", arises naturally in this economy as the flip side of consumption
smoothing.
In the future, which begins with period 2 in Figure 9, productivity retums to
its original benchmark level. The only difference relative to period zero is that the
economy has accumulated some capital and only a relatively small amount since the
productivity shock lasted just for one period. In line with the transitional dynamics that
we discussed in Section 3 above, the optimal policy for the economy is to gradually
reduce this excess capital by enjoying higher levels of consumption and leisure. The
real interest rate again signals individuals to adopt these consumption and leisure
paths: with a purely temporary change in productivity, the real interest rate falls in the
impact period and in all future periods, making it desirable for individuals to choose
consumption profiles that decline through time toward the steady-state level.
The impulse response makes it clear that there will be no tendency for a period of
high output and work effort to be followed by another period which has similarly high
output. That is: the basic neoclassical model does not produce substantial internal
propagation of temporary productivity shocks, a point which has been stressed by
Cogley and Nason (1995). The effects of the one-time shock are propagated over
time: the large investment in period 1 leads to high values of the capital stock that
keep output above its steady-state level in the following periods. But this propagation
mechanism is very weak. This weakness, together with the fact that Solow residuals
display substantial persistence led most RBC studies to focus on specifications in which
the persistence is inherited from the shock process.
What happens with serial correlation in productivity consistent with Solow
residuals? The solid line in Figure 10 depicts the effect of a serially correlated
productivity shock using the estimate discussed in Section 3 above ( p = 0.979).
In this case, the different series exhibit realistic persistence, which is inherited from
the shock. The same mechanisms are at work as in the case of a purely temporary
shock, but these effects are now drawn out over time. We now have an extended
interval in which productivity is above normal. During this interval, workers respond by
increasing their labor supply and most of the additional output is invested. Interestingly,
high productivity is now initially associated with a high real interest rate, since the
marginal product of capital schedule [At+ iD1F(kt+l,Nt+ 1) - 6] is shifted upwards
by the productivity shock and by a higher level of future labor input, with capital
responding only gradually via the accumulation of investment. However, later in the
impulse responses, the rate of return is below its steady-state level because the capital
stock has been built up while the stimulative effects of the productivity shock and
labor input have dissipated. This leads consumption to initially grow through time and
then subsequently to decline back toward the stationary level. Later in the impulse
responses, as productivity converges slowly to its normal level, labor supply actually
drops below the steady-state level as the economy enters a phase that resembles the

R.G. King and S.T. Rebelo

968
Productivity

1.2

Capital

14
1.2

1
1
0.8

0.8

:0.6

O.S
0.4

0,4

&2
0
-O.2

-0.2
1

26
,

,0

26

lO{)
,

51

76

~00

Qual'~e~

Q.a~m

Consumpf~l

I.vestillent

5-

14

4~

O.8,

0.62-

~" 0.4
0.2

26
26

-O.2

51

IO0

76

100

Q.aae~

Quar~'l

Output

Labor Input

1.4

0;7

1.~

0.6
0.5

&8

0.4

o.e

o,3

0.4
0.2

0.2
0.1

-O.2
1

26

51
Quarters

76

=0,1 I
1

lOO

Real Wages

I
26

I
51
Quarters

76

I
lOO

Real Interest Rate

25 - [

1.2

0.8

15

06

!:

,o

== 0.4

-0.2

26

51
Quart~m

76

100

Quarters

Fig. 10. Comparative dynamics to more persistent productivity shock. Circled lines are impulse responses
filtered with the Hodrick-Prescott filter,

Ch. 14: ResuscitatingReal Business Cycles

969

transitional dynamics discussed above. Investment also eventually drops below the
steady state, as the economy runs down the capital that was accumulated during the
initial expansion.
As with the case of the purely temporary shock discussed above, the early part of
the impulse responses is dominated by the fact that the productivity shock raises the
desirability of work effort, production, investment and consumption; the latter part of
the impulse response function is dominated by the transitional dynamics, i.e., reduction
o f capital back toward its stationary level.
These impulse responses govern the autocovariances of productivity, output and
other variables. With many periods of high output, there will be positive correlation
between output and its past values: expansions and recessions will persist for many
periods.
Since the HP filter is so widely used in the real business cycle literature, it is
worthwhile investigating its effects on the impulse response function, as an indication
o f the effects that it has on the moments of the different variables: In Figure 10, the HPfiltered impulse responses are given by the generally lower paths that are highlighted
with the 'o' symbol. One notable feature of this filtered impulse response is that there
is less tendency for series to remain above or below their normal levels, i.e., filtering
reduces the persistence of the various series: This effect is particularly noticeable for
output and for productivity. Filtering also flattens the response of consumption and the
real wage, at the same time that it makes the capital stock largely acylical.

5.2. The influence of productivity persistence

In the basic RBC model~ the persistence parameter governing the productivity process
has an important influence on the effects of shocks. For example, if we compare the
responses of output in the two figures that we just looked at, that there is a larger initial
output response in Figure 9 (where p = 0) than in Figure I0 (where p = 0.979). In
particular, the additional persistence lowers the impact effect on output from about 2
when p = 0 to about 1.5 when p = 0.979. Similarly, the impact effect on work effort is
smaller and the impact effect consumption is larger in Figure 10 than it is in Figure 9.
When the productivity is very persistent, in the sense that the coefficient p is near
unity, there are very dramatic effectS of small changes in the value of p. In this
subsection, to exposit these effects, we focus on the consequences of assuming that
productivity is a random walk. Economically, this involves the plausible assumption
that changes in technology are permanent and there is some empirical support for
the idea that productivity contains a unit root [e.g., Nelson and Plosser (1982)].
Mathematically, this amounts to setting p = 1 and implies that all shocks to
productivity are expected to have an equal effect on current and expected future
productivity.
Impulse response analysis: Figure 11 shows that the impulse responses of all
variables are substantially affected by changing the driving process parameter p from
0.979 to 1. Part of this difference involves the fact that a permanent productivity shock

R.G. King and S.T. Rebelo

970
Productivity

Capital
1.6
1.4

1,

E~:~--~

1.2

.....

0.~.

~ O.S

o.~,
o.4.

O.4
o.2.

0.2
0
2

1
Quam~

13 14 15 I 6 17 18 19 20

10 1~ ~2 13 14 ~5 16 17 18 19 20
Q~aers

Investment

Consumption

4.~
aS

O.2
c.

:
2

:
3

:
4

:
5

:
6

:
8

0.5
o.

: : : : : : : : : : : :
9 10 11 12 13 14 15 16 17 18 19 20

10 11 12 13 14 15 16 17 18 19 20
Quar~

Ouarm~

Laborlnput

Output

0.7
1.2
E
1

"

:
2

:
3

----*--*~*--~*----,~.o

o.~ ~
o.4
o.2

0.2

c,
1

:
4

:
5

:
6

:
7

:
8

"~2~,:~:p.~

~~

~,:~ j,;~,~

,,

;T ..................

: : : : : : : : : : : :
9 10 11 12 13 14 15 16 17 18 19 20

9 10 11 12 13 14 15 16 17 18 19 2(1
Quarle~

Quart~m

Real Wages

1.6

2~T
2O '

e.
1

9 10 11 12 13 14 15 16 17 18 19 20

Quar~

"

~; t , ,
-s

I
4

I
5

I : : "
:
"~~"~
6

: :
: ;
:
; :
:
:
:
:
10 11 12 13 t4 15 16 17 18 19 2(1
Quariers

Fig. 11. Comparative dynamics to fully permanent shock. Standard model, p = 0.979 (circles); p = 1
(stars).

Ch. 14: ResuscitatingReal Business Cycles

971

leads to an identical, proportional, long-run increase in consumption, investment and

output, while the stationary shock has no long-run effect. There are also important
differences in how the economy responds in the short-run depending on the value o f p .
For example, in the impact period of the shock (t = 1), there is a much smaller response
of labor and output to a permanent shock (the ' . ' path) than the standard shock (the
' o ' path). The date t = 1 shock is assumed to be 1% in both cases so that labor rises
by 0.7% with productivity when p = 0.979 and by 0.5% when p = 1.0. Conversely,
the impact effect on consumption is larger when p = 1 than it is when p = 0.979.
After the impact period of the shock, the differences between the unit root case and
the base case involve a combination of the differing direct effects of the shocks as
well as the differing responses to permanent and temporary shocks. For example, one
year after the productivity shock, the stationary model implies that 0.919 = p4 of the
initial one percent impulse to productivity is (expected to be) present when p = 0.979
and the unit root model implies that there is a one percent higher productivity level.
Explaining the influence of persistence: We previously used our intuition to explain
the general shape of impulse response patterns, as in our discussion o f Figures 9 and 10
above. We described how the consumption and labor supply plan of the representative
household are affected by shocks that affect wealth and the time path of wages.
However, in the standard RBC model, there are general equilibrium effects that are
subtle to think through. Consumption and labor supply decisions also depend on the
time path of interest rates as well as wages. At the same time the time path of wages
is influenced by labor supply decisions.
To understand the channels of effect by which increased persistence affects the
impulse responses, we adopt a version of Hick's celebrated demand decomposition
that is suitable for dynamic models. 41 To exposit this decomposition, let us focus on
the determination of the increase in consumption and leisure at the initial date t = 0.
When a productivity shock occurs, the representative household understands that
there is a higher amount of wealth as a result of this shock. I f wages and interest
rates are unchanged, then this wealth effect would be used to finance a permanently
higher level o f consumption and a permanently lower level of work effort. These
effects are shown in Figure 12 for the persistent shock ( p = 0.979) and the fully
permanent shock ( p = 1). There are two notable aspects of these wealth effects,
which are computed in Hicksian fashion by finding the constant increments to the
consumption and leisure paths that yield the same utility change as arises in the general
equilibrium of the model. First, the wealth effects are the same for consumption and
leisure in proportionate terms, which reflects the fact that the preference specification
[u(ct,Lt) = log(&)+ Olog(Lt)] makes the wealth elasticities equal across goods.
Second, the wealth effects are much larger when p = 1 as they are when p = 0.979.
The representative household knows the path of wages which will arise as a result of
the shock to productivity. Taking into account just the change in the wage path, we can

41 This decompositionis developed in King (1991).

R.G. King and S.T. Rebelo

972

Consumption: Interest Rate EffeCt

C o n s u m p t i o n : Wealth Effect

o.+t

o.e+ T
.:~- -+.p- +:+- ~ p -+:+~ - ~:P -~:p ~: P ~::~::~':+ ++P+,~++- -.+:<+~z+~z- +,:<~+P -,++

o.~

o:1

0 m5 ~l..=l_=,l__l+l=+l~l+l__l+l+l+l__l+l__l__l+l__l__l__

+,ia

~+"

,/.,-+~+~ ~ . ~ .

o.2

0*15

"~-~,~,

0.1

0.0

26

76

lOO

+0.8 1
1

2+

~1

57+

100

Consumption: Wage Effect

Consumption: Total Effect

ole
0.7 ,-+, . . , + + , . + 4 . - , - , - + , + . - , . . , . , . + , . . , . + , + , . - ,

,+,

0+
0..I
o.+ I
0.3
0.2
o.1
o
1

I
76

-, + + , - . , + ,

0.2
I
51

2s

--"

0:1

16

I1

loo

.I6

1100

Quarle~

Leisure: Wealth Effect

0.35.

0.6

+m+m+mmmmm++zm+:mmmmm
..m++'

0.4'
o,25-

=--,--,--,--,--,--,--,--,=,

0,2

+-,+--,--, -+=.-,+.+.=-+,-+,+-,-.,-~=

02.
0.15

-0,2

0.1-

.0.4
-06

0.05
o

~6

Sl

16

4.8

5~

10o

Leisure: Wage Effect

'

76

i~

Leisure: Total Effect

0.6

+=~,

0.4

,~,~,~,I,~,

002
o

~+'~'+

0,2
0

-0,2

'\

-0.4

,- + ' ~ "

+~,_,_=,=,_,_,_,_~,_,_,
,~ . + : ~ : + . . ~ ~ ~ - - A : ' + . - - . + ~
"

, / + . . ++ ' '::+- ~ -~

m,o2

+3.o+

"%i~

+"+I/l"

f,1"

+o.+m "i"

,+"

.~"~]'+"

-0.6
-0.8
-1

"+ m m + m + + + , z - , ~ . m

51

o+.~am

+.14 .p/
-0.++,

m ram+ram+++
71s

loo

o,+I

++

7+

1oo

Quarl~

Fig. 12. Substitution and w e a l t h effects o f persistent and p e r m a n e n t shocks: stars, p e r m a n e n t s h o c k s ;

squares, p e r s i s t e n t , s h o c k s .

Ch. 14: Resuscitating Real Business Cycles

973

determine the consequences for consumption and leisure at date O, which we call the
wage effect. This effect is analogous to the Hicksian effect of the wage on consumption
and leisure, in that it holds utility fixed, tracing out a substitution response. However,
in our general equilibrium model, the productivity shock implies that wages change in
all periods, {wt}t-0. Thus, the wage effect in Figure 12 takes into account the entire
change in the time path of wages, combining static and intertemporal substitutions.
When p = 0.979, the representative household correctly understands that productivity
will raise the path of wages at date 0 and in many future periods, but that the long-run
level of the wage will be unchanged. Accordingly, the household plans to consume
more at date 0. Leisure hardly changes at all because the current period is about
"average"; this conclusion depends on the particular p value. However, this pattern
is sharply altered when p = 1, for then the household recognizes that the current wage
is below the long-run wage and leisure rises due to the wage effects that stem from a
positive productivity shock 42.
In the general equilibrium of our RBC model, there is one additional channel:
interest rate effects that induce intertemporal substitutions of consumption and leisure.
In general, these intertemporal price effects are a powerful influence, but one that is not
much discussed in informal expositions of the comparative dynamics of RBC models.
In particular, permanent increases in productivity lead to high real interest rates and
these induce individuals to substitute away from date 0 consumption and leisure as
shown in Figure 12.
We are now in a position to describe why a permanent shift in productivity (arising
when p = 1) has a smaller effect on labor than a persistent but ultimately temporary
shock ( p = 0.979). When the shock is temporary, there is a small wealth effect
that depresses labor supply but temporarily high wages and real interest rates induce
individuals to work hard. When the shock is permanent, there are much larger wealth
effects and the pattern of intertemporal substitution in response to wages is reversed
since future wages are high relative to current wages. However, labor still rises in this
case in response to productivity shocks due to very large intertemporal substitution
effects of interest rates.
5.3. Why not other shocks?

We have just seen that the basic real business cycle model driven by persistent
technology shocks can produce realistic business cycle variation in real quantities.
Do these same patterns emerge when the economy is buffeted by other disturbances?
Shocks to fiscal and monetary policy have been long standing suspects in the search

42 The wage effect on consumptionis constant acrosstime in each case because the separablemomentary
utility function implies that efficient consumption plans do not depend on the amount of work.
Equivalently, with this utility function, there is a general substitution effect on consumption at all
dates that works much like a wealth effect.

974

R.G. King and S.T. Rebelo

for the causes o f business cycles. It is thus natural to ask what are the effects o f these
shocks in the standard RBC model.
Shocks to government spending cannot, by themselves, produce realistic patterns
o f comovement among macroeconomic variables 43. This result stems from the fact
that an increase in government expenditures (financed with lump sum taxes) gives
rise to a negative wealth effect that induces consumption to fall at the same time that
labor and output rise. Thus, if government spending were the only shock in the model,
consumption would be countercyclica144.
Changes in labor and capital income taxes have effects that are similar to
productivity shocks. However, these taxes change infrequently making them poor
candidates for sources o f business cycles fluctuations.
Monetary policy shocks have small effects in this class o f models both in versions
in which money is introduced via a cash-in-advance constraint [Cooley and Hansen
(1989)] and in models that stress limited participation [Fuerst (1992), Christiano and
Eichenbaum (1992b)]. Many researchers are also currently investigating the nature of
business cycles in models that start with the core structure of an RBC framework
but also incorporate nominal rigidities o f various forms 45. This research has not yet
produced a business cycle model that performs at the same level as the RBC workhorse
described in Section 4.

6. Extensions of the basic neoclassical model

Since the basic RBC model contains explicit microeconomic foundations, part o f the
literature has tried to improve its predictions for individual behavior. Other researchers
have sought to improve the fit between model and data, focusing on moments and
sample paths o f macroeconomic time series. In this section, we discuss two strands of
this research: work on labor supply and on capital utilization.
6.1. The supply of labor
There is a substantial body of work that focuses on the labor supply and, more
generally, on the labor market in RBC models. This research is motivated by four
difficulties encountered by the basic model on micro and macro dimensions. In most

43 There is a large literature that investigates the effects of fiscal policy in an RBC context. References
include Wyrme (1987), Christiano and Eichenbaum (1992a), Rotemberg and Woodford (1992), Baxter
and King (1993), Braun (1994), McGrattan (1994), and Cooley and Ohanian (1997).
44 For an early discussion of this difficulty, see Barro and King (1984). There is actually some evidence
that in historical periods dominated by large shocks to government expenditures consumption was
countercyclical, see Correia, Neves and Rebelo (1992) and Wynne (1987).
45 Examples include Cho and Cooley (1995), Dotsey, King and Wolman (1996), and Chari, Kehoe and
McGrattan (1996).

Ch. 14: ResuscitatingReal Business Cycles

975

RBC models the implied labor supply elasticity to wage changes is very large, relative
to micro studies. All of the variation in aggregate hours in the model arise due to
movements in hours-per-worker, while the US experience is that most of the action
comes from movements of individuals in and out of employment. Labor in the model
lacks a close correspondence to labor in data (see Figure 6). Finally, labor input and
its average product are very highly correlated in the model, but not in the data.

6.1.1. Estimated and assumed labor supply elasticities

Labor economists have long been interested in estimating the response of the labor
supply to a change in the real wage rate. In the standard static model, an increase in
the real wage produces a substitution effect which leads to an increase in N and C
as well as a wealth effect which leads to a decline in N and an increase in C. While
the effect of a wage increase on consumption is unambiguous, the effect on the labor
supply involves conflicting substitution and wealth effects. In a dynamic model, the
effect of a wage change is complicated by the fact that the size of the wealth effect
depends on the anticipated duration of the wage change: temporary wage changes have
a small wealth effect and permanent ones have a large wealth effect.
In a dynamic setting, the key equation that determines the supply of labor is the
requirement that the marginal utility of leisure equal its cost along the intertemporal
budget constraint. Many empirical studies of dynamic labor supply [e.g., MaCurdy
(1981)], suppose that the utility function has the separable form (4.2), that we
introduced in our discussion o f the approximation of the RBC model in Section 5
above and for which we showed that
1-N ^
= ~-(w
+ ,~).

(6.1)

In this expression, the term ~~-N

- is the )~-constant elasticity of labor supply. To isolate
the substitution effect, labor economists often estimate a )t-constant elasticity of labor
supply and we organize our discussion of labor supply issues around this elasticity.
In the basic RBC model, with its assumption of log utility (77 = 1) and a steadystate fraction of time spent working o f N = 0.2, it follows that the implied labor supply
elasticity is four: a one percent change in the wage rate calls forth a four percent change
in hours worked if there is little wealth effect ()~ constant), as with a temporary wage
change. Yet, the microeconomic evidence on variations in hours worked is sharply at
odds with the elasticity built into the RBC model. While estimates of this elasticity
vary across different gender and race groups, they are typically much lower than unity
[e.g. Pencavel (1986)].

6.1.2. Implications of varying the aggregate labor supply elasticity

To show the consequences of adopting a labor supply elasticity in line with
microeconomic estimates, the third and fourth panels of Figure 8 show the effect of

R.G. King and S.T. Rebelo

976

choosing 1-N 1 which is the upper bound suggested by Pencavel's estimates, rather
than ~-N = 4 as in the model of Section 4. There is an important reduction in the
volatility of output in the third panel of Figure 8. However, the model loses most of
its ability to produce fluctuations in labor (see the fourth panel of Figure 8). In terms
of moments, the standard deviation of output falls from 1.39 to 1.16 with the smaller
labor supply elasticity and the standard deviation o f labor falls from 0.67 to 0.33.
=

6.1.3. Modeling the extensive margin

RBC researchers have investigated ways of enhancing the aggregate labor supply
response by focusing on' the extensive margin. Figure 4 shows that most fluctuations
in total labor input occur as households substitute between employment and nonemployment (the extensive margin) rather than between a greater or smaller number of
per capita hours worked (the intensive margin). Explaing these facts seems to require
that there are fixed costs of going to work or other attributes of the technology that
lead to nonconvexifies in the individual's opporttmity set.
There are two strategies for incorporating the extensive margin into business cycle
analysis. The first is to assume that households are heterogeneous with respect to
their reservation values of work, probably due to differences in fixed costs of working
such as travel time to the job. This is a conventional approach in labor economics
[see, e.g., Rosen (1986)] that has been introduced into a business cycle model by
Cho and Rogerson (1988) and Cho and Cooley (1994). In order to make such a
model tractable, it is necessary to view individual agents as efficiently sharing the
resulting employment risks 46. An alternative approach, developed by Rogerson (1988)
and applied to business cycles by G.D. Hansen (1985), assumes that households are
identical but agree on an efficient contract which allocates some individuals to work in
each period while leaving the remaining idle. A remarkable feature of both approaches
is that there is a stand-in representative agent whose preferences generally involve more
intertemporal substitution in work than displayed by the underlying individual agents.
For simplicity and congruence with the literature, we focus our discussion on
the economies with indivisible labor and lotteries, following Rogerson (1988). Each
individual in the economy has to choose between working a fixed shift of H hours and
not working at all. Suppose that preferences are such that individuals would ideally
like to supply a number of hours N < H. This arrangement is not possible because
the choice set is not convex, it includes N = 0 (with zero labor income) and N = H
(with labor income wH) but no linear combinations of these two points. In this set up
agents can be made better off by the introduction of lotteries which convexify their

46 In actual economies,variationsin aggregate hours reflect changes at both the intensive and extensive
margins. In a model where workers have different fixed costs of going to work, Cho and Cooley (1994)
have captured both of these responses. Such a framework appears necessary to explain the differing
cyclical patterns of employmentand hours-per-workerin the USA and Europe that are documented by
Hansen and Wright (1992).

Ch. 14: Resuscitating Real Business Cycles

977

choice set. By entering a lottery an agent can choose to work a fraction p of his days
remaining unemployed a fraction (1 - p ) of his time. Let us use the subscript 1 to
denote those agents who are assigned to work by the random lottery draw and the
subscript 2 to refer to the unemployed agents. The expected utility of an individual
prior to the lottery draw is
p u ( c l , 1 - H ) + (1 - p)u(c2, 1),

(6.2)

where p is the fraction of the population assigned to work. Feasible allocations of

consumption across the employed and unemployed agents must obey
p c l + (1 - p ) c 2 = c,

(6.3)

where c is per-capita consumption. Maximizing Equation (6.2) subject to condition (6.3), we find that marginal utility of consumption must be equated across types,
i.e.,
DlU(Cl, 1 - H ) = DlU(C2, 1),

(6.4)

which is an efficient risk-sharing condition in this situation of employment lotteries as

in many other contexts.
The standard indivisible labor model. The typical treatment of the indivisible labor
model, as in Rogerson (1988) and Hansen (1985), involves assuming separable utility.
Within the general class of utility functions (3.8), this corresponds to a = 1 so that
u(c, L) = log(c) + log(o(L)). In this case, efficient risk-sharing implies that the employed
and unemployed share the same level of consumption (c~ = c2). Using this fact,
expected utility can be written as
u(c, L) = log(c) + (1 - L) ~1 log(V~
\ 02//"] + log(v2),

(6.5)

where L = 1 - p H is the average number of hours of leisure in the economy and where
vl = v(1 - H ) and v2 = v(1).
There are three notable features of this economy. First, even though each individual
agent has a finite elasticity of labor supply, the macroeconomy acts as if it were
populated by agents with a more elastic supply of labor. In particular, the standin representative agent for this economy has preferences that are linear in leisure,
implying a infinite )>constant elasticity of labor supply [see Equation (6.1) with
t / = 0], a feature whose consequences we explore further below. Second, contrary to
conventional wisdom, this is an economy in which it is optimal to have unemployment.
Finally, agents actually choose to bear uncertainty by entering the lottery arrangement
instead of working a fixed number of hours in every period.
It is interesting to explore further why the individual elasticity of labor supply differs
from that of the economy as a whole and the consequences of this difference for the

978

R.G. King and S.T. Rebelo

determination of output and labor. The individual elasticity of labor supply answers the
question "how many more hours would you work in response to a 1% raise in salary?".
But the answer to this question is irrelevant because the number o f hours worked is not
flexible, it is either H or zero. In other words, the intensive margin is not operative and
hence its elasticity of response is irrelevant. Proceeding to the consequences for the
determination of labor, the preferences o f the stand-in representative agent (6.5) imply
that small changes in wages and prices can lead to very large effects on quantities. To
see this, consider an isolated individual maximizing

[3tIlg(ct)+(1-Lt)llgQ~
) + log(v2) 1 t=0

Along the relevant intertemporal budget constraint, suppose that the discounted cost of
a unit o f leisure is [3t)~twt. Then, for the individual to work part of the time (0 < Lt < 1)
But, if this condition is
in each period, it must be the case that )~twt = 1 1og(vl/V2)47.
satisfied, the individual is indifferent across all sequences of leisure which imply the
same level of ~ _ 0 /3t [(1 - Lt ) ~ log(vl/v2 )]: there is an infinite intertemporal elasticity
of substitution in work.
One implication of this labor supply behavior is that it is the demand side o f the
labor market which determines the quantity o f employment and work effort in the
equilibrium o f the indivisible labor model. From this perspective, firms choose the
quantity o f labor that equates its marginal product to the real wage, with the position
of the demand schedule being shifted by the level o f productivity and the capital
stock. Since the capital stock and the multiplier )~t are endogenously determined, this
labor market equilibrium picture is incomplete, but it is a useful partial equilibrium
description.
The indivisible labor model with more general preferences: When the indivisible
labor model is generalized, as in Rogerson and Wright (1988), there are interesting
new conclusions. To develop these, we use the utility function (3.8), with a 1.
Efficient risk-sharing condition implies that consumption allocations must satisfy

Cl ~C2

(6.6)

According to this specification, if a > 1 there will be more consumption allocated

to the employed (group 1) than to the unemployed (group 2) 48. Thus, as more
individuals are allocated to the market (higherp) aggregate consumption will rise even

47 If AtW~ < 1 1og(v~/O2), our agent spends all available time at t in leisure (L = 1). If
,~twt > log(vl/V2), our agent devotes no time to leisure (L = 0).
4s This conclusion makes use of the fact that v2 = v(l) > vI = v(1 -H), which follows from the fact
that v is an increasing function.

979

Ch. 14." Resuscitating Real Business Cycles

if consumption o f employed individuals and unemployed individuals stays relatively

constant. Further, using this consumption rule along with the expected utility objective,
there is a stand-in representative agent whose preferences are 49
1

u(c,r) =

{cl-av*(L) l - a -

1}

(6.7)

where
o

v*(L)=

v1~ +

1-

v ~-) i ~ .

There are two points about this expression. First, the stand-in's utility function inherits
the long-run invariance o f hours to trend changes in productivity from the underlying
utility function (3.8). Second, the stand-in's utility function inherits the original utility
function's properties with respect to effects of changes in leisure on the marginal utility
of consumption. In particular, when a > 1, the marginal utility of consumption is
decreasing in leisure.
Let us again think about an isolated individual maximizing lifetime utility,
~ _ o f i t u ( c t , L t ) , but with the new momentary utility function (6.7). As with our
discussion of the representative worker in Section 4 and as with our previous discussion
in this section, the stand-in agent equates the marginal utility of consumption and the
marginal utility o f leisure to the shadow values along the economy's resource constraint
(Dlu(ct,Lt) = )~t and Dzu(ct, Lt) = ~twt = ),tAtDzF(kt,Nt)). These conditions must
always hold if there is an interior optimum for work effort, i.e., 0 < Lt < 1 in each
period. Taking loglinear approximations to this pair of conditions, we find
- a ~ t + (1 - a)xL,

where Ic economy 50.

= ~t,

LDo* (L)

v*(r)

(6.8)

(6.9)

is pinned down by information on the steady state of the

49 There are two steps to this demonstration. First, one shows that efficient risk-sharing implies that
expected utility is proportional to:

1 {

1-a

[ (1 a)

ct a [ pol~

( ]-o'~]0 }
+(l-P)V2'J-1
if a l ,

and then one substitutes in for leisure using L = 1 -pH.

50 That is, tc- LDo*(L)
- v*(L)

) - Lw - L (wN/y)
-LD2u(c,L
CDlu(c,L)
c
N (c/y)"

R.G. King and S.T. Rebelo

980

This set of equations reveals that there is infinitely elastic labor supply even when
the preference specification is not separable. That is, the pair of equations implies that
0 = ~, + a~,
which is the statement that the stand-in will supply any amount of work at a
particular real wage. But because preferences are nonseparable, variations in work
require variations in consumption. When a > 1, in particular, workers require more
consumption than nonworkers and aggregate consumption is negatively related to
leisure, i.e.,

Thus, this model involves a modified form of the permanent income hypothesis, which
includes the effects of changes in work effort on the marginal utility of consumption.
Baxter and Jermann (1999) have argued that this type of preference nonseparability
will arise in any model with household production; they have also stressed that this
specification can make consumption more cyclically volatile.
6.2. Capacity utilization

In the standard version of the neoclassical model, there is a dramatic contrast between
the short run and long run elasticities of capital supply. The short run elasticity of
capital supply is zero: there is no way for the economy to increase the capital stock
inherited from the previous period. In contrast, the long run elasticity of capital supply
is infinity: there is only one real interest rate consistent with the steady state o f the
economy. This difference between short run and long run elasticities stems from the
assumption that capital services are proportional to the stock of capital. This is an
assumption we make every time we write a production function as Y = F ( K , N ) .
While this assumption may be suitable for some purposes, it is clearly problematic
for business cycle analysis. The third panel of Figure 3 suggests that capacity
utilization displays pronounced cyclical variability. The fact that equipment and
machinery are used more intensively in booms than in recessions is corroborated by the
procyclical character of electricity consumption in manufacturing industries [Burnside,
Eichenbaum and Rebelo (1995)] and by the fact that expansions are accompanied by
the use of two and three shifts in manufacturing industries [Shapiro (1993)]. All this
evidence suggests that the flow of capital services is high in expansions. In contrast,
recessions are times when capital tends to lie idle, thus producing a small service flow.
Several authors have extended the basic RBC model to incorporate variable capital
utilization. Kydland and Prescott (1988) showed that introducing time-varying capital
utilization enhanced the amplification capability o f their 1982 model. Greenwood,
Hercowitz and Huffman (1988) introduced variable utilization in a model that features

Ch. 14: Resuscitating Real Business Cycles

981

shocks to the productivity o f new investment goods 51. Finn (1991) used a similar
framework to study the interaction between capital utilization and energy costs. In
her model, more intensive capital use accelerates the depreciation o f capital and raises
marginal electricity consumption. Burnside and Eichenbaum (1996) explored a model
with both capital utilization and labor hoarding. They showed that these two features
significantly enhance the ability of the model to propagate shocks through time 52.
Modeling variable utilization. Most studies o f variable utilization assume that
depreciation is an increasing function of the utilization rate 53. The benefits from
variable capital utilization can be incorporated into the production function as follows:
Yt = AtF(ztKt,NtXt) = At(ztKt) l a(NtXt)a.
where zt denotes the utilization rate 54. The costs o f variable capital utilization are
imbedded in the following law o f motion for the capital stock:
K t + 1 : ~ + [1 - b ( z , ) ] K t ,

where 6(.) is a convex, increasing function o f the utilization rate 55.

To determine its optimal rate o f utilization, a firm maximizes its profits holding fixed
its future capital stock. The marginal benefit of a higher utilization rate is additional
output (AtDiF(ztKt, NtXt)Kt) and the marginal cost is higher (replacement) investment
(dIt = Db(zt)Kt). Equating these and using the Cobb-Douglas production function, we
find that efficient utilization implies
(1 - a)At(zt)-a(Kt)~-a(NtXt) a = Dr(zt)Kt,

(6.10)

which is the requirement that the marginal benefit in terms o f additional output
produced be equated to the marginal cost in terms o f additional units o f capital being
worn out.
The consequences o f variable utilization. To explore how efficient variation in the
utilization rate affects the linkages in the economy, we linearize Equation (6.10) to

51 These shocks tend to make consumption and investment move in opposite directions. Introducing
capital utilization eliminates this counterfactual correlation between consumption and investment.
52 Their model is also capable of producing a humped shape response of investment to technology
shocks - a feature that is common in empirical impulse response functions estimated using VAR
techniques.
53 An exception is Kydland and Prescott (1988).
54 For simplicity, we use the Cobb-Douglas form throughout our discussion of capital utilization.
55 Thus, it has a positive first derivative Dr(.) and a positive second derivative De6(.).

R.G. King and S.T. Rebelo

982

obtain an expression for ~t and substitute this result into the linearized production
function:
33t = 3t + a-~t + (1 - a)(]c~ + ~t)
= A t + (1 - a)/ct + aNt + ~1 - a ( A t - a ] c t + a N t )

(6.11)

In this expression ~ represents the elasticity o f Db(zt), which is positive if there

is increasing marginal depreciation cost of higher utilization 56. The model without
utilization occurs as a special case in which ~ is driven to infinity, since in that case
the quantity o f capital services does not respond to changes in the marginal product of
these services. At the other extreme, as ~ is driven toward zero, the response of output
becomes )t = FAt
1 ^ + Nt.
^ For this reason, time-varying capital utilization is sometimes
described as leading to a short-run production fimction that is nearly linear in labor.
Variable utilization makes the marginal product o f labor - the real wage rate - less
responsive to changes in labor input. The comparable log-linear expression for the real
wage rate is

~t:(f:,-Nt):3t+(1-a)[ct+(a-1)Nt+

1-a

(At-alct+aNt)

(6.12)

and, as ~ is driven toward zero, the response o f the real wage approaches wt = FAt.1
^
In other words, the labor demand schedule drawn in (w,N) space "flattens" as
depreciation becomes less costly on the margin (~ falls). When ~ is driven to zero,
the labor demand curve becomes completely flat.

7. Remeasuring productivity shocks

We have seen that productivity shocks are an essential ingredient of real business cycle
models. In the absence of measurement error in labor and capital services, these shocks
coincide with the Solow residual. Prescott (1986) used the Solow residual as a measure
of technology shocks to conclude that these shocks "account for more than half the
fluctuations in the postwar period with a best point estimate near 75%".
There are three reasons to distrust the standard Solow residual as a measure of
technology shocks. First, Hall (1988) has shown that the Solow residual can be
forecasted using variables such as military spending, which are unlikely to cause
changes in total factor productivity. Similarly, Evans (1992) showed that lagged
values o f various monetary aggregates also help forecast the Solow residual. Second,
the conventional Solow residual implies probabilities of technological regress that
are implausibly large. Burnside, Eiehenbaum and Rebelo (1996) estimate that the

56 It can be shown that ~ = z(D26)/D6 > O.

Ch. 14: ResuscitatingReal Business Cycles

983

probability o f technological regress associated with the conventional Solow residual is

37% in US manufacturing. Finally, cyclical variations in labor effort ("labor hoarding")
and capital utilization can significantly contaminate the Solow residual.
There are two strategies for dealing with these extra, hard-to-measure sources o f
factor variation. The first strategy is to use an observable indicator to proxy for
the unobserved margin. For example, since individuals working harder may have
more accidents in an industrial setting, the frequency o f worker accidents could be
used as an indicator o f unobserved effort 57. More commonly, electricity consumption
in manufacturing industries is taken as an indicator o f capacity utilization. The
second strategy is to use implications o f the model to solve out for the unobserved
factor variation and then to examine other implications o f the m o d e l economy. We
discuss application o f each o f these strategies to measuring capacity utilization in the
remainder o f this section.
Capital utilization proxies: Burnside, Eichenbaum and Rebelo (1996) employ
electricity use as a proxy for capacity utilization. In particular, assuming that the
utilization rate is proportional to electricity utilization, they can use the Solow
decomposition in modified form,
log SR[ = log Yt - a log Art - (1 - a)[log Kt + log(z[)],

(7.1)

where log(z/) is the log o f electricity use. They find that when electricity use is
employed as a proxy for capital services the character o f the Solow residual associated
with the manufacturing sector changes dramatically: (i) there is a 70% drop in the
volatility o f the growth rate o f productivity shocks relative to output, implying that a
successful model must display much stronger amplification than the basic RBC model;
(ii) the hypothesis that the growth rate o f productivity is uncorrelated with the growth
rate o f output cannot be rejected; and (iii) the probability o f technological regress
assumes much more plausible values, dropping to 10% in quarterly data and to 0% in
annual data. These corrections to the Solow residual significantly reduce the fraction
o f output variability that can be explained as emanating from shocks to technology 58.
Using the model to measure capacity utilization: A n alternative strategy is to
use the model's implications for efficient utilization to solve for the unobserved

57 Several variants of this proxy strategy have been used to shed indirect light on the presence of labor
hoarding. Bils and Cho (1994) use time and motion studies to document the presence of variability in
effort. Shea (1992) uses data on on-the-job accidents to construct an indirect measure of labor hoarding.
Burnside, Eichenbaum and Rebelo (1993), Sbordone (1997), and Basu and Kimball (1997) postulated
a model of labor hoarding that they proceeded to use to purge the Solow residual of variations in the
level of effort.
s8 Aiyagari (1994) proposed a method to compute a lower bound on the contribution of technology
shocks to output volatility. His procedure relies on knowledge of two moments in the data: the variability
of hours relative to the variability of output and the correlation between hours worked and labor
productivity (which is essentially zero in the data). Unfortunately, his method is not robust to the
presence of labor hoarding or capacity utilization.

984

R.G. King and S.T. Rebelo

utilization decision, i.e., zt. In essence, this empirical strategy corresponds to our
theoretical method in the previous section, when we solved out for zt in order to
derive Equation (6.11), which describe how output responds to changes in labor, capital
and productivity when utilization is efficiently varied. One possibility would be to
exactly follow this strategy, substituting observed variations in labor and capital into
Equation (6.11) to compute the productivity residual, but we use a more "reduced
form" approach that we describe more fully in the next section.

8. Business cycles in a high substitution economy

Motivated by the vanishing productivity shock, we now construct an economy in which
small variations in productivity can have large effects on macroeconomic activity, i.e.,
an RBC model in which there is substantial amplification of shocks. There are two
central ingredients to this model. First, as in Section 6.1, we assume that there is
indivisible labor. This makes the supply o f aggregate hours strongly responsive to
changes in wages and intertemporal prices. Second, as in Section 6.2, we assume
that there is variable capacity utilization. This makes the supply o f capital services
strongly responsive to changes in the level o f aggregate hours. Taken together, these
ingredients mean that the economy has high substitution in all factors o f production.
Further, the Solow residual is a very poor measure o f technology shocks in our model
economy. However, the very same structural feature that makes the Solow residual
a bad measure o f technology shocks (unmeasured variation in capital services) also
provides a powerful amplification mechanism that allows our model to account for the
observed output variation with much smaller shocks. Finally, our model provides a
means o f implicitly measuring the smaller shocks that occur, which can be viewed as
a variant o f Solow's approach 59.
8.1. Specification and calibration

The specification and calibration o f the model follows the same general approach that
we used in Section 4, but with some relatively minor modifications.
Restrictions on the steady state: First, we know that the production side o f the basic
model determines most aspects o f the steady state and that continues to be true with
variable capital utilization. The efficiency condition for utilization in the steady state
determines a steady-state utilization rate such that r + b(z) = D6(z), with the remainder
o f the steady-state relative prices and great ratios then adjusted to reflect the fact that
the flow o f capital services is z K rather than K.

59 The approach was suggested by Mario Crucini in unpublished research many years ago, so perhaps
we should call these "Crucini residuals". Another application is contained in Burnside, Eichenbaum and
Rebelo's (1993) study of unobserved effort (labor hoarding). Ingram, Kocherlakota and Savin (1997)
use a similar procedure to infer information on observed shocks to the home production sector.

Ch. 14: Resuscitating Real Business Cycles

985

Table 4
Calibration of high substitution economy
~r

(Ye

0.984

1.004

0.667

0.025

0.1

0.9892

0.0012

Second, since we are assuming an indivisible labor model, there is a different

calibration of the preference side of the model. Evidence from asset pricing studies
suggests that a is larger than the unit value used in the basic model; this means that our
model will have the realistic implication that more consumption is allocated to working
individuals than to nonworking individuals. Drawing on Kocherlakota's (1996) review,
we use o = 3. We assume that 60% of the population is employed in the steady state
and that employed individuals work 40 hours. This implies that an average individual's
hours are N = 0.214, i.e., 24 hours out of a weekly 112 hours o f nonsleeping
time. Then, this information (including the assumed value of a ) determines the ratio
v(1)/v(1 - H ) which dictates the ratio of consumptions o f the two types o f individuals.
It turns out that the ratio CJCe is 3.31 so that workers have substantially higher
consumption than nonworkers. Table 4 summarizes our parameter assumptions. Unless
otherwise discussed, the parameters are the same as in Table 2.
Measuring technology shocks: We use the implications of our model as discussed
in the last section to produce a series on technology shocks which is consistent with
unobserved variation in capacity utilization 6. In particular, we start by assuming a
value for the persistence and volatility of technology shocks and solve the model. The
decision rule for output can be written as

Yt = : ykkt + ZyAA,.
Using this decision rule together.with data for output and capital (which we logged
and linearly detrended), we can compute an initial guess about the time series for
technology shocks 61:
1

_ ,ryk

60 There is no unique way of computing this shock process, but rather any of the model's decision
rules could be used in this way or these rules could be combined with other relationships in the
model. For example, one could exploit the decision rule for utilization as in Burnside, Eichenbaum
and Rebelo's (1993) analysis of labor hoarding, ~t = JVyklct+ ~yA~lt, and combine this with the modified
Solow decomposition(7.1). This alternativemethod would produce a different shock process, which lead
to broadly similar, but somewhat less dramatic results. The difference between these two productivity
measures lies in whether labor in Equation (7.1) is taken from the data or from the model.
61 We should not use the empirical capital stock series since these are flawed in the eyes of the model:
they are computed assuming constant rates of depreciation. This can be circumventedby using a second
decision rule to compute the "true" capital stock series. In practice this has little impact on the results.

986

R.G. King and S.T. Rebelo

This guess is not exactly fight because the serial correlation coefficient (p) for this zit
series need not match that used to solve the model and to construct the Jr coefficients.
Therefore, once we obtain a time series for zit, we compute its persistence (p) and use
this new value to solve the model again. Using the new decision rule, we recompute
~it and once again its calculate its persistence. We continue this process until the new
and old estimates for the serial correlation of~it are the same. This iterative procedure
yielded an estimate of 0.9892 for the first-order serial correlation and 0.0012 for the
standard deviation of the et.
8.2. Simulating the high substitution economy
With a series of productivity shocks in hand, we simulated our model economy's
response to these shocks just as we previously did for the standard RBC model.
Figure 13 displays the results, which we think are dramatic. Panel 1 shows the model
and actual paths for output, which are virtually identical. In part, this is an artifact of
our procedure for constructing the technology shock, which is a weighted average of
output and capital as we just discussed. For this reason, we think that the performance
of the model should not be evaluated along this dimension. Instead, the model has
to be judged by its predictions for other variables of interest. The remaining panels
of Figure 13 display the model's implications for total hours worked, consumption
and investment, with all of these series detrended with the HP filter. The correlation
between the empirical and the simulated series is 0.89 for labor, 0.74 for consumption
and 0.79 for investment! This remarkable correspondence leads to three sets of
questions, similar to those which arose in the analysis of the standard RBC model.
First, how do small variations in productivity have such dramatic effects? Second, what
are the properties of the technology shocks? Third, how sensitive are the results?
8.3. How does the high substitution economy work?
The high substitution economy contains four mechanisms that substantially amplify
productivity shocks and lead to strong comovements of output, labor, consumption
and investment. To begin, variable capacity utilization makes output respond more
elastically to productivity shocks in Equation (6.11), which we repeat here for the
reader's convenience:

Since utilization of capital increases when there is a positive productivity shock, there
is a direct effect which is part of the amplification mechanism. In the limiting case of
= 0 for example, a labor's share of a = 2 implies that the productivity shock raises
output by ~1 or 3 times its direct effect. We use a value of ~ = 0.1 in constructing our
simulations, so that the effect with a = 2 is 1 + ~l-a = 1+33
~_~ = 1.43. Thus, variable
utilization helps create amplification, but only in a modest manner.

Ch. 14." Resuscitating Real Business Cycles

987

Output

51

56

61

66

71

76

81

86

91

96

Date

Input

Labor

4.

2,
0
4-2,

#.

-4.

"

--

........

Data

-6,
I

51

-8

56

61

66

71

76

8I

86

91

96

Date

15

Investment

Mode[

10
5

~- -5
-10
-15

51

56

61

66

76

71

81

86

91

96

-20

6.
5.
4.
3.
2.

Consumption
~..~

Model

--,-~-- - Data

~.
~o

-1.
-2.
-3.

51

56

61

66

71

76

81

86

91

96

Date

Fig. 13. Capacity utilization model: simulated business cycles. Sample period is 1947:2-1996:4. All
variables are detrended using the Hodrick-Prescott filter.

R.G. King and S.T. Rebelo

988

Relative to the standard RBC model that we discussed in Section 4, most of the
increased amplification in the model of this section comes from greater elasticity of
the labor demand and labor supply schedules. Highly elastic labor supply is due to
indivisible labor: work effort is highly responsive to small changes in its rewards.
In fact, we have previously argued that it is the demand side which approximately
determines this quantity in indivisible labor economies. Variable capacity utilization
makes the labor demand more elastic. As discussed above, labor demand is implicit
in the equation:

~t = ( ) t _ ~ t ) = ~ t + ( l _ a ) ~ + ( a _

1)~t + 1 - a

(At-aict+aNt)

In the model without variable utilization (or with ~ = c~), a one percent increase
in labor quantity causes the real wage to fall by 0.333 percent when a = 2, since
the coefficient on Nt is (a - 1). At the other extreme, as ~ is driven toward zero,
the response of the real wage to a productivity shock approaches ~t = FAt,
1 ^ i.e., the
labor demand schedule becomes more elastic until it is completely elastic in the limit.
With variable utilization, the combined coefficient on labor is (a - 1) + ~1-a
a . Using
a = ~ and ~ = 0.10, as in our simulations, we find that the combined coefficient is
(0.67 - 1) + 0.33
n 67 = -0.043: a one percent change in labor requires a decline in the
0.77 ....
wage that is an order of magnitude smaller than in the standard model. With indivisible
labor and variable utilization, a small productivity shock shifts up labor demand and
calls forth a large increase in labor supply. In order to determine the exact size o f this
change, however, it is essential that we simultaneously determine the path of capital
(kt) and the multiplier ()~t).
The final structural feature that is important for the simulated time series is the
nonseparable form of the utility function. In the standard Hansen-Rogerson case
of log utility, most of the model's change in output goes into investment rather
than consumption. However, since the efficient plan calls for the allocation of more
consumption to employed individuals when ~r > 1, the high substitution economy
displayed in Figure 13 involves more volatile consumption that corresponds closer to
the data. We return to a discussion of this feature in the context of impulse responses
later in this section.

8.4. What are the properties of the shocks?

Is this remarkable coherence between data and model achieved by using an empirically
unpalatable productivity shock as a driving force? Figure 14 answers this question. The
first panel depicts the level of the productivity, which involves a combination of the
deterministic trend and stochastic component (i.e., AtXta). It increases through time
smoothly in the manner that many economists believe is appropriate for the level of
technology. The second panel of Figure 14 shows the growth rate of productivity in
our economy. This graph shows that the average rate of technical progress is large

989

Ch. 14." Resuscitating Real Business Cycles

A. Model Productivity Level
8.28.187.97.8-

7.7-

3 7.67.5. j ...........- , -

7.47.3-

7.2

51

56

61

66

71

76

81

86

91

99

Da~

B. Model Productivity Growth

0.9
0.8
0.7
0.6

0.5
0.4

9.3

9.2
9.1
0
-0.1

I
51

I
56

I
61

I
66

71

I
76

I
81

I
86

I
91

I
96

Date

C. Model Productivity (-) and Empirical Solow Residual (..)

4
3
2
1

i,

:L,V

. . . .

;'..

;'~

'

".

:~',

'

-1.
-2.

-3,
-4

I
51

I
56

I
61

I
66

I
71

I
76

I
81

I
86

I
91

I
96

Date

Fig. 14. Capacity utilization model: productivityand the Solow residual.

enough that a measured technological regress occurs only very rarely, given the low
variability of technology shocks. The third panel of Figure 14 graphs business cycle
variation in the conventional Solow residual and the productivity shock used in our
model, using the HP filter to create these components. Figure 14 illustrates that it

990

R.G. King and S. T. Rebelo

Table 5
Sensitivity analysis to different ~ values
value

ec
1
l
1
I
1

7
11o

Standard deviations
I
N
A

1.36
1.39
1.40
1.40
1.41
1.41
1.42

1.01
0.94
0.92
0.91
0.91
0.90
0.89

2.62
2.86
2.94
2.99
3.05
3.09
3.15

0.90
1.07
1.13
1.16
1.20
1.23
1.26

0.79
0.45
0.34
0.28
0.22
0.19
0.15

Persistence
parameter (p)

Likelihood of
technical regress

0.0061
0.0034
0.0026
0.0021
0.0017
0.0014
0.0012

0.9783
0.9798
0.9822
0.9841
0.9866
0.9880
0.9892

0.1859
0.1106
0.0653
0.0352
0.0101
0.0050
0.0050

is possible to explain the variability o f US macroeconomic activity with productivity

shocks that are much smaller than those conventionally used in the literature.
8.5. H o w sensitive are the results?

We next discuss the sensitivity o f our results to the choice of parameters and to the
measurement o f output.
Sensitivity to parameterization. The value chosen for the parameter ~ is a key
ingredient in the results. This is not surprising since we know that when ~ equals
infinity the model with capital utilization reduces essentially to the standard model.
Table 5 shows how some key model statistics change with different values for ~.
For every value of ~ we used the iterative process described above to ensure that
the stochastic process assumed for A~ is in fact consistent with the properties o f the
technology shock implied by the model. In every case we report the persistence of
the shock ( p ) and the standard deviation of the innovation (e) as well as the implied
probability o f technological regress. Low probabilities o f technological regress can be
1
obtained for values o f ~ that are lower than 3"
As an alternative check on the sensitivity o f the model to ~, Figure 15 depicts the
impulse response for this model for three values o f ~: oe, I and 1 . To simplify the
comparison between these impulse responses we did not adjust the stochastic process
for the technology shock. All three responses were computed with the same standard
deviation o f innovation (a~, = 0.0072) and same persistence ( p = 0.979).
The three impulse response functions depicted in this figure have similar dynamic
properties, but vary mostly in the degree of amplification. The solid line is a fixed
capital utilization model (~ = oc) like the basic RBC model of Section 4, but with
indivisible labor. In this model, a productivity shock has a larger effect on output than
in the standard RBC model: when there is a one percent productivity shock, output rises
by just less than two percent on impact with fixed utilization (~ = ec). However, the

Resuscitating Real Business Cycles

Ch. 14:

991

Productivity

1.2

Capital

5.
45,

1.

4.

0.8,

3.5,

. . . .

~0.6.
0,4.

,.,="

............................

3.
2.S.

2.
1.5.
=

1,

O.2.

.~..1

,. ................................................

O.5', ', :
2 3 4

o.

:
5

:
6

:
7

:
8

:
9

:
:
:
:
:
'. :
:
:
:
:
10 11 12 13 14 15 16 17 18 19 2O

0
2

Ouarte~

=~

10 11 12 13 14 15 16 17 18 19 20
Quarters

Consumption

35

Investment

7
6

~2ot

.......

o,
1

10 11 12 13 14 15 16 17 18 19 20

:
1

'.
3

'.
4

'.
5

'.
6

'.
7

'.
8

'.
',
'.
'.
'.
', :
', ', ',
:
10 11 12 13 14 15 16 17 18 19 20

'.
9

Quarters

14 T

Quarters

Output

14 112

~8

10 1I

12 13 ~4 15 16 17 18 19 20

Labor

.............
.
1

Quarters

1'i I

..

:.., ;~2.'-.~,:-=. =--:~'-

10 11 12 13 14 15 16 17 18 19 20
Quartg~

iit

Real Wages

Input

'' -;"~T~- '-- '-J--:~';~:'--;

...

n,.r.,.a,o

0.6 ..............
0.4
0.2
0

. . . . . . . . . . . . . . . . . .
1

10 11 12 13 14 15 16 17 18 19 20
Quartar~

10 11 12 13 1,4 15 16 ~7 18 19 20
Quarters

Fig. 15. Sensitivity analysis to alternative utilization costs (~): solid line, ~ = e~; diamonds, ~ = ;
squares, ~ = ~ .

R.G. King and S.T. Rebelo

992

increase in amplification is small relative to what happens when indivisible labor and
capacity utilization are introduced simultaneously. A one percent productivity shock
has an impact effect on output o f 8 percent when ~ = 0.2 and o f 13 percent when
= 0.1. From various experiments with this model economy, it is clear that values
of ~ less than one are important to obtain substantial amplification. For example, if
there is a value of ~ = 1 then there continues to be on average a regress in the level of
productivity every ten quarters (see Table 5 above). It is important that econometric
evidence be produced on the cost o f varying capital utilization, so as to determine the
extent to which this high substitution economy is realistic 62.
One specific feature o f the impulse response in Figure 15 is worth some additional
discussion. In all o f the cases, the real interest rate increases in response to a positive
productivity shock, at least for the first twenty quarters shown in the graph. In all cases,
the level o f consumption broadly resembles the level o f output and the growth rate of
consumption is negative, even though the real interest rate is high by comparison to
its steady-state level. This behavior o f consumption reflects the fact that aggregate
consumption is the sum o f consumptions by individuals that are working and those
who are not. Since working agents have more consumption, an increase in the fraction
o f individuals working makes aggregate consumption rise and fall with aggregate
employment 63.
Sensitivity to the measurement o f output. We have seen that variable utilization and
indivisible labor produce an economy in which (i) small productivity shocks have large
effects on output; (ii) the standard Solow residual is substantially mismeasured; and
(iii) labor and output move together on an approximately one-for-one basis. In this
economy, however, there is an important sense in which output is mismeasured. There
is a standard line o f intuition which suggests that "intermediate" activities such as
utilization should not be too important for economic activity and, in this case, suggests
that the large effects o f productivity on output and the strong eomovement o f output
and labor are simply artifacts of output mismeasurement. To explore these ideas, output
net o f depreciation can be defined as
Ot = Yt - 6(zt)kt = AtF(ztkt, Nt) - 6(zt)k~

(8.1)

and this expression can be used to make four important points. First, output is also
mismeasured in the standard neoclassical model, i.e., even in the absence of a variable
depreciation rate. Second, with efficient utilization, changes in net output are
dot = F(ztkt, Nt) dA, + AtO2F(ztkt, Nt) dN,
+AtDlF(ztkt, Nt)(kt dzt + zt dkt) - D6(zt) ]~tdzt --

(~(Zt)

dkt

= F(ztkt, Aft) dAt + AtO2F(ztkt, Nt) dNt + AtOlF(ztkt, Nt) zt dkt - 6(zt) dkt,
62 Basu and Kimball (1997) provide an estimate of a parameter that is essentially our ~. Their point
estimate is about unity, but the parameter is very imprecisely estimated.
63 Baxter and Jermann (1999) stress that equilibrittm models with nonseparable preferences can generate
apparent excess sensitivity of consumption to income, working in a model where labor supply variation
is on the intensive rather than extensive margin.

Ch. 14: Resuscitating Real Business Cycles

993

where the latter equality follows from AtD2F(ztkt, Nt) kt dzt - D6(zt) ktdzt = 0 when
utilization is efficient. Thus, there is a sense in which the standard intuition is correct
because net output does not respond to utilization. Third, near the steady state, the
Solow decomposition for net output is
(8.2)

where m = ~ = [1 @]-l. This modification takes into account the fact that the
net production function :is more labor intensive and the fact that productivity shocks
affect gross output but not depreciation. Thus, for example, if depreciation investment
is 10% of output, then m = 1.11. Thus, if output is measured as net of depreciationindependent of whether capacity utilization affects depreciation - then this will tend
to strengthen the magnitude o f labor's effect on output. Fourth, most importantly for
our purposes, the net production function qSt = AtF(Nt, ztkt) - 6(zt)kt has the same
marginal product schedule for labor, A t D I F ( N t , ztkt) as does the standard production
function. Thus, our analysis of the "labor demand" consequences of efficient utilization
are unaffected by whether depreciation costs are deducted from output or whether
they are not. Returning to Equations (6.11) and (6.12), we can thus see that a "net
output" measurement requires that we replace Equation (6.12) with the modified
growth accounting expression (8.2), but that we need not change the labor demand
schedule (6.11) at all. Further, it is a highly elastic labor demand that is the key force
behind the great amplification present in our high substitution economy.
-

9. Conclusions

This chapter provides a perspective on developments in the literature on real business

cycles over the last decade. We discussed the structure of these models, their
successes and their deficiencies. We also argued that three main criticisms levied
against first-generation real business cycle models have been largely overcome. First,
the performance of the basic RBC model has proved to be remarkably resilient
to alternative parameterizations, including versions in which the elasticity of labor
supply is small at an individual level but large in the aggregate economy. Second,
the model has been usefully extended to accommodate more realistic price behavior.
Finally, we showed by example that there are RBC models which can provide enough
amplification so that the underlying technology shocks can be small and involve
a low probability of technological regress 64. Our example made clear that major

64 Just as this first round of problems is set to rest, new challenges arise for the RBC model regarding
the comovement between productivity and economic activity. In a recent paper, Gali (1996) argues,
using VAR techniques, that technology shocks actually reduce input usage in the aggregate economy.

994

R.G. King and S.T. Rebelo

amplification o f productivity shocks requires highly elastic labor supply and readily
variable capital utilization 65.
Although we have concentrated on the one sector neoclassical model, which has
been the central laboratory for most work on real business cycles, the next stages
o f RBC research will likely use richer frameworks, as we discuss next. However, we
believe that the exploration o f these richer frameworks will require consideration of
the structural features that we have stressed in this chapter.
One exciting research direction is the exploration o f models with multiple sectors,
i.e., a long overdue continuation o f the trail scouted by Long and Plosser (1983).
Interesting recent work on these models retains most o f the assumptions on preferences
and production opportunities commonly incorporated in the one-sector RBC model
[Horvath (1997), Dupor (1998)]. The one-to-one movement between hours and output
observed in aggregate data also holds at a sectoral level. To us, this suggests
the importance o f introducing variable capacity utilization into sectoral production
structures. Another promising direction is work on models with heterogeneous agents
[Krusell and Smith (1998), den Haan (1993)]. This work seems particularly important
for enriching labor market dynamics and modeling unemployment 66. Fleshing out
labor market dynamics is important on its own terms. But this work may also provide
us with an alternative way o f obtaining a highly elastic aggregate labor supply which
appears necessary for RBC modeling. A third interesting research direction seeks to
tmderstand the industry dynamics that seem intimately related to the business cycle
[Hopenhayn and Rogerson (1993), J.R. Campbell (1998)]. Finally, there are many
aspects o f microeconomic activity in addition to employment in which discrete choice
seems very important. It has frequently been suggested, for example, that the volatility
o f investment is related to the fact that much o f firm investment is lumpy in character
label and Eberly (1995), Caballero and Engel (1994)]. The incorporation o f lumpy
investment decisions into the RBC model and its implications for aggregate dynamics
is an exciting new direction o f research on which some initial progress has been made
[Veracierto (1996), Thomas (1997)]. The interaction o f lumpy investment with costly
capacity utilization seems a particular important topic o f investigation. All four of

This finding receives indirect support from two sources that do not rely on the VAR methodology:
Burnside, Eichenbaum and Rebelo (1996) document that a sectoral capital-utilization adjusted measure
of technology shocks is essentially tmcorrelated with production in 2-digit SIC manufacturing industries.
Basu, Fernald and Kimball (1997) show that, for this same set of industries, input usage is negatively
correlated with technology shocks. One interpretation of these facts is that they reflect the presence of
nominal rigidities that keep nominal aggregate demand fixed and lead inputs to contract in response
to a productivity increase [Gali (1996)]. An alternative flexible-price explanation for these same facts
involves a multisector model in which goods are complements so that a technology shock to an individual
sector does not necessarily warrant an expansion of input usage in that sector.
65 All interesting and open question is whether these same mechanisms can amplify other shocks besides
productivity shocks sufficiently that these can produce realistic business cycles.
66 Some recent examples include Andolfatto (1996), Merz (1995), Gomes, Greenwood and Rebelo
(1997) and den Haan, Ramey and Watson (1997).

Ch. 14: Resuscitating Real Business Cycles

995

these lines o f inquiry involve enriching the RBC model in ways that seemed virtually
impossible a decade ago.
While we think that economists may have prematurely dismissed the idea that the
business cycle m a y originate from real causes, we also think that m a n y o f the lessons
drawn from current and future RBC research are likely to be independent o f the main
source o f business fluctuations. This is one important reason why the RBC literature
has been a positive technology shock to macroeconomics.

Appendix A. Dynamic theory

This Appendix discusses some theoretical aspects that underlie the construction o f
Real Business Cycle Models.

A. 1. Assumptions on preferences and technology

The specific forms o f the momentary utility and production functions used in RBC
models may seen arbitrary, but they are typically chosen on the basis o f economic
theory and empirical observation.
Preferences: In order for preferences to be consistent with steady-state growth in
a deterministic version o f the basic RBC model they must have two properties: (i)
households must be willing to expand their consumption at a constant rate when the
real interest rate is constant; and (ii) it must be optimal for households to supply a
constant number o f hours when the real interest rate is constant and the real wage rate
grows at a constant rate.
King, Plosser and Rebelo [1988a] study the admissible utility specifications when
utility depends on "pure leisure" (L)67. These two requirements imply that momentary
utility must have the form

j_d[Cv(L)]1-G

l
l-or

if

o > 0,

if

o = 1.

cr ~e 1,
(A.1)

u(C,L) =

log(C) + log v(L)

It is easy to verify two properties o f these specifications. First, i f agents have a budget
constraint for goods and leisure o f the form e + wL <. w, where w is the real wage
rate and 1 is the time endowment, then there is invariance o f L to the level o f w 68.

67 Another possibility is that utility depends on leisure in efficiency units, i.e., on leisure augmented
by technological progress (L~Xt). In this case it is sufficient to assume that u(C, LX) is homogeneous,
of class C2, and concave. The dependency of utility on leisure measured in efficiency units can be
justified by introducing home production into the model. See Greenwood, Rogerson and Wright (1995,
pp. 161-162) for a discussion.
68 This invariance extends to a setting where the budget constraint includes nonwage income which
grows at the same rate as the real wage.

R.G. King and S.T. Rebelo

996

Second, u s i n g U H o p i t a l ' s rule, the s e c o n d case is the limiting expression o f the first
as a --+ 1. We require that utility be sufficiently differentiable as well as c o n c a v e and
increasing in c o n s u m p t i o n and leisure; this implies restrictions that m u s t be p l a c e d on
v w h i c h d e p e n d on the value o f a 69. Differentiability allows us to characterize efficient
allocations u s i n g variational methods. W h e n c o m b i n e d w i t h convexity o f the constraint
set, c o n c a v i t y o f preferences insures that the s o l u t i o n to the planner's p r o b l e m is
unique, w h e n e v e r lifetime utility ( U ) is finite 7. Since, as we will see shortly, the
c o m p e t i t i v e e q u i l i b r i u m under rational expectations c o i n c i d e s with the solution to the
planner's p r o b l e m , this guarantees that the c o m p e t i t i v e equilibrium is also unique.
T e c h n o l o g y : The p r o d u c t i o n function F ( . ) is also t w i c e continuously differentiable,
concave and h o m o g e n e o u s o f degree one. Constant returns to scale implies that the
n u m b e r o f firms in the competitive e q u i l i b r i u m is undetermined. W i t h increasing
returns to scale a competitive e q u i l i b r i u m does not exist because it w o u l d entail
negative profits for all firms 71. In contrast, with d e c r e a s i n g returns to scale we w o u l d
see an infinite n u m b e r o f infinitesimal firms w h o s e total output w o u l d be infinite 72.
Alternatively, firms w o u l d earn e c o n o m i c profits if, for some reason, entry were
limited.
We a s s u m e that F ( . ) satisfies the f o l l o w i n g l i m i t i n g conditions, often referred to as
Inada conditions 73:
lim DIF(K,N)

K --~ c,o

= 0,

lim DtF(K,N)

K-+O

= cxz.

These c o n d i t i o n s ensure the existence o f a steady state in which the level o f capital is
strictly positive. One can also show that they i m p l y that labor is essential in production:
F ( K , O) = O.

69 More specifically, we assume that the fimctions vi are twice continuously differentiable. If a - 1,
then concavity requires that the function log(v) must be increasing and concave. If a is not equal to 1,
then v 1-a must be increasing and concave if a < 1 and decreasing and convex if a > 1. In addition we
need - a v ( L ) v"(L) > (1 - 2a)[v'(L)] 2 to assure the overall concavity of u.
70 Whenever there is one path that yields infinite utility it is always possible to construct other paths (in
fact a continuum of paths) that also yield infinite utility. Thus, to ensure that there is only one solution
to the planner's problem we need to constrain the discount factor so that life-time utility, U, is finite.
The requirement (by I a < 1) involves the interaction of preferences and technology. See Alvarez and
Stokey (1999) for a discussion of this type of conditions.
71 See Hornstein (1993), Rotemberg and Woodford (1995), and Chatterjee and Cooper (1993) for a
discussion of models that move away from perfect competition and incorporate increasing returns to
scale.
72 Suppose, for example, that the production function is Cobb-Douglas and that there is a stock of
capital K and a number of labor hours N which will be divided equally among n fu-ms. Total production
will be given by Y = nA(K/n) a~(N/n) a2 - AKa~Na2n 1 a~ a2. With decreasing returns to scale a I + a 2 < 1
and lim, _~~ Y = 0<~.
73 As ill the main text we use the notation DiF(.) to refer to the partial derivative of F(-) with respect
to its ith argument. We use DF(.) to refer to the total derivative of a fimction of a single variable.

Ch. 14: Resuscitating Real Business Cycles

997

A.2. The dynamic social p l a n n i n g problem

Let us consider first the case in which allocation decisions are made by a benevolent
planner who maximizes the welfare of the representative agent. The solution to this
problem will be a symmetric Pareto-optimum in which all agents receive the same
consumption and leisure allocations.
The stationary economy: In the steady state of a deterministic version of this
economy Y, C, I, and K all grow at rate ~, i.e., the model captures the Kaldor growth
facts. This suggests that it is useful to write the planner's problem for this economy
in terms of variables that are constant in the steady state: y = Y/X, c = C/X, i = I / X ,
k = K/X. Using these stationary variables the planner's problem is given by
oo

max Eo ~

f l u ( c , 1 - Nt)

(A.2)

t-0

subject to:
Yt

= AtF(k,,Nt),

(A.3)

Yt

= ct + it,

(A.4)

~/kt + 1 = it + (1 - b)k,,

(A.5)

k0

(A.6)

> 0,

where fi =_ b y ~-.
In a deterministic environment the solution to the problem of maximizing Equation (A.2) subject to conditions (A.3)-(A.5) would be a sequence of consumption,
labor supply and capital accumulation decisions: {ct}t=0,~ {N~}t=0,ooand {]~t}t~l.~ These
decisions could be made at time zero, since no relevant information is revealed later
on. In contrast, in a stochastic economy agents learn over time the realizations of
the random shocks that affect their environment. It would be inefficient to ignore this
information that will be available later on and cast in stone the consumption and leisure
decisions at time zero. For this reason, the solution to the utility maximization problem
is a set of contingency rules, which specify how much to consume and work at each
point in time as a function of the state of the economy in that period. Since the state
of the economy can be, at any point in time summarized by two variables, the value
of At, which influences current output and helps predict future productivity, and the
value of the stock of capital. Thus contingency rules take the form c = c ( k , A ) and
N = N(k,A).
D y n a m i c programming: To use this approach, we write the planner's problem in

recursive form as
V ( k , A ) = max{u(c, 1 - N ) + f l E V ( k ' , A ' ) } ,

(A.7)

c,N,k I

subject to:

c + y k ' - (1 - 6)k = A F ( k , N ) .

(A.8)

where we use primes ( ) to denote the value of a variable in the next period. The
value function V ( k , A ) represents the expected life-time utility of the representative

R.G. King and S.T. Rebelo

998

agent of an economy with a capital stock equal to k and a level of productivity

equal to A. Equation (A.7) decomposes this life-time utility into two parts: the utility
flow that accrues in the current period, u(e, L), and the expected utility that results from
starting tomorrow with a stock of capital k' and a shock A' and proceeding optimally
from then on. The planner will decide today on the value of U, so this variable is
known with certainty at time t. However, the value of A' will only be known in the
next period, so we have to compute the expectation of fiV(U,A') with respect to A':
[3EV(U,A') = [3 f V(U,A')H(dA',A). Bellman's Principle of Optimality guarantees
that the solution to the problem (A.2)-(A.5) coincides with the solution to the recursive
problem (A.7)-(A.8) [see Stokey, Lucas and Prescott (1989), Section 9.1].
The efficiency conditions for the planning problem can be computed forming a
Lagrangian in which Equation (A.7) is the objective and Equation (A.8) the constraint.
The optimal value of c is dictated by
DI u(c, 1 - N) = )~,

(A.9)

where X is the multiplier associated with the constraint (A.8).

The optimal value of N, which we assume has an interior solution (0 < N < 1), is
given by
D2u(c, 1 - N) = )~ADzF(k, N).

(A. 10)

The optimal U is given by

)~y = flED1 V(k',A')
This condition involves the expectation of the term DI V(U,A'), which is unknown,
since we do not know the form of the value function. Information about D1V(k,A)
can, however, be obtained differentiating the Lagrangian with respect to k:
D 1 V ( k , A ) = )~ [ADIF(k,N) + (1 - 6)]
+ [)~ADzF(k, N) - D2u(c, 1 - N)]

V(k',A')-

dN

d~-

dk'
dk"

Using the same logic as in the derivation of the "envelope theorem" in demand theory,
this equation can be greatly simplified by using the first-order conditions (A.9) and
(A.10) to set the two bracketed terms equal to zero. Intuitively, given that the values
of N and U were optimally chosen, there are zero net benefits from the adjustments
in these quantities that will arise from a change k. Thus D~ V(k,A) can be simplified
to
D1V(k',A') = )~ [A'D1F(U,N') + (1 - 6)].

(A.11)

Finding the decision rules: Conditions (A.9) and (A. 10) can be used to solve for c
and N as a function of )t, k and A. These functions are not quite the decision rules for

Ch. 14: Resuscitating Real Business Cycles

999

consumption and labor, since they depend on ,~ which we have not yet determined. We
specify the resulting functions as N = N(k, ).,A) and c = ~(k, )~,A). To find the decision
rule for capital, we proceed as follows. Using N = N(k, )~,A) and c = ~(k, X, A), we
can express the optimization conditions as a first-order system o f nonlinear stochastic
difference equations in ;. and k:

)~7

= flEX' [A'D1F(k',N(k',)(,A')) + (1 - 6)],

(A.12)

A F [ k , N ( k , )~,A)] = O(k, )~,A) + yk' - (1 - 6)k.

The solution to this system is a pair of decision rules U = h(k,A)and )~ = )t(k,A). In
turn, these imply decision rules for consumption and labor N = N ( k , A ) and c = c(k, A).
Taking these decision rules for c,N,;~,U, we have a complete description of how
quantities in the real economy will efficiently evolve through time.
The steady state of the optimal economy: The stationary distribution of A is given
by the function G(A) such that: G(A') = f H ( A ' , A ) G ( d A ) . Given this stationary
distribution the mean value o f A can be computed as A* = f AG(dA). If we ignore, for
the moment, the stochastic nature of A and set it equal to its mean, A = A*, the model
reduces to a variant of the Cass-Koopmans neoclassical model. It is well known that
this deterministic model has a unique non-trivial steady state which is globally stable
[Stokey, Lucas and Prescott (1989), Section 6.1].
Replacing A and A ~ by A* in Equations (A.8)-(A.11) we obtain the system of
equations that characterize the steady state:

A*DIF(k*,N*)+(1-6)
= 7/3,
A*D2F(k*, N*)D1 u(c*, 1 - N*) = D2u(c*, 1 - N*),

(A.13)

7k*

(A.15)

= A * F ( k * , N * ) - c* + (1 - 6 ) k * .

(A.14)

We use an asterisk to denote the steady-state values o f the different variables. This
system of equations is recursive. Equation (A.13) determines the value of k*/N*;
recall that F is homogeneous o f degree one and thus D1F is homogeneous of degree
zero implying that DlF(k*, N*) = D1F(k*/N*, 1). Equations (A.14) and (A. 15)jointly
determine c* and N*. We will return below to discussing the nature of the steady state
in the competitive economy.

A.3. A dynamic competitive equilibrium interpretation

Our theoretical discussion so far has focused on a planning problem. However, the
stylized facts described in Section 2 pertain to market economies where economic
decisions are made in a decentralized manner. For this reason we now turn our attention
to this economy's competitive equilibrium under rational expectations.
There are several ways of decentralizing the basic R B C model economy. Here we
will focus on a sequential competitive equilibrium in which households own the firms

R.G. King and S.T. Rebelo

1000

and the stock of capital and make three inter-related decisions: how much labor to
supply (Ns), how much capital to accumulate (k~), and how much to consume (c). In
this decentralization scheme, households have to take into account the law of motion
for the wage rate (w) and for the rental price of capital (R). Both of these prices are
a function of the state of the economy, as summarized by the productivity level A and
the aggregate capital stock k:
w = w(k,A),

(A.16)

R = R(k,A).

(A.17)

To forecast these prices, agents have to know the functions w and R and the law of
motion for A and k. The variable A evolves according to H ( A ' , A ) , while the law of
motion for the aggregate capital stock will be described as
k'=g(k,A).
The H o u s e h o l d Problem. With these preliminaries in place we can now write the

household problem as:

v(k~;A, k) = max {u(c, 1 - N~) + fiEv(k~;A', k')},
c,N~,k~

subject to:
c + yk~ = w(k,A)N~. + (1 + R ( k , A ) - b)k~ + zc.

(A.18)

where v is the value function of the household and :v denotes the firms' profits, which,
as we will see in a moment, are always equal to zero.
It is useful to define the real interest rate as the rental price of capital net of
depreciation:
r ( k , A ) = R ( k , A ) - 6.

The solution to the household problem is described by the following contingent

rules:
k~ = ks(ks, k , A ) ,
c

= c(ks, k,A),

Ns = N(ks, k,A).

These rules must satisfy the following set of efficiency conditions:

D2u(c, 1 - Ns) = Dl u(e, 1 - Ns) w ( k , A),

(A.19)

g D l u ( e , 1 - Ns) = f l E D l u ( c , 1 - Ns)[R(k' c Y ) + (1 - 6)].

(A.20)

Ch. 14:

Resuscitating Real Business Cycles

1001

The Firm "s Problem. The firms in this economy solve a static problem. They have
to decide how much capital and labor to hire in the spot competitive markets for both
of these factors:

max

k,t , Nd

Jr =

AF(kd, Nd)

wNd

Rkd.

The familiar optimization conditions for this problem are:

ADtF(kd, Nd) = R(k, A),

(A.21)

ADzF(kd, Nd) = w(k, A).

(A.22)

Given that the production function exhibits constant returns to scale, profits will always
be equal to zero:
= AF(kd, Nd) - AD2F(kd, Nd)Nd -- ADIF(kd, Nd)kd = O.
Market Clearing. There are three markets in this economy: spot markets for capital,
labor and output. By Walras's law if two of these markets are in equilibrium the third
market will also have to be in equilibrium. Thus we can state the equilibrium conditions
limiting ourselves to the factor markets:

kd =k,=k,

Nd=Ns.

To ensure that this is a competitive equilibrium under rational expectations, the law
of motion conjectured by households for the competitive equilibrium has to coincide
with the actual aggregate law of motion for this variable:
ks(k, k , A ) = g(k,A).
The steady state in the market economy: If we treat N as fixed for the moment, we
can interpret Equation (A. 13) as equating the long run demand and supply for capital.
The real rate of return to capital in a decentralized version of this economy is given
by r = A D 1 F ( k , N ) - 6. This can be seen as a demand schedule; given the value of
r (and the value of N) it tells us the value of k that the economy would choose. The
long run supply of capital is given by r = y/fi - 1 and is thus perfectly elastic: the
capital stock of the economy always adjusts so that the steady-state real interest rate
is r = y / f i - 1 .
A.4. The welfare theorems

To show heuristically the connection between the competitive equilibrium and the
Pareto Optimum we can now compare the first-order conditions of the competitive
equilibrium with those of the planner's problem to show that they coincide. Replacing

1002

R.G. King and S.T. Rebelo

Equations (A.21) and (A.22) in (A. 18) and exploring the fact that F(.) is homogeneous
of degree one, we obtain a resource constraint that is equivalent to the one implied
by Equations (A.3)-(A.5). Making use of Equations (A.21) and (A.22) it can also
be readily shown that (A.19)-(A.20) are equivalent to (A.9)-(A.11). Notice that the
assumption o f rational expectations is crucial for this comparison. The equivalence
between the conditions that characterize the two problems underlies the two welfare
theorems that apply to this economy: the competitive equilibrium is Pareto Optimal
and a Pareto Optimal allocation can be decentralized as a competitive equilibrium.
The fact that the competitive equilibrium can be solved as a solution to a planning
problem has important technical implications. Since the planners problem involves
maximizing a continuous function defined over a compact set we know that a solution
to the problem exists. Furthermore, since the planner's problem is strictly concave, its
solution is unique. Thus, the existence and uniqueness o f the competitive equilibrium
can then be established by exploring its equivalence to the planner's problem.
There are many instances in which we may want to explore economies where the first
welfare theorem does not hold. Examples include economies with distortionary taxes,
externalities, or monopolistic competition. Rarely can the competitive equilibrium for
these economies be mapped into a concave planning problem TM. We can still linearize
the system o f equations that characterizes the competitive equilibrium to explore some
of its properties. However, we no longer have the guarantee that the equilibrium
exists or that it is unique. This is the reason why the multiple equilibrium literature
discussed in Farmer (1993) focuses on economies in which the competitive equilibrium
is suboptimal.

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1003

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Chapter 15

STAGGERED PRICE A N D WAGE SETTING IN

MACROECONOMICS *
JOHN B. TAYLOR
Stanford University

Contents
Abstract
Keywords
1. Introduction
2. A n empirical guide to price and wage setting in m a r k e t e c o n o m i e s
2.1. General observations about wage and price setting
2.1.1. Wage setting
2.1.2. Price setting
2.2. Individual firm and worker evidence
2.2.1. Direct evidence on wage setting
2.2.2. Indirect evidence on wage setting
2.2.3. Direct evidence on price setting
2.3. Summary of findings about price and wage setting
3. Market-clearing and expected-market-clearing approaches
3.1. Market-clearing models
3.1.1. Empirical tests
3.2. Expected-market-clearing models
4. Staggered contracts m o d e l s
4.1. A simple price setting model
4.2. More general staggered wage- and price-setting models
4.2.1. Fixed duration models
4.2.2. Random duration models
4.2.3. State-dependent duration models
5. Bolstering the theoretical foundations o f staggered contracts m o d e l s
5.1. Deriving the optimal price: the role of market power
5.2. Towards dynamic optimizing models of staggered price and wage setting
5.3. Staggered price and wage setting in general equilibrium models

1010
1010
1011
1013
1013
1013
1014
1015
1015
1017
1018
1020
1021
1021
1022
1024
1027
1027
1029
1029
1030
1031
1032
1033
1033
1035

* This research was supported by the Center for Economic Policy Research at Stanford University.
I wish to thank VV Chari, Christopher Erceg, Robert Hall, Ellen McGrattan, Akila Weerapana, and
Michael Woodford for useful comments and assistance.
Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford
1999 Elsevier Science B.V. All rights reserved
1009

1010
5.4. Explanationsof why price and wage setting is staggered
5.5. Indexingand optimal contractlength
6. Persistence puzzles and possible resolutions
6.1. Inflationpersistence
6.2. Real output persistence
6.3. Changes in stabilityand nominal rigidity overtime
7. Concluding remarks on policy applications and future research
References

JB. Taylor
1037
1038
1038
1039
1040
1042
1042
1044

Abstract

This chapter reviews the role of temporary price and wage rigidities in explaining of
the dynamic relationship between money, real output, and inflation. The key properties
to be explained are that monetary shocks have persistent, but not permanent, effects
on real output, and that the correlation between current output and inflation is positive
for leads of inflation and negative for lags of inflation.
The paper begins with a short empirical guide to price- and wage-setting behavior
in market economies. It then compares alternative price- and wage-setting theories and
argues that staggered contracts models continue to provide the most satisfactory match
with the key macroeconomic facts. It then examines the microeconomic foundations
of staggered contracts models and reviews some of their extensions and applications.
Research in this area has been very active in the 1990s with a remarkable number
of studies using, estimating , or testing models o f staggered price and wage setting.
A new generation of econometric models incorporating staggered price and wage
setting with rational expectations has been built. Researchers have begun to incorporate
staggered wage and price setting into real business cycle models. Close links have been
discovered between the parameters of people's utility functions and the parameters of
staggered price- and wage-setting equations. There is now a debate about whether
standard calibrations of utility functions prevent staggered price models, at least those
with frequent price changes, from explaining long persistence of real output.
A theme of the paper is that the advent of rational expectations in the 1970s led to
models of price and wage rigidities which were more amenable to empirical testing
than earlier models, and this is one reason for the recent controversies and debates.
There is much to be discovered from these debates and from the future research they
stimulate.
Keywords
staggered price and wage setting, staggered contracts model, contract multiplier,
money, monetary policy, monopolistic competition, market clearing, expected market
clearing, time-dependent pricing, state-dependent pricing
JEL classification: E32, El0

Ch. 15: StaggeredPrice and WageSetting in Macroeconomics

1011

1. Introduction

Why does a change in the money supply cause real output and employment to change
in the short run, but not in the long run? This is one of the oldest questions in
macroeconomics, yet it persists as both the most difficult and the most practical of
all. From David Hume in the 18th century to Milton Friedman in the 20th, economists
have had a common answer: there are temporary price and wage rigidities in the
economy. In other words, in the short run, price and/or wage levels do not change as
much as the money supply changes. Thus, if the money supply increases, then real
money balances rise, stimulating production and employment. As described by David
Hume more than 200 years ago, "by degree the price rises, first of one commodity, then
of another", or as stated more recently by Milton Friedman "prices are sticky" [see
Rotwein (1955, p. 38) and Friedman (1982, p. 64)]. Except in unusual circumstances,
it takes time for price and wage levels to fully adjust; as prices and wages gradually
rise, real money balances return to their original level and in the long run the real
economy is unaffected.
The purpose of this chapter is to review the current state of knowledge about the
nature of price and wage rigidities and their ability to explain the dynamic relationship
between money, real output, and inflation. I survey recent research, classify the major
facts and models, and draw some conclusions and suggestions for future research.
Because both price rigidities and wage rigidities are important for macroeconomic
dynamics, both types of rigidities are reviewed.
The dynamic stochastic properties of money, output, and inflation that we would
like the theories to explain have been carefully documented using modern time series
techniques in the chapters by Stock and Watson (1999) and by Christiano, Eichenbaum
and Evans (1999) in this Handbook. In addition to the property that money shocks have
a short-run impact on output and a long-run impact on inflation, three other important
properties of the money, real output, and inflation relation have attracted attention.
These properties are (1) that a monetary shock has a persistent effect on real output a propagation effect that lasts well beyond the initial impact effect of a monetary shock,
(2) that there is a positive correlation between real output and future inflation, and
(3) that there is a negative correlation between inflation and future real output. [See
Stock and Watson (1999), Table 2, lines 41 and 54, and Christiano, Eichenbaum and
Evans (1999), Figures 2 and 3, which compare the impact of alternative measures
of money shocks.] Properties (2) and (3) can also be characterized using vector
autoregressions and the concept of Granger-causality: property (2) is that real output
Granger-causes inflation positively and property (3) is that inflation Granger-causes
real output negatively. This "reverse dynamic" cross correlation was shown to hold
in the USA and other countries in Taylor (1980a, 1986). The ability to explain such
robust findings represents an important measure of success for any theory of price and
wage rigidities.
It was in the early 1970s that the rational expectations revolution in macroeconomics
first began to take hold. Of course, price and wage rigidities were a big part of

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J.B. Taylor

macroeconomics before the early 1970s; indeed, they were central to both Keynesian
and monetarist ideas. However, by forcing macroeconomists to think in economywide (general equilibrium) terms, the rational expectations revolution fundamentally
changed how economists model price and wage rigidities. It was at this time that the
staggered contracts model was first proposed. This model emphasizes the overlapping
of individual prices and wages due to staggered price and wage setting. It could
explain not only why changes in money impact real output, but also why the other
properties mentioned above are found to hold in many countries. Fron~ the start
the staggered contract model was explicit enough that testable hypotheses could be
formulated and, as a result, the model underwent extensive empirical and theoretical
scrutiny, generating much debate. This explicimess was necessitated, in my view, by
the discipline of the rational expectations approach to modeling.
During the 1980s, researchers extended and modified models of staggered price and
wage setting, fitted them to data from many different countries, and began to give them
a more specific theoretical footing. Models of staggered price and wage setting were
frequently used as a source of monetary nonneutrality in rational expectations policy
studies of monetary policy rules. By using these theories of price and wage rigidities
for policy analysis and by confronting them with practical tests using real world data both microeconomic and macroeconomic - much has been learned about the process
of wage and price formation in market economies.
In the 1990s research on staggered price and wage setting has shown no signs
of slowing down. Modifications motivated by a need to explain inflation dynamics
more accurately or to reduce model complexity have been introduced and used in
econometric models. A new generation of econometric models incorporating price and
wage rigidities with rational expectations has been put in place for policy analysis at
many central banks including the Federal Reserve Board. Perhaps even more exciting,
researchers have begun to incorporate theories of staggered wage and price setting into
what would otherwise be real business cycle models. This research has uncovered close
links between the parameters of people's utility functions or firm's production functions
and the parameters of staggered price and wage setting equations. The research has also
uncovered a puzzle: in some models, standard calibration of utility function parameters
indicates substantially less persistence of real output than had been found in earlier
estimates of staggered contract models that had not made this formal link to individual
utility maximization. Several ways to resolve this puzzle have been proposed and
are discussed here. On balance, the staggered wage and price setting models still
seem to be consistent with the broad features o f the data, but there is much to be
discovered in future research. With the price and wage setting theories so amenable
to empirical testing, it is not surprising that controversies and debates about price and
wage rigidities continue.
I begin the chapter with a short guide to price and wage setting behavior in market
economies based on direct and indirect observations. I then review alternative price
and wage setting models and show how models based on staggered price and wage
setting match the facts mentioned above, a match that explains, in my view, why

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the models have proved useful to macroeconomists doing applied econometrics and
policy work. I then go on to explore the microeconomic foundations for these models,
discussing several intriguing puzzles and their possible resolutions. Finally, I discuss
several historical and policy applications of econometric models based on staggered
price and wage setting.
As research on staggered price and wage setting has developed, several surveys
of research on price and wage rigidities have appeared, including Taylor (1985),
Btanchard (1990), Roberts (1995), and Goodfriend and King (1997), as well as several
good graduate textbook treatments including Blanchard and Fischer (1989, Chapter 8)
and Romer (1996, Chapter 6). In this survey I try to focus on topics that are either more
recent or that have not been emphasized in these other surveys and reviews. I also try
to trace out the gradual evolution of the staggered contracts model over time.

2. An empirical guide to price and wage setting in market economies

Hume's theoretical idea - that slow price adjustment provides an explanation for the
short run impact of changes in money on production - was based on his observations
of price changes in the market economy in which he lived. Thanks to research in recent
years we now have much more quantitative information about the timing, frequency,
and determinants of price and wage changes.
2.1. General observations about wage and price setting

Before discussing this quantitative evidence, I think it is useful to first review some
general observations about wage and price setting which are simply part of our
everyday experience as participants in market economies. One might criticize these
types of observations as arbitrary and subjective, but in fact such informal case studies
have informed the theoretical research in this area much as David Hume's casual
observations informed his theory.
2.1.1. Wage setting

One observes a great variety of ways in which wages are determined through the
interaction of workers and firms in a market economy. These mechanisms evolve over
time especially when there are large changes in the economic environment such as a
change in the tax law or a rise in the average rate of inflation. There are, however,
some important common features of these wage setting arrangements.
For most workers employed in medium to large sized firms, wages (including
benefits) are normally adjusted at rather long discrete intervals, most commonly once
per year. The wage adjustment is typically associated with an extensive performance
and salary review. A large fraction of the wage payment is usually stated in a fixed
amount of dollars (or other currency) per unit of time (hour, week or month), but

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J.B. Taylor

overtime pay, bonuses, profit sharing, piece rates, and other incentive arrangements
are not uncommon for part of workers' pay. Indexing of wages to macroeconomic
variables, such as the inflation rate, occurs, but is rare in wage setting arrangements
of one year or less.
It is important to emphasize that setting nominal wages at a fixed level for more than
several quarters and usually for as long as a year appears to be just as prevalent for
workers who are not in unions, or who do not have formal employment contracts, as
for union workers with employment contracts. It is a mistake to limit studies o f how
wages are set to formal employment contracts. As we will see below there is more
quantitative information about indexing and contract length for workers and firms in
the union sectors, but in the USA only a relatively small fraction of workers are in
unions, so the evidence is less relevant.
Throughout the economy wage setting is not usually synchronized in any one period.
Rather wage adjustments occur at different times for different firms throughout the
year, much as the dates for firms' fiscal years vary throughout the year. There are
exceptions to this nonsynchronization. In Japan, for example, there has been a Shunto,
or spring offensive, during which wages at most large firms are set.
Wage decisions are clearly influenced by wages paid to other workers in a
community or in similar occupations. When hiring new engineers or business school
graduates, firms must consider the prevailing wage in the market for similarly educated
workers when designing a wage package. Pattern bargaining among labor unions where
the wage set at one union becomes a strong influence at another union is common.
2.1.2. Price setting
There are even greater varieties of price setting than of wage setting. Prices change
continuously in auction markets for commodities and financial instruments. The idea
of price rigidities seems ludicrous when applied to such markets.
On the other hand, prices change infrequently in posted-price customer markets for
goods and services. [Okun (1981) used the term "customer markets" to distinguish
these types of markets from "auction markets".] Prices of final goods in customer
markets seem to be more responsive to changes in the costs of intermediate inputs to
production than they are to changes in demand. In other words, changes in markups
seem less of a source of price change than changes in costs. But even within socalled customer markets, prices - and markups of prices over costs - can and do
change rapidly. For example, the price of airline tickets changes on a day to day basis
depending on estimates of demand. Some airline tickets are now even auctioned on
the Internet.
Like wages, the prices of goods and services appear to be staggered over time and
set taking the prevailing price of competing producers (or monopolistically competing
producers) into account. News accounts suggest, for example, that a decision to
change the price of Big Macs is closely watched by Burger King and other fast food
companies. Case studies of pricing at large supermarket chains by Levy, Dutta, Bergen

Ch. 15: Staggered Price and Wage Setting in Macroeconomics

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and Venable (1998) show that obtaining information about the prices of competitors
is the first step in deciding on how much to change prices; they find that "people are
sent on a weekly basis to competitors" stores to gather and record (usually by hand)
their price ... ". Clearly some degree of non-synchronized or staggered price setting
is necessary if such surveys of competitors' prices are to be useful. The policy o f
matching a competitor's price is common among discount stores. The prevailing price
is even an important consideration in price setting in auction markets. For example,
knowing the price of recently auctioned items influences the reservation price of buyers
and the minimum price of sellers in auctions for art and other rare goods.
Because surveys of competitors and other steps in the process of changing prices
(such as changing and verifying tag changes) are costly to undertake, Levy, Bergen,
Dutta and Venable (1997) find that the costs to a retail store of changing prices are
quite large. Examining several large US supermarket chains, they find that the fixed
cost is about $0.52 per price change; such costs are "fixed" in the sense that they do
not depend on the size of the price change. (Because the cost of changing a menu also
does not depend on the size of the price change, such costs are usually called "menu
costs".) Using a different methodology Slade (1996) finds the fixed costs of a retail
price change to be even larger.
2.2. Individual f i r m and worker evidence

One of the great accomplishments of research on wage and price rigidities in the 1980s
and 1990s is the bolstering of these case studies and casual impressions by quantitative
evidence from thousands of observations of price and wage setting collected at the
firm, worker, or union level. By carefully studying these data one can learn much
about the nature of wage and price rigidities in the USA and other countries. Some of
the conclusions I draw from these data are summarized in Section 2.3 below, but it is
worthwhile to consider in detail several of the individual research studies.
2.2.1. Direct evidence on wage setting

Most quantitative microeconomic information on wage setting comes from government

data collected on the union sector. For example, Taylor (1983) and Cecchetti (1984) use
data from major union contracts in the USA to get some quantitative measures for wage
rigidities. Unfortunately, the large labor union sector represents only about 10 percent
of US employment. More than half of the wage agreements in the union sector last for
more than one year, with the remaining being either one-year or two-year contracts.
Slightly over 50 percent of the multiyear contracts in this sector are indexed.
The data reported by Taylor (1983) demonstrate how the wage setting is highly
nonsynchronized. In any one quarter only about 15 percent of the workers are adjusting
their contracts. In any one year only about 40 percent are adjusting their contracts.
For example, aerospace, trucking, and automobile workers contracts are generally
renegotiated in different quarters.

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J.B. Taylor

Cecchetti (1984) computed a time series of average duration of wages in the USA
for the large union sector. He found that the average period between wage changes was
slightly less than 2 years (7 quarters) in the 1950s and 1960s when inflation was low,
but then fell to about one year (four quarters) in the 1970s during the high-inflation
period. Hence, there is some evidence that the length of the period between wage
changes is sensitive to the underlying inflation rate. However, even in the years of the
great inflation wages were set at fixed nominal levels for one year on average. Cecchetti
(1984) also found evidence that the amount of indexing increased as the inflation rate
rose from the 1960s to the 1970s.
Of course, quantitative observations on wage setting at the microeconomic level is
not confined to the USA. For example, Fregert and Jonung (1986) provide evidence
from Sweden. Their data show that contract length decreased in Sweden as inflation
and monetary uncertainty rose. However, average contract length never dropped below
one year. They also found that wage setting showed little synchronization until the
1950s when centralized wage bargaining was introduced. Recall that Japan is another
country where much union wage setting occurs at the same time each year.
Lebow, Stockton and Wascher (1995), McLaughlin (1994), and Card and Hyslop
(1997) provide evidence about wage rigidity in the USA using individual wage data
from the Panel Study of Income Dynamics. Because these studies, which reach similar
conclusions, are not restricted to union workers, they are an important addition to
the earlier studies on unions. However, because the wage is only sampled once per
year, these studies do not provide information about whether the average duration of
fixed wages is less than one year. Card and Hyslop (1997), who also examine data
from the US Current Population Survey form 1979 to 1993, report that between 6 and
15 percent of workers (among those who do not change jobs) have their nominal wages
unchanged from one year to the next, suggesting a relatively small number of workers
whose wages change less frequently than once per year. Card and Hyslop (1997) also
report that the frequency of wage adjustment increases with inflation: during the highinflation period of the late 1970s, only 6 to 10 percent of workers with the same job
had unchanged wages from one year to the next, while during the lower-inflation period
of the 1980s the fraction of workers with unchanged wages was close to 15 percent.
This confirms the results observed by Cecchetti (1984) using union wage data in the
USA and Fregert and Jonung (1986) for Sweden. Card and Hyslop (1997) also report
information on downward wage rigidity (again for annual wage changes) and find that
a significant fraction of workers (15 to 20 percent) experience nominal wage reductions
from one year to the next. This suggests that downward wage rigidities are no more
significant for macroeconomics than upward wage rigidities. In fact, few of the models
of price and wage rigidities used empirically in macroeconomic models make use of the
distinction between upward and downward rigidity - in particular asymmetric rigidities
have little relevance for the key empirical correlations mentioned in the introduction.

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2.2.2. Indirect eoidence on wage setting

The microeconomic evidence on wage setting procedures can be supplemented with

more indirect evidence based on macroeconomic data. I f some structural assumptions
about the general form of wage setting are made, it is possible to extract information
about individual wage setting mechanisms from the autocorrelation functions of
aggregate time series data. The indirect method is similar to estimating the parameters
of utility functions or production functions from data on consumption and investment.
The duration o f fixed nominal wages - and the distribution of the different durations
in the economy - has implications for the aggregate time series; from the time series
data one can back out estimates of the wage duration distribution. Examples of these
indirect methods are Benabou and Bismut (1987), Levin ( 1991 ), Taylor ( 1979b, 1993 a),
Montgomery (1983), Christiano (1985), and Backus (1984).
Benabou and Bismut (1987), Levin (1991), and Taylor (1993a) examine the
distribution of workers by length of wage setting interval in the USA. There are
similarities in the results even though different data sets are used. Benabou and Bismut
(1987) find that the average length of time between wage adjustments is about 1 years
with a mode length of one year; the distribution of workers by contract length is not
geometric: there are fewer workers with one-quarter wage setting intervals than fourquarter intervals.
Levin (1991) also reports estimates of a cross sectional distribution of wage changes
in the USA. He finds that about 10 percent of wages are adjusted in one quarter,
25 percent in two quarters, and 65 percent in four quarters. Levin uses quarterly data on
aggregate wages to obtain these estimates.Using a less flexible geometric/exponential
distribution assumption and focussing on Canada, Backus (1984) used exchange rate
data to infer a median contract length slightly over a year, ranging from 5.4 quarters
to 8.4 quarters.
Estimates reported in Taylor (1993a) also indicate that annual contracts are the most
common length of wage setting interval. Aggregate time series for wages in the USA
imply that about 80 percent of workers have annual contracts; the fraction is somewhat
smaller in Canada and Germany. Estimates of time-varying cross-section distributions
are also reported in Taylor (1993a) to accommodate some synchronization as in the
case of the Shunto mechanism in Japan. (The distribution of wage changes can not
be the same in each quarter in Japan because more workers have their wages adjusted
in the Spring quarter.) But, even in the Japanese economy, not all workers have wage
adjustments in the second quarter. Some annual wage changes occur in the summer
quarter and not all annual wage contracts are adjusted as part of the Shunto. Moreover,
wages for some workers change more frequently than once per year. According to the
estimates in Taylor (1993a), aggregate wages behave as if 88 percent of wage contracts
in Japan are annual, 12 percent are adjusted every quarter, and a negligible amount
are adjusted every two quarters. Of the 88 percent, 42 percent of workers have their
wages changed in the spring quarter, 26 percent in the summer quarter, 16 percent in
the fall quarter and 3 percent in the winter quarter.

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J.B. Taylor

Some empirical researchers have also endeavored to determine whether wages

are set relative to the prevailing wages as the casual observations mentioned above
indicated. They use auxiliary structural assumptions about the wage process to derive
spillover effects from aggregate data. Montgomery (1983) and Benabou and Bismut
(1987) report little evidence of such spillovers, but these estimates require strong
auxiliary assumptions.
In sum, these empirical studies suggest that the most common wage setting interval
for the USA is about one year and that wage setting dates are staggered. However, a
potential problem with these indirect estimates is their dependence on time aggregation
of the quarterly data employed. Using continuous time econometric methodology,
Christiano (1985) examined whether any wage setting intervals were shorter than the
minimum quarterly interval in the aggregate wage data, and found evidence that there
were some that short. These disadvantages of the use of the indirect methods point to
the great value of better data on wage setting in the economy as a whole.
2.2.3. Direct evidence on price setting

Carlton (1986, 1989), using actual transactions price data that originated with Stigler
and Kindahl (1970), has documented in great detail the extent of price rigidity for a
wide variety of products in the USA. [Carlton (1989) also provides a useful summary
of studies of price rigidity prior to Stigler and Kindahl (1970). One of the most
interesting early findings, attributed to EC. Mills, is that the empirical frequency
distribution of price change is U-shaped: goods with low-frequency and high-frequency
price changes are more common than goods with medium-frequency price changes].
For most product groups, Carlton (1989) found that the time between adjustment of
transactions prices seems remarkably long: ranging from about 1 years for steel,
cement, and chemicals to about g1 year for plywood and nonferrous metals. Carlton
found little evidence for a fixed cost of adjusting prices, but observed a positive
correlation between industry concentration and price rigidity.
Cecchetti (1986) collected data on US magazine prices and also found price changes
to be remarkably infrequent. In the 1950s the average length of time between price
changes was 7 years; in the high-inflation years in the 1970s the time between price
change was much lower at 3 years, but still remarkably infrequent given the changes in
demand and costs during such long periods. Similarly, Kashyap (1995) found that mailorder companies keep their catalog prices fixed for periods ranging from six months
to two years.
Surveys of pricing policies at firms by Blinder (1994) and by Blinder et al.
(1998) confirm the findings of Carlton and Cecchetti. Blinder (1994) found the mode
frequency of price adjustment for firms in the survey to be one year. About 40 percent
of firms tend to change their prices once per year, while only 10 percent change
prices more frequently than once per year; the remaining 50 percent leave their prices
unchanged for more than a year. Blinder (1994) also reports that the mean lagged
response of price changes to changes in demand or costs is about three months and is

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1019

invariant to whether the change is positive or negative, supporting Carlton's (1989)

result. In another study of survey data, Buckle and Carlson (1995) found that the
average duration of prices at small business was about 8 months in the USA during
the 1980s and 1990s and about 7 months in New Zealand during the early 1990s.
These durations are only slightly smaller than Blinder's findings. Buckle and Carlson
also found that the average duration between price changes was shorter in periods of
higher inflation.
Until very recently few of the studies of price setting have examined directly the
degree to which prices are set in a staggered or synchronized fashion. Domberger and
Fiebig (1993) look at the amount of staggering by examining the skewness of the
distribution of price changes. They look at prices in 80 disaggregated industry groups
in the UK. They find a significant lack of symmetry, indicating that many prices are
not changed in a given quarter. Moreover, the sign of the skewness is related to the
sign of the average price change. An increasing average price causes a rightward skew,
and a decreasing average price causes a leftward skew.
Using a data set on retail store prices, Lach and Tsiddon (1992, 1996) find that the
prices at retail stores are staggered across different price-setters. Eden (1994a), Levy
et al. (1997), Warner and Barsky (1995) also examine the patterns of individual price
changes at the retail level. The data used by Lach and Tsiddon consist of the prices
of different meat products and wines at retail stores in Israel. They find that in any
given month only a fraction of stores are changing the price of a given meat product
or wine. The monthly fractions of stores changing prices are usually in the 30 to 40
percent range. Interestingly they find that price changes for different products within
a store are highly synchronized. When stores change prices they seem to change the
price for most of their products at the same time: within-store synchronization. But
most stores make these adjustment at different times: across-store staggering.
Dutta, Bergen and Levy (1997) provide evidence of much more frequent price
change at the retail level than would be expected from the work of Carlton (1986),
Cecchetti (1986), and Blinder (1994). Dutta, Bergen and Levy (1997) examine retail
and wholesale prices of several types of frozen and refrigerated orange juice in the
Midwestern USA. They find that orange juice prices at supermarkets change very
frequently: about every 2 weeks, much more frequently than the price change observed
by earlier researchers. Dutta, Bergen and Levy (1997) argue that the frequent price
adjustment in their study reflects the highly competitive nature of the supermarket
business in the Midwest. Such rapid price adjustment may also reflect weekly, monthly,
or seasonal discounting - the price could simply fluctuate between a rigid "regular"
price and another "rigid" sale price, and not reflect any true price flexibility. In fact,
Dutta, Bergen and Levy (1997) find the adjustment of retail orange juice prices
to changes in costs to be somewhat slower than the average duration of prices about three to six weeks - in comparison to the twelve to sixteen weeks reported by
Blinder (1994).

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JB. Taylor

2.3. Summary o f findings about price and wage setting

It is difficult to summarize briefly the large amount of microeconomic evidence on
wage and price setting discussed above. And we still have much to learn from this
evidence. But I would emphasize the following general features of price and wage
setting in a market economy based on this research:
(1) While casual observation may suggest that wage rigidity is greater than price
rigidity, the detailed studies do not provide evidence that one form of rigidity is
more significant than the other: the studies suggest that price changes and wage
changes have about the same average frequency - about one year. It would
be inaccurate and misleading to build a model in which the average frequency
of price or wage adjustment is longer than one year. Price and wage rigidities
are temporary. But one should also feel comfortable with a model that assumes
that prices and wages do not all change instantaneously and simultaneously, as
if determined on a spot market with full information. And there is no empirical
reason - aside from the need for a simplifying assumption or the desire to illustrate
a key point - to build a model in which wages are perfectly flexible (determined
on a spot market with full information) while prices are temporarily rigid, or vice
versa.
Except for the findings of Blinder (1994) and Dutta et al. (1997) on the effect
of changes in costs on prices, this review of wage and price rigidities has said
little about the connection between prices and wages, a subject taken up in the
chapter by Rotemberg and Woodford (1999) in this Handbook. There is a long
history of thought on the behavior of real wages, or product wages, over the
business cycle, leaving the impression that there is little correlation, either positive
or negative, between real wages and the business cycle. Domowitz, Hubbard
and Petersen (1986) and Carlton (1989) review the empirical literature on the
relationship between price rigidities and wage rigidities. There is little agreement
among empirical researchers about whether the mark-up of price over costs is
procyclical or countercyclical. Of course there is a strong correlation between
the growth of real wages and long-term productivity growth, as the slowdown in
productivity and real wage growth in the t970s illustrates. But this is a correlation
between long-term trends, not a business cycle phenomenon related to the effects
of money on the economy.
(2) There is a great deal o f heterogeneity in wage and price setting. In fact, the
data suggest that there is as much a difference between the average lengths of
different types of price setting arrangements, or between the average lengths of
different types of wage setting arrangements, as there is between wage setting and
price setting. Grocery prices change much more frequently than magazine prices frozen orange juice prices change every two weeks, while magazine prices change
every three years! Wages in some industries change once per year on average,
while others change once per quarter and others once every two years. One might
hope that a model with homogeneous "representative" price or wage setting would

Ch. 15." StaggeredPrice and WageSetting in Macroeconomics

1021

be a good approximation to this more complex world, but most likely some degree
of heterogeneity will be required to describe reality accurately. It is worth noting
that the aggregate time series studies of Christiano, Eichenbaum and Evans (1999)
and Stock and Watson (1999) also show considerable heterogeneity in price and
wage setting: for example, commodity prices seem to respond more quickly to
money shocks than general price indices or than wages.
(3) Neither price setting nor wage setting is synchronized. Except for cases of national
union bargaining, wage setting is staggered through time, whether one looks at
union or non-union workers. Price setting is also staggered through time. These
facts, which are apparent in casual observation, are confirmed in studies of wages,
retail prices, and industrial prices.
(4) The frequency of wage and price changes depends on the average rate of inflation.
Data from union workers and non-union workers in different countries show that
the frequency of wage setting increases with the average rate of inflation. Similarly,
prices at small businesses, industrial prices, and even the prices of products like
magazines are adjusted more quickly when the rate of inflation is higher. This
dependency of price and wage setting on events in the economy is one of the
more robust empirical findings in the studies reviewed here. However, it should
be emphasized that for the range of inflation rates observed in the developed
economies in the 1970s the average duration of wages and prices remained high.
Moreover, we have no empirical evidence that anything other than a change in the
inflation rate would change the frequency of price and wage adjustment, though
one would expect legal or technological changes that increase the cost of changing
prices would reduce price adjustment frequency. For a given average inflation rate,
constant frequencies of price adjustment may not be a bad assumption to make in
an empirical or policy model.

3. Market-clearing and expected-market-clearing approaches

Having examined the nature of price and wage setting at the microeconomic level,
I now turn to a discussion of how price and wage rigidities can explain the impact of
money on the economy. I focus on explanations of the impact effect of money on real
output in this section, considering both market-clearing and expected-market-clearing
approaches. In general I assume that expectations are endogenous and described by
the assumption of rational expectations. The rational-expectations assumption rules
out the possibility that biased or adaptive expectations are a source of monetary nonneutralities, though I briefly discuss learning models which can temporarily result in
such biases.
3.1. Market-clearing models
Market clearing models assume that prices and wages can adjust instantaneously to
satisfy equilibrium conditions. In order for such models to explain the slow adjustment

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JB. Taylor

of prices and thereby explain the impact of a change in money on the economy a la
Hume and Friedman, it is necessary to posit some lack of information by people
which slows down the adjustment of prices endogenously. Imperfect information about
whether a change in the money supply or some other factor is the source of the shift
in a firm's demand curve, for example, may cause prices to change by less than they
would if the firms were fully informed. Thus, prices become temporarily rigid or sticky
in an otherwise perfectly flexible price model.
Robert Lucas's (1972) path-breaking "expectations and the neutrality of money"
paper - which introduced rational expectations and dynamic optimization into
economy-wide monetary models - takes this approach. McCallum (1984) provides
a good review of this model and Lucas (1996) provides a recent survey of the
general imperfect-information approach in comparison with other approaches. The
Lucas (1972) model is an overlapping-generations model with rational expectations
in which trading takes place in decentralized markets. The overlapping-generations
model assumption is used to create an endogenous demand for money. The old, who
are neither able to store goods they produce when young nor produce goods when old,
use money to pay the young for the goods. When the old exchange money for goods a
price is determined. Under certain uniqueness assumptions, a single equilibrium price
level can be found in each period. If the money supply is constant, and distributed
evenly to the old, then the price level will be a constant. When everyone is perfectly
informed, the price level will be proportional to the money supply. Thus, with perfect
information there are no price rigidities as defined here: a once and for all increase in
the money supply will lead to a proportional increase in the price level and employment
and production will be tmchanged.
Price rigidities arise as a result of limits on information that prevent a realization of
the money stock from being revealed to both the young and the old. The mechanism
for limiting information is that trading takes place in two distinct markets. Then an
increase in the price in one of the markets can signal either (1) that the money stock has
increased, in which case there is a general increase in all prices and no need to change
production, or (2) that there are fewer suppliers in the market and that the relative price
has increased, in which case it makes sense to increase production. Hence, with limited
information about the source of the price rise, suppliers must solve a signal extraction
problem; the solution to the problem is to increase supply when the price rises, but by
an amount that is less than the increase in the money supply. The response of prices to
the increase in the money supply depends on the relative variability of money supply
changes and market specific shocks. Thus, in this case there is a price rigidity: the price
level rises by less than the increase in the money supply and production increases.
3.1.1. Empirical tests"

Lucas (1973) provided the first test of this model; he looked at the price-output
behavior in several countries and found evidence that an increase in the variability of
the general price level tended to raise the response of prices to changes in aggregate

Ch. 15: Staggered Price and Wage Setting in Macroeconomics

1023

demand as predicted by the theory. Later, Ball, Mankiw and Romer (1988) provided
further support. For example, in a sample of 43 countries Ball, Mankiw and Romer
(1988) find a significant negative relationship between the response coefficient of real
output to aggregate nominal demand shocks (a more general measure of demand than
the money supply) and the variability of nominal demand.
Soon after the Lucas model appeared, Barro (1977) endeavored to test the theory
by empirically distinguishing between unanticipated and anticipated changes in money,
finding that the effects of unanticipated money were larger, as predicted by the theory.
Barro's study triggered an enormous amount of research and debate about whether
anticipated money had any effect at all. Because his tests could not completely
distinguish between limited information models and other models with rational
expectations (such as the ones discussed later in this paper) that also predicted a
difference between expected and unexpected money, questions were raised about the
relationship between his test and the Lucas theory. See Mishkin (1982) for a good
summary and econometric assessment of this debate.
Three types of empirical results, however, raised questions about market clearing
models with imperfect information as an explanation of the impact of money on the
economy. First, contrary to the theory, actual measures of mis-perceived changes in
money had little impact on production; Barro and Hercowitz (1980), for example,
provided evidence for this by comparing preliminary and revised data on the money
supply in the USA; the difference between the preliminary and the revised data was
taken as a measure of mis-perceived money. One can question the Barro-Hercowitz
method as taking the Lucas model too literally - clearly many people are unaware
of the money supply even after it is revised. Perhaps a better test of the spirit of the
model would use a more general measure of aggregate demand as in Ball, Mankiw and
Romer (1988). Nevertheless, the information limitations assumed in the Lucas model
do seem strong without direct evidence for their existence.
A second empirical result that raised questions about the market-clearing approach
with limited information, is that unanticipated changes in prices seem to explain only
a small fraction of the changes in production over the business cycle, again contrary to
the causal mechanism of the model when taken literally. Sargent (1976), for example,
showed that unanticipated changes in prices had little effect on production using data
for the USA. However, like the Barro-Hercowitz tests, these tests may focus too much
on the details of the Lucas model and not enough on its more general implications. For
example, in models with sequential purchase restrictions [such as Lucas and Woodford
(1994) and Eden (1994b)], an unanticipated increase in demand causes an increase in
sales without an immediate increase in prices to signal more production.
A third empirical shortcoming relates to the persistent effects of a money shock
on real output. In market-clearing limited information models, the duration of the
effect of a money shock on real output is no longer than the time it takes to resolve
the uncertainty about the source of the shock. It is unlikely that such information
would take longer than a few months let alone longer than a year to obtain. Hence,
without adding other sources of persistence the market-clearing models with limited

1024

J.B. Taylor

information have difficulty explaining a key fact about the money, real output, inflation
relationship. To be sure, it is possible to add in such persistence effects through
adjustment costs or inventories, but doing so leaves other aspects of the business
cycle - such as the reverse dynamic cross correlations between inflation and output
discussed in the introduction - unexplained. It is because of these difficulties in
explaining persistence, in my view, that most estimated economy-wide monetary
models do not utilize the perfectly flexible-price, market-clearing, assumption, even
with limited information.
In any case, there has been relatively little research in recent years on imperfect
information as a source of price rigidities in models with perfectly flexible prices.
However, for reasons discussed below it is likely that a complete theory of price
rigidities will eventually involve elements of the limited information theory, though
perhaps in conjunction with the staggered wage and price setting formulations
discussed below. One rationale for infrequent price changes stems from the information
value that a stable price conveys to customers. Moreover, as discussed below, the
microeconomic foundations of the staggered contracts models - and in particular why
staggering even exists - involves imperfect information about whether a shock is
temporary or permanent or local or economy-wide.

3.2. Expected-market-clearing models

Soon after the Lucas (1972) model appeared, several researchers began to try to
incorporate some form of sticky price or wage formation directly into rational
expectations macro models, as an alternative to the imperfect information approach.
This research originally had two objectives. The first objective was to develop new
econometric models that could be used for monetary policy evaluation. That existing
econometric models with adaptive expectations and arbitrary lag structures were
inadequate for this purpose was shown clearly in the Lucas (1972) paper and even more
transparently in Lucas's (1976) critique paper, which showed, using the example of
the output-inflation tradeoff, the pitfalls of doing monetary policy evaluation without
paying careful attention to expectations and the reactions of agents in the model. In
order to overcome these pitfalls it was clear that a model with rational expectations
was needed. If one had doubts about the ability of the imperfect information theory
to explain fully the impact of monetary policy on the economy, then a sticky price
formulation was a good alternative. Its long tradition in macroeconomics (among both
monetarists and Keynesians) and the hope that it could help explain the persistence
effects of monetary shocks as well as the impulse effects made it attractive.
The second objective was to respond to the work of Sargent and Wallace (1975)
which showed that, under Lucas's (1972) imperfect-information assumption with
perfectly flexible prices, monetary policy had no effect - the so called "policy
ineffectiveness proposition". Thus, the second objective of the research on sticky prices
was to demonstrate that this proposition was due to the flexible price assumption
rather than to the rational expectations assumption. Another approach to explaining

Ch. 15: Staggered Price and Wage Setting in Macroeconomics

1025

the real effects of money in rational expectation models with perfectly flexible prices
assumes that people must learn about monetary policy during a "transition" to rational
expectations [Taylor (1975), Brunner, Cukierman and Meltzer (1980)]. Models with
learning have developed considerably in the 1980s and 1990s as discussed in the
chapter by Evans and Honkapohja (1999) in this Handbook.
Incorporating sticky prices or wages directly into an economy-wide rational
expectations model meant assuming that prices or wages are set in advance of the
market period when they apply and then are fixed at that level during the market period.
For example, automobile firms might set their price pt for the quarter t at the start of
quarter t - 1 and then keep the price at that value throughout the market period. Or
firms might set the wage wt for year t at the start of period t - 1 and set the wage Wt+l
for the year t + 1 at the start of period t, and so on. To make this model operational in
an internally consistent rational-expectations model of the economy, one might assume
that prices or wages are set in such a way that markets are expected to clear during the
period in which the price or wage applies. If we let St(pt) represent supply in period t
and Dt(pt) represent demand in period t, then expected market clearing simply means
that the price pt which is set in period t - j is chosen so that
Etq(St(pt)) = Et-j(Dt(pt)),

(3.1)

where Et_j is the conditional expectation given information through periods t - j . This
is the approach taken by Fischer (1977), Gray (1976) and Phelps and Taylor (t977)
to incorporate price and wage rigidities into economy-wide models. In applying this
approach Phelps and Taylor (1977) focussed on the aggregate price level; they assumed
that firms set prices one period in advance so that expected aggregate demand for
goods (a negative function of the price level) equals expected aggregate supply. Fischer
(1977) and Gray (1976) assumed that wages were set in advance in an analogous
fashion with the price level perfectly flexible. They assumed that the wage was set
so that the expected quantity of labor supplied equaled the expected quantity of labor
demanded. In other words, in the Fischer and Gray models the wage is set in advance
and D and S refer to the economy-wide labor market during the period when the wage
applies, while in the Phelps and Taylor (1977) model prices are set in advance and
D and S refer to the aggregate goods market during the period when the price applies.
This is also the approach taken in more recent work by Cho (1993), Cho and Cooley
(1995), and Rankin (1998) to incorporate price or wage rigidities into real business
cycle models, though the D and S functions in these models are far more complex
than in the relatively simple macro models in which price and wage rigidities were
inserted in the mid-1970s.
When setting prices or wages, agents in the model are assumed to make forecasts
of supply and demand conditions in the future. Because the forecasts of supply and
demand depend on the price in the next period, it is possible to find a price so that
the expected quantity supplied equals the expected quantity demanded as shown in
Equation (3.1). This price is the expected equilibrium price level; it is this value

1026

J.B. Taylor

which is assumed to be set in advance of the market period and then not changed.
Actual supply and demand conditions will differ from these expected values because of
unforeseen shocks. But because the price is fixed, the actual quantity demanded will not
equal the actual quantity supplied - hence there is an excess demand or excess supply.
The convention is then simply to assume that the quantity demanded determines the
supply. For example, firms are assumed to supply whatever is demanded at the fixed
price for that period. In the meantime the price is set for the next period and the model
proceeds through time.
Of course, this expected-market-clearing mechanism describing how the price is
determined is not necessarily a realistic description of how firms actually set prices, no
more than the standard market-clearing assumption in perfectly flexible-price models
is meant to be a realistic description of how firms actually set prices. In the equilibrium
models, it is hoped that the market-clearing approach gives good predictions and so it
is with the "expected equilibrium" models.
One advantage of this approach to sticky prices or wages is that the longrun neutrality of monetary policy is always preserved, a point first emphasized by
McCallum (1982) in an earlier survey. However, there is a serious disadvantage:
the expected-market-clearing approach provides no explanation of the persistence
of monetary shocks. The persistence caused by this type of sticky wage or price
mechanism could last no longer than the longest lead time for wage and price setting.
Recall that the review of the studies of wage and price setting in the previous section
showed that the average duration of nominal wages and prices was no longer than
one year. Yet the persistence of money shocks lasts well beyond one year. In other
words, the expected-market-clearing approach has the same empirical shortcoming as
the market-clearing approach, and trying to remedy these shortcomings by introducing
other sources of persistence leads to a counterfactual implication for the inflation and
output dynamics.
It was in trying to apply the expected-market-clearing approach in constructing an
estimated econometric model that I realized how serious this disadvantage was. The
empirical problem with such a formulation was that real output jumped back to the full
employment level much too quickly and sharply after a money shock. I found that in
building an empirical model I could not use the expected-market-clearing formulations
that had proved useful in building the simple theoretical models of Phelps and Taylor
(1977), Gray (1976), or Fischer (1977). It is interesting that Yun (1994, Chapter 2)
had a similar experience when endeavoring to introduce sticky prices into an empirical
real business cycle model; he found that setting a price for a single market period in
advance could lead to no longer persistence than the length of the longest lead time
in price setting, and for this reason he eventually adapted to an alternative approach
used prior to the development of real business cycles - a version of the staggeredprice-setting approach described in the next section.
In retrospect, it is interesting to observe that the persistence problems of the
expected-market-clearing models with prices or wages set in advance are similar
to those of the market-clearing model with perfectly flexible prices and limited

Ch. 15.. StaggeredPrice and Wage Setting in Macroeconomics

1027

information. The persistence of a shock to money would not last beyond the length
of the longest lead time for price setting or beyond the longest time for learning the
source of an observed shock to aggregate demand.

4. Staggered contracts models

The staggered price and wage setting approach focuses on the nature of the price
or wage decision itself, asking what would be a reasonable way to describe how
prices and wages are set in different circumstances. Many of the general observations
about real world price and wage setting described in Section 2 guide the formulation.
These general observations include: (1) Wage and price setting appears to be
staggered or unsynchronized; not everyone sets prices or wages in the same period.
(2) Wages and prices are set at fixed values for fairly long periods of time (frequently
called a "contract" period) and are frequently, though not always, non-contingent on
events that occur during the contract period. Wage changes occur annually for many
workers but the length of time varies and is not a fixed time length in many instances.
Because price or wage setting is staggered these contract periods overlap with each
other - hence, the term "staggered contracts". (3) When setting prices or wages, firms
find that other prices and wages in the economy, or at least in closely related markets,
are relevant for their decisions; this is true both for competitive markets and for markets
where price setters have a degree of market power.
4.1. A simple price setting model

The staggered contract model developed in Taylor (1979a, 1980a) was explicitly
designed to have these features; it is a simple model of price or wage setting designed
to highlight certain key properties of real-world price and wage setting. The equations
are essentially the same for wage setting and price setting. Consider the case of price
setting. In the basic model prices are set for a fixed number (N > 1) of periods and are
not changed during the length of this N-period "contract period". Each period, 1/N of
the firms change their "contract prices". At any moment of time, the prevailing price
would be an average of the N outstanding contract prices determined in the current
and the last N - 1 periods. When setting the current price, firms would take account
of both future and past price decisions of other firms because these would be part
of the prevailing price. Thus the equations have both forward-looking and backwardlooking terms which are implied automatically from elementary considerations about
how prices are set. These staggered contract equations had the feature that there is
no long-run trade off between inflation and unemployment: regardless of the steadystate inflation rate the unemployment rate would equal the natural rate, although this
property requires that future prices are not discounted when setting today's price, a
property that may be a good approximation for short contracts of one year or less.

1028

J.B. Taylor

To be concrete, suppose that N = 2, and that Pt is the log of the average price
prevailing in period t, xt is the log of the price set in period t to apply to period t
and t + 1, and Yt is the log of aggregate real output. Then, the basic staggered price
setting model is
Pt = 0.5(xt +xt-1),

(4.1)

xt = 0.5(pt + Etp~+l) + ]/Yt + yEtYt+l + et,

(4.2)

where et is a shock to price setting. The first equation states that the current price is
the average of the two outstanding "contract prices". Equation (4.2) posits that this
contract price will depend on prices prevailing during the contract period and on a
measure of total demand in the economy during the two-period contract length. In
Taylor (1979a, 1980a) I viewed the role of Yt in this equation as representative of
excess demand in the markets during the periods when xt applied, but as discussed
below this is only one interpretation. The model can be closed by assuming a simple
demand-for-money function such as (rot - P t ) = Yt, where mt is the log of the money
supply, and by specifying a stochastic process for the money supply.
Suppose for example that mt = rot-1 + th, where t/t and et are serially uncorrelated
random variables. Then, by substituting for Yt in Equation (4.2) using the demand
for money and then substituting for pt using Equation (4.1) one can easily derive an
autoregressive moving average process for Yt in which the autoregressive parameter
(the coefficient onyt_~) is a = e - (e 2 - 1)-J , where c = (1 + ]/)(1 - )-1 and the moving
average terms depend on the shocks to money and the price-setting equation. The
autoregressive parameter a is inversely related to the parameter y. For small y, the
parameter a will be large and there will be a lot of persistence. Hence, 7 is a
key parameter.
The autoregressive part of the process for Yt arises because the price xt set by one
firm partly depends on the price xt-1 set at other firms - as can be seen by substituting
Equation (4.1) into (4.2). Because of the autoregression, a shock to the money supply
has a long drawn out effect on output and the price level. The autoregressive term
is analogous to a dynamic multiplier and for this reason I used the term "contract
multiplier" to describe this persistence effect. This autoregressive component is why
the effect on output lasts much longer than the length of the longest contract (2 periods
here).
West (1988) and Phaneuf (1990) showed with more detailed models and data from
the USA and other countries, that the persistence could be large enough to explain the
near unit-root behavior that had been associated with real business cycle models. In
other words they showed that near unit-root behavior was consistent with a monetary
theory of the business cycle with relatively short-lived staggered prices and wages.
Moreover, as I showed in Taylor (1980b), there is also a pattern of reverse dynamic
cross correlations implied by this model in which a higher level of real output is
followed by a higher price level, while a higher price level is followed by a lower level
of real output - in other words real output Granger-causes the price level (positively)

Ch. 15." Staggered Price and Wage Setting in Macroeconomics

1029

while the price level Granger-causes real output (negatively). This reverse correlation
is found in the data from many countries as reported in Taylor (1980b) and mentioned
in the introduction to this chapter. Hence, even this highly stylized model is capable
of explaining key facts of the dynamic relation between money, output, and the price
level. Note, however, that these facts pertain to the behavior of the price level rather
than the rate of inflation, an important issue to which I will return in the discussion
o f inflation persistence below.

4.2. More general staggered wage- and price-setting models

Given the heterogeneity of wage- and price-setting structures summarized in Section 2,
it is likely that the simple uniform-length staggered contract structure in Equation (4.1)
would have to be generalized for empirical work to describe a world with a multiplicity
of contracts of different lengths. For example, rather than have all prices or wages
change every N periods, one could have a range of contracts of lengths N I , N2, N3 . . . . .
representing different types of price- or wage-setting arrangements. Thus some prices
would be set for a relatively long period of time while others would usually change
more frequently. One way to represent such a model is to generalize Equation (4.1)
as

Pt = Z

~,xt-,,

(4.3)

s=0

which is drawn from Taylor (1979b); Equation (4.2) can also be generalized in an
analogous fashion with ~ weights replacing 1/N or 1 in the case o f N = 2. In the special
case where ar0=a~ =0.5 and the rest of the a~'s are zero, Equation (4.3) reduces to
Equation (4.1), the two-period price-setting case. Alternatively, if there were an equal
number of prices with durations of one through four quarters, then the a~ weights would
decline linearly. In the next several sections, I consider versions of Equation (4.3) that
have proved useful in research.

4.2.1. Fixed duration models

In a series of empirical studies [Taylor (1979b, 1983, 1993a)] I used the general
formulation (4.3) in several different ways, none of which restricted the parameters to
any special stylized case such as Equation (4.1). This allowed for a general frequency
distribution of different contract lengths: some workers and firms would set their price
or wage each quarter, others every two quarters, others every year and so on.
In Taylor (1979b) I estimated the ~ weights using aggregate wage data for the USA.
I assumed a flexible functional form for the pattern of the Jr weights in order to reduce
the number of parameters - the functional form allowed the frequency of contract
length to increase, reach a peak, and then decrease. By estimating the parameters of that
distribution, I was able to infer the distribution of contract lengths in the USA. In Taylor

1030

JB. Taylor

(1983) I calibrated the ~ weights using union wage data in the USA; the observed
contract distribution varied in length from 4 quarters to 12 quarters. The resulting
model was then used to simulate different disinflation paths for the USA to follow to
bring the inflation rate down from the high levels of the late 1970s and early 1980s.
Finally, in an estimated multicountry model [Taylor (1993a)] I estimated implied
distributions of contract length for the largest seven industrialized countries, with the
allowance of more synchronization in Japan, where observation of the wage setting
process suggested there would be synchronization. (These estimates were discussed in
the section on indirect observations of wage setting above.)
Blanchard (1983, 1987) significantly extended the idea of unsynchronized price and
wage setting to a complete stage-of-process model in which the price of inputs affects
the price of outputs which then affects the price of an input to another firm and so on.
The process of passing through price changes at each stage of production generates
staggered price setting with the dynamics depending on the input-output structure
of the economy. Hence, this provides another way to calibrate, or at least interpret,
staggered price- and wage-setting models. Gordon (1981) also places great emphasis
on stage-of-process effects in models of aggregate price dynamics.
Christiano's (1985) extension of the staggered price and wage setting model also
proved useful. He allowed for adjustment of contracts more frequent than the time
interval for data collection and estimation. For example, Christiano's generalization
could be used to estimate a model in which some contracts last only one quarter, but
the data are annual. Using this approach Christiano was able to improve the goodness
of fit of the simple staggered contract model.
Buiter and Jewitt (1981) generalized the staggered contract model to allow wage
setters to take the real wages of other workers into account rather than nominal wages.
They showed that this change preserved many of the dynamic properties of the basic
model, but allowed for additional effects because different price indices might be
relevant for workers and firms. This is especially relevant in international economics
where distinguishing between consumer and producer prices allows one to consider
the important implications of exchange-rate pass-through.
4.2.2. Random duration models

Calvo (1982, 1983) developed a simple, but useful, version of Equation (4.3) by
assuming that the Jr weights had a simple geometric form: Jr~. = a ~' for a < 1. Calvo's
original suggestion was to convert the staggered contract model to continuous time and
thus assume an exponential distribution. Moreover, Calvo (1982) provided a stochastic
interpretation of the staggered contracts model: in his words "we basically adopt the
same assumptions [as the standard staggered contracts model] except, to simplify
the mathematics, we suppose that contract length is stochastic and independent and
identically distributed across contracts" rather than described by a fixed distribution
of contracts of different lengths. Calvo (1982) suggested that the equations could be
interpreted as implying that the contracts ended randomly according to a geometric (or

Ch. 15: Staggered Price and Wage Setting in Macroeconomics

1031

exponential) distribution, thereby leading to a random duration version of staggered

wage setting. To complete the geometric version of the staggered price-setting model,
Calvo generalized Equation (4.2) as in Taylor (1979b).
Levin (1989, 1991) proposed a more general version of the random duration model
in which the frequency distribution of contracts is not necessarily exponential. He
estimated the distribution for the USA and found it to be significantly different than
geometric with one-year wage setting intervals more common than shorter intervals.
The stochastic interpretation implies that firms or workers will randomly change prices,
which might seem less realistic than the assumption that the price changes occur at a
typical time each year, such as in the spring. Backus (1984) and Chadha (1987) found
the geometric assumption useful in discrete time empirical formulations, but Levin
(1991) and Benabou and Bismut (1987) found that the distribution of contracts is not
generally geometric. Hence, the simple geometric assumption should probably be used
with caution in empirical work.
4.2.3. State-dependent duration models

The exogeneity of the price- and wage-change intervals in both the fixed and
random-duration staggered price-setting models has been one of their most criticized
assumptions. Making the price change or contract termination decision endogenous
is important for policy or empirical work, especially if exogeneity is a poor
approximation. Fortunately, a number of recent studies have begun to develop models
in which the duration of price and wage decisions depends on the state of the economy;
this approach is called state-dependentpricing. In contrast the simple staggered priceand wage-setting model is called time-dependentpricing because prices change at fixed
or randomly selected times.
Caplin and Spulber (1987) developed a widely-discussed model in which all prices
are completely state dependent; that is, there is no explicit dependence on time as in
the staggered contract models. With state-dependent pricing each firm is faced with
fixed costs of price adjustment and uses an (S, s) policy to determine whether the
price will change and by how much [see Sheshinski and Weiss (1988) for more on
(S, s) policies in price adjustment]. Because not every firm will change its price in
every period the resulting pattern of price adjustment looks just like staggered timedependent pricing. However, Caplin and Spulber (1987) find the switch from pure
time-dependent pricing to pure state-dependent pricing greatly reduces the effects of
staggered wage and price setting on the macroeconomy. In particular they find that
money can be completely neutral in such a model. The reason is that if all price setters
are following a (S, s) policy, with a wide enough band, then they can all change prices
by the full amount of a monetary shock as soon as the shock appears. In contrast with
the time-dependent pricing in the staggered price-setting model discussed above, some
firms will not change their price so that the aggregate price level adjusts slowly.
Tsiddon (1991, 1993) shows that slow aggregate price adjustment and the nonneutrality of money reappear if the changes in the money supply are highly persistent or

1032

J.B. Taylor

have large swings. In such cases the size of the firm's price change is reduced leading to
smaller changes in the aggregate price than the money supply. Conlon and Liu (1997)
show that if firms change prices in response to other things than price misalignment
(a product upgrade, a new model or a new product mix), then the nonneutrality of
money reappears. Essentially this change results in a mixture of time-dependent and
state-dependent pricing, a situation which probably better reflects reality than either
extreme.
An important recent application of state-dependent pricing is found in a general
equilibrium model developed by Dotsey, King and Wolman (1996), who modified the
geometric staggered contract framework of Calvo (1982) to allow for state-dependent
pricing. In the Dotsey, King and Wolman (1996) model the fraction of firms that are
changing their prices in any one period increases when the inflation rate rises. This
prediction of the model is supported by many of the papers surveyed in Section 2. An
important advantage of the Dotsey, King and Wolman (1996) paper is that they embed
state-dependent pricing into an economy-wide model and preserve some degree of
time dependence. They find that the money, output, and price dynamics resulting from
their state-dependent model are not too dissimilar from the dynamics of the purely
time-dependent model discussed above.
Another example of state-dependent pricing is the model of Caballero and Engel
(1993). Like the Caplin and Spulber (1987) model, only a fraction of prices will be
adjusted each period in the Caballero and Engel model. Thus staggered price setting
emerges. However, Caballero and Engel (1993) assume that the probability that an
individual price will adjust depends on both the size and the sign of the deviation of
the price from some desired price. Caballero and Engel (1993) look at the implications
of their model for time-series behavior of the aggregate price level focussing on
the producer price index. The detrended log of the index itself is described by a
second-order vector autoregression with coefficients of 1.68 and -0.76. The Caballero
and Engel (1993) model with its emphasis on first-order adjustment has difficulty
mimicking this humped-shape behavior implicit in a second-order process, but at least
the model generates the persistence or stickiness of the aggregate price levels found
in the pure time-dependent staggered contract model.

5. Bolstering the theoretical foundations of staggered contracts models

As described above in Section 4.1, the basic staggered contract model was constructed
to be consistent both with certain observed features of price- and wage-setting
behavior and with basic microeconomic principles about the operation of competitive
or imperfectly competitive markets. In particular, the idea that the price and wage
decisions of firms depend on the prevailing prices and wages - and thus on the
price and wage decisions at other firms - is an essential characteristic of staggered
wage- and price-setting equations. In a sense these equations endeavor to describe
a price discovery process in markets with posted prices, much like the equilibrium

Ch. 15.. StaggeredPrice and WageSetting in Macroeconomics

1033

of supply and demand equations is a description of price discovery in spot markets.

Davis and Holt (1997) have noted the development of price rigidities in experimental
markets with posted prices and it is likely that experimental economics will help
improve on current formulations of staggered wage and price setting. Nevertheless, the
price- and wage-setting mechanism in the original staggered contract models was not
derived from an explicit maximization problem, and this lack of a formal optimization
underpinning is a potential disadvantage that many researchers have pointed out.
Fortunately, many studies over the years have provided a more solid microfoundation
for these equations.
5.1. Deriving the optimal price: the role of market power
Most formal derivations of price determination take as given either (1) the cost of
adjusting price, or (2) the fixed (or possibly random) interval for setting the price.
Subject to this constraint an optimal value of the price to maximize profits can be
found. Arrow (1959) first pointed out the need for some degree of market power to
make the price decision of a firm meaningful. He outlined a possible framework in
which even competitive firms had a temporary degree of market power at the time of
the price decisions. Prescott (1975) also outlined a model of price setting in which
firms had some degree of market power, but the market is essentially competitive in
that the efficiency conditions of competition hold.
Models in which firms have market power - due usually to a monopolistic
competition assumption - so that an optimal price can be calculated are used frequently
in studies of price and wage rigidity. In an early paper on this subject, Rotemberg
(1982) assumed that firms face an explicit cost of adjusting prices, a cost that depends
on the size of the price change. He also assumed that each firm faces a downwardsloping demand curve. These assumptions enabled him to derive a price-setting rule
in which the actual price level adjusts slowly toward the optimal monopoly price.
Rotemberg (1982) originally used this approach as an alternative to staggered price
setting, but Rotemberg (1987) and Roberts (1995) show that the cost of price-level
adjustment model leads to very similar equations as staggered contract models.
In two influential papers, Svensson (1986) and Blanchard and Kiyotaki (1987)
developed complete macroeconomic models in which monopolistic competition plays
a role in determining the optimal price for firms. These models incorporate money
formally and can be used to show the impact of a change in aggregate demand rising
from changes in the money supply. In their original form, the Svensson (1986) and
Blanchard and Kiyotaki (1987) models were static and were not addressed to the
problems of persistence or dynamic cross correlations that are the main subject of
this review.
5.2. Towards dynamic optimizing models of staggered price and wage setting
Blanchard and Fischer (1989) developed a dynamic model that could address such
issues. The model combines monopolistic competition with staggered price setting.

1034

JB. Taylor

The combination is achieved in two steps. The first step is to find the optimal price from
a monopolistically competitive model without staggered price setting, such as Svensson
(1986) or Blanchard and Kiyotaki (1987). For example, a typical optimal pricing
rule would say that the price should depend on the average of other monopolistically
competitive firms prices (p) and on a constant times aggregate output (y), which would
represent a demand shift. A linear version of such a rule would look like
x = p + yy,

(5.1)

where x is the firm's price, p is the average of other firms prices, and y is aggregate
output.
Now, suppose that pricing is staggered with 2 period contracts so that the price xt
must last for two periods: t and t + 1. Then it seems reasonable that firms would set
their price to be the average of the optimal price during the two periods during which
the price applies. This reasoning leads to the second step which sets
xt = 0.5(pt + YYt) + 0.5(Et lPt+l + ]/Et-lYt+l).

(5.2)

Note that Equation (5.2) is identical in functional form (ignoring the random shock)
to Equation (4.2). Hence, pricing under monopolistic competition gives a more formal
underpinning of the staggered price setting model. However, now the role of y
is to shift firms' demand functions rather than to serve as a measure of (excess)
demand pressure in the market. Blanchard and Fischer then went on to describe
various persistence properties when Equation (5.2) is imbedded in a model. Because
Equation (5.2) is identical to Equation (4.2), the properties are identical to those
I discussed above. Romer (1996) presents a very useful textbook treatment of this
type of derivation of the staggered price setting equation, providing useful details of
the derivations and fin'ther discussion. Rotemberg's (1987) derivation of a staggered
price setting mentioned above is similar to the one of Blanchard and Fischer (1989)
described here, except that rather than using the example in Equation (4.2) he uses the
version of Equation (4.2) with geometric declining weights on future p's and y's as in
Calvo's (1982) geometric version of the staggered contracts model [see the discussion
following Equation (4.3)].
Although the above derivation of the staggered price setting equations provides
a helpful microeconomic interpretation, it is still not a fully optimizing treatment.
In work that began in the mid-1980s, Akerlof and Yellen (1991) developed a
dynamic model in which Equation (4.2) or (5.2) emerged directly from a monopolistic
competition model without the two steps described above. They showed how the simple
staggered contract equations could be derived from a maximization problem in which
monopolistically competitive firms interact.
Consider a simple two-firm model in which each firm faces a downward-sloping
demand curve and thus has a degree of market power. The demand curve depends on
real income in the economy, its own price, and the price charged by its rival. (The

Ch. 15: StaggeredPriee and WageSetting in Macroeeonomics

1035

process determining real income is left unspecified, but is eventually related to the
money supply as in other models.) One firm sets prices in even periods and the other
firm sets prices in odd periods. The prices are fixed at the same nominal value for
two periods. The rival firm can be thought of as a monopolistic competitor that sets a
constant nominal price every other period. Akerlof and Yellen (1991) show that if each
firm chooses a price to maximize expected profits taking as given (1) the price set by
the rival firm (a Bertrand price setter) and (2) income in the economy, then the optimal
price is given by the simple staggered price setting model in Equations (4.1) and (4.2).
To get linearity in the decision rule, Akerlof and Yellen (1991) approximate the profit
function by a quadratic.
5.3. Staggered price and wage setting in general equilibrium models

Although Akerlof and Yellen (1991) derived staggered price- and wage-setting
equations from first principles, they did not endeavor to embed the equations in a fully
optimizing model of the economy - that is, a model that includes utility functions for
representative households. During the late 1980s and 1990s there has been a great
amount of research aimed at doing just that. Nelson (1997) provides an excellent
review of the most recent part of this research, but some discussion of earlier work
is useful too. In one of the earliest studies along these lines, Deborah Lucas (1985,
1986) developed a full optimizing model in which some prices are determined in spot
markets and some are determined in contract markets. The prices in spot markets
are determined in the usual market-clearing way. The wage contracts are assumed
to last two periods; 50 percent of the contracts are set in odd periods and the other
50 percent are set in even periods. The contract specifies a fixed nominal wage for
two periods: the current period and the next period. Interestingly, Lucas (1985, 1986)
developed a wage-setting mechanism for the contracts in competitive markets, so that
the results do not depend on the market power of firms. The terms of the contract are
determined in a market-clearing fashion. As stated by Lucas (1986), "In the process
of competing for the N workers available to a given sector, the economy equilibrates
so that the marginal utility gained from the wages paid over the contract period equals
the marginal disutility of labor over the contract period". Note that this approach to
modeling wage determination in the contracts is analogous to that used in the optimal
contract literature [see Azariadis (1975)]; it is different from both the monopolistic
competition assumption and the expected-market-clearing approach mentioned above.
Deborah Lucas (1985, 1986) used a cash-in-advance approach to money demand
and has prices set for two periods, with decisions being made every other period.
Simulations demonstrated the effect of the nominal rigidities on the effect of monetary
policy. In her model, the amplitude of cycles was proportional to the fraction of markets
with wage contracts compared with spot pricing.
Levin (1989, Chapter 2 and 1990) also developed an optimizing model in which
wages are set in a staggered manner and determined optimally. Levin also obtained
estimation and policy results. He estimated the model using maximum likelihood

1036

JR Taybr

methods and US data. He then stochastically simulated the model to derive optimal
feedback rules for monetary policy, and calculated the tradeoff between output stability
and price stability. Because the parameters of Levin's model were estimated he could
obtain quantitative estimates of the policy rule and the policy tradeoff.
Yun (1994, 1996) developed a general equilibrium model with staggered price
setting, both with a fixed and random duration. Because Yun uses monopolistic
competition, his analysis of staggered price setting has similarities to that of Blanchard
and Fischer (1989) above, but it is not a two-step approach. Staggered pricirrg equations
of the form (5.2) emerge from the optimization problem without requiring that one first
find the optimal price without staggering and then inserting that price into the basic
staggered price-setting equations. A difference in the resulting equations is that prices
in furore periods are discounted relative to current prices; that is (pt + Yyt) would get
a larger weight than (Et lPt+1 + yEt lYt+l) in Equation (5.2) because the firms' profits
in the second period would be discounted. Yun's approach shows explicitly how the
single price in a staggered price-setting model must balance out profits in different
periods because the price cannot be at different levels in different periods.
Kimball (1995) discusses several results that emerge when he places formally
derived staggered price-setting equations in a general equilibrium model. Kimball
(1995) noted that the parameters of the resulting equations may give less persistence
than earlier estimated staggered price-setting models (for reasons similar to those
mention in my discussion of Blanchard and Fischer) and discussed several factors that
could lengthen persistence that have proved useful in later work. In commenting on
Kimball (1995), Woodford (1995) gives a nice comparison of the Yun (1994, 1996)
and Kimball (1995) models.
Compared to other research in this area, the work by King and Wolman (1996)
focusses more explicitly on policy analysis. King and Wolman (1996) develop a utility
maximization model with price and wage rigidities. Like Deborah Lucas (1985, 1986),
Levin (1989), and Yun (1994) they add price rigidities to the model, using a staggered
price-setting model. Money enters their model through a transactions technology
device in which monetary services allow for higher levels of consumption. As with
Levin (1989) and Deborah Lucas (1985, 1986), money has a real effect in the model
because of the nominal rigidities. King and Wolman (1996) examine inflation targeting
procedures and other important issues in the design of monetary policy rules.
By the mid-1990s there were also a number of papers that added other forms of price
and/or wage rigidities to a general equilibrium model. Hairault and Portier (1993),
Kim (1995), and Ireland (1997) used a quadratic cost of price adjustment approach
as suggested by Rotemberg (1982), while Cho and Cooley (1995) assumed that prices
were set in advance in such a way that the overlapping features of staggered price
setting would not play a role in producing persistence. Other work in this general
area has been motivated by various policy, empirical, and methodological issues and
includes Leeper and Sims (1994), Bernanke, Gertler and Gilchrist (1999), Ohanian
and Stockman (1994), Chari, Kehoe and McGrattan (1998), and others. The paper by
Chari, Kehoe and McGrattan (1998) raised some puzzles about the ability of staggered

Ch. 15: StaggeredPrice and Wage Setting in Macroeconomics

1037

price and wage equations to deliver persistent dynamics and is taken up along with
several responses later in this chapter.

5.4. Explanations of why price and wage setting is staggered

Although based on empirical observations, the staggering of wage and price setting
is simply assumed in all the models discussed thus far in this chapter, from Taylor
(1979b) through Chaff, Kehoe and McGrattan (1998). Why is price and wage setting
staggered? This question has been pursued by many researchers in the 1980s and 1990s
and is still the subject of debate. The question goes to the heart of the price discovery
process in a market economy and well beyond macroeconomics.
Fethke and Policano (1984, 1986) develop a model in which wages must be set
several periods in advance and then are fixed without contingencies. The question is
whether in such a world the wage settings should be staggered or all occur at one time.
Fethke and Policano (1984) proved that staggering is a good way for the economy to
adjust to sector-specific shocks. When disturbances are primarily due to relative, as
distinct from aggregate, shocks, staggering of decisions is optimal because adjustments
of some prices enable the sectors that are locked into fixed wages or prices to partially
adjust. Parkin (1986) also shows that the degree of staggering depends on the relative
size of aggregate shocks versus sector specific shocks. The analysis of monetary policy
in this type of model is considered in Fethke and Policano (1987). They derive a
Nash equilibrium where timing of monetary policy intervention and synchronization
of contracts are simultaneously decided upon.
An entirely different explanation for the existence of staggering comes from
informational considerations. Ball and Cecchetti (1988) show that staggering allows
firms to obtain information about what is going on in other markets. By observing
the price in other markets firms are able to extract information about whether shocks
are aggregate or relative. In addition, Ball and Romer (1989) find that there is a
more rapid adjustment to sector (idiosyncratic) shocks with staggering. As shown
by Ball (1987), these microeconomic advantages are offset, at least in part, by
macroeconomic disadvantages of slow aggregate price adjustment, a concept he refers
to as "externalities from contract length". Sheshinski and Weiss (1988) consider the
question of staggering in oligopolies where timing is endogenous. Lau (1996, 1997)
explores the strategic issues between price setters in an oligopoly game. The strategic
rationale for staggering was explored by Matsukawa (1986) in the case of wage
setting.
In a recent paper, Bhaskar (1998) derives endogenous price staggering in a
model with heterogeneous firms. Firms within an industry have stronger strategic
complementarities than firms in different industries. This results in an equilibrium in
which there is synchronization within industries but not across the economy. De Fraja
(1993) also utilizes such strategic considerations in a model in which staggered price
setting can be endogenous.

1038

J.B. Taylor

5.5. Indexing and optimal contract length

A major puzzle in the area of wage and price rigidities is why contracts are fixed in
nominal terms for so long. Gray (1978) provided at least part of the answer in a paper
on the optimal degree of indexing. In a model in which there are both nominal and
real shocks, Gray (1978) showed that it is not optimal to fully index a wage contract
to a single variable like the price level. A still unsettled issue is why contracts would
not be indexed to all relevant information. Complexity, asymmetric information, and
measurement problems must all be part of the answer.

6. Persistence puzzles and possible resolutions

A general theme of this chapter is that the assumption of rational expectations and the
need for economy-wide modeling has led to more specific models of wage and price
rigidity than before the rational-expectations revolution. This greater specificity has
led to the formulation of many statistical tests of the price- and wage-rigidity models.
Several years ago, Blinder (1994) noted that models of price and wage rigidity have
not been tested, saying, "Try to think of even a single case in which a theory of sticky
prices has been rejected econometrically". But, while this criticism may apply to prerational-expectations theories, it certainly does not apply to the price- and wage-rigidity
models that have arisen since the 1970s. Indeed, the simple representative staggered
contract model described in Equation (4.1) is an example of a theory of sticky prices
that - at least in that stylized form - was rejected econometrically as early as 1982.
In a 1985 survey paper I stated that "Empirical tests of the sticky-price models have
not yet been as extensive as the information-based models." [see Taylor (1985)], but
they had already begun. Because of the extensive testing of staggered price-setting and
other sticky-price models in recent years, it would not be accurate to make that 1985
statement today.
Recall first that staggered price- and wage-setting models do explain in broad terms
the observations summarized in the introduction of this chapter. For example, many of
the serial correlation properties of the aggregate data - including the reverse dynamic
cross correlation, the persistent effect of monetary shocks on real output, and the
permanent effect of monetary shocks on prices - are all explained by the simple
staggered contracts model. More generally, simulations of the impact of monetary
policy shocks, summarized in Taylor (1993a), look much like vector autoregressions
reported by Christiano, Eichenbaum and Evans (1999). However, when one looks more
closely at the properties of the serial correlation, one starts to see discrepancies, which
raise interesting puzzles. Most of these discrepancies are related to the ability of the
models to explain persistent movements of real output or inflation. In an early paper on
testing the staggered price and wage setting model, Ashenfelter and Card (1982) found
that the simple staggered contract model was inconsistent with the serial correlation of
wages. Levin (1991) has shown, however, that the more general formulations of these

Ch. 15: StaggeredPrice and Wage Setting in Macroeconomics

1039

models such as Equation (4.3) above do pass goodness of fit tests like those proposed
by Ashenfelter and Card (1982).
Another empirical criticism of the staggered contract model is found in Dezhbakhsh
et al. (1984). They argued that the statistical Phillips curve correlations reported in
Taylor (1980b) arose after supply shocks, not demand shocks, and that correlations
were actually based on forward looking derivatives (differences). While the point about
the supply shocks is correct, the more typical statistical Phillips curve correlations
would arise if demand shocks were correlated. A related point was made by Phaneuf
(1987a,b). He pointed out that uncorrelated demand shocks showed a negative effect
after the length of the longest contract. This property can be avoided with serially
correlated demand shocks.
6.1. Inflation persistence

A widely discussed econometric problem with the staggered contract model is its
apparent inability, without serial correlation or other sources of dynamics, to generate
the persistence (or inertia) of inflation observed in the data. For example, Ball (1994)
showed how it was possible to reduce inflation without recession - indeed with the
right policy to have a boom! Phelps (1978), Taylor (1983), and Abraham (1987)
also examined costless disinflations with rational expectations, but they did not relate
this finding to empirical defects with the model. Though the inconsistency between
these results and the observed costly disinflations can be easily explained by learning
or by lack of credibility, the inconsistency raises some doubts about the ability of
staggered contracts models with rational expectation to generate inflation persistence.
The apparent inconsistency has led some empirical researchers to use a modification,
proposed by Fuhrer and Moore (1995a,b), of the staggered contracts model.
Fuhrer and Moore (1995a,b) present autocorrelation plots that nicely document
some of the difficulties with the ability of the staggered contract model to produce
inflation persistence. They show that the cross autocorrelation functions based on
actual inflation and output data were not closely matched with the simulations of
the basic staggered contract model. Note that the tests reported in Taylor (1980b)
mentioned in Section 4 above compared price levels rather than rates of inflation;
hence, the reason for one test passing and the other failing.
To remedy this problem Fuhrer and Moore (1995a,b) modified the staggered contract
model. Rather than current price levels being based on expected future price levels
as in the standard staggered contract models, their modified model has current price
inflation being based on expected future price inflation. The replacement of levels by
rates of change generated a model with inflation persistence rather than simply pricelevel persistence. However, the theoretical foundations of the staggered contract model
are based on levels not rates of change [recall the discussion of the derivation by
Akerlof and Yellen (1991) above].
To be sure, Fuhrer and Moore motivated their alternative formulation by restating
the price decision in "real" terms. To see this most simply, set 7 = et = 0 and replace

1040

J.B. Taylor

rational expectations by perfect foresight in Equation (4.2). Note that after substitution
from Equation (4.1) we get
xt = 0.5(x,_l +xt+l),

(6.1)

which illustrates how the current contract price depends on future and lagged contract
prices. Now suppose that rather than using xt in Equation (6.1) we formulate the
price decision in terms of xt - P t , which looks like a "real" price: the current (log)
contract price is deflated by the (log) aggregate price. Replacing xt+~ with Xt+s-Pt+s
for s = 0, 1 and -1, in Equation (6.1), we get (after some algebraic manipulation)
Axt = 0.5(Axt_l + Axt+l),

(6.2)

where Axt = x t - x t 1. Thus, all the properties stated above in terms of price levels are
now restated in terms of the inflation rate. However, this definition of the real price
effectively deflates by a price that does not apply to the full period (t and t + 1) of the
contract price; that is, pt applies to only 1 of the period that xt applies to. Replacing
xt in Equation (6.2) with x t - 0.5(pt +Pt+1) may seem to result in a more appropriate
real price. Thus, while the Fuhrer-Moore formulation may work in macroeconomic
empirical applications, it leaves puzzles about the microfoundations.
Rotemberg (1997), in commenting on Fuhrer (1997), argues that there is nothing
wrong with appealing to other sources of persistence of inflation within the staggered
contracting approach. It is possible, of course, that inflation persistence could be due
to serial correlation of money, but since one of the aims of these models is to explain
persistence, leaving all the persistence of inflation to exogenous serial correlation is
not a completely satisfactory conclusion either.
In a recent paper Roberts (1997) re-examines Fuhrer and Moore's (1995a,b)
findings. By exploring alternative expectations-formation mechanisms, Roberts (1997)
demonstrates that a small amount of"imperfect information" about the determinants of
inflation when combined with staggered price setting is enough to explain the observed
serial correlation of inflation. In my view, Roberts' (1997) results indicate why it is
likely that a full understanding of price and wage rigidities will eventually involve both
imperfect information and staggered contracts of some form. Gertler (1981, 1982)
developed a model of wage rigidities and wage inertia that is based on imperfect
information. Rudin (1987) developed a formal model of staggered price setting in
which there are diverse expectations on the part of firms giving rise to a situation
where firms' expectations depend on other firms' expectations, and so on.
6.2. Real output persistence

The recent study by Chari, Kehoe and McGrattan (1998) emphasizes another potential
persistence problem with the staggered price- and wage-setting model. Their study and
the responses it has stimulated nicely illustrate the potential benefits of using dynamic

Ch. 15:

Staggered Price and Wage Setting in Macroeconomics

1041

optimizing models to study wage and price stickiness. As mentioned above, Chari, Kehoe, and McGrattan (1996) place a staggered contracts mechanism into an optimizing
model in which price-setting rules are derived assuming monopolistic competition;
they assume that money is in the utility function. They then examine the dynamic
properties of the model and compare the properties with the staggered contract mechanism when placed in a model with less formal optimization; that is, with Equations
(4.1) and (4.2) above. Through a pairwise comparison of the models, they find that,
with reasonable parameter values calibrating the optimizing model, they cannot get
coefficients on the staggered price setting equations that are large enough to generate
empirically realistic serial correlation; they find virtually no persistence beyond the
length of the longest contract. In terms of Equation (4.2), the value of 7 they get from
their calibration exercise is much too large. Hence, the persistence is much shorter than
the kind of persistence that West (1988), Blanchard (1990), and Phaneuf (1990) have
found with the staggered contract model. Ascari (1998) develops an optimizing model
of staggered wage setting which also implies that the y parameter is way too large.
Several interesting papers have already been written in reaction to the findings
of Chari, Kehoe and McGrattan (1998). Gust (1997) shows that restricting capital
mobility between sectors can increase persistence in the Chari, Kehoe and McGrattan
(1998) model. Kiley (1997) and Jeanne (1997) show that increasing the size of real
rigidities [in the sense of Ball and Romer (1990)] can increase persistence in the model.
A common theme of these papers is that there needs to be some neighborhood effects
between price setters, so that one firm pays close attention to the price decision of
the next firm and the most recent firm, thereby linking the price decision of one firm
to another and causing the persistence effects. Gust's (1997) model illustrates this by
tracing out in detail the effects of shocks with and without capital mobility; in his
model capital plays a role in affecting the linkage between price decisions in different
markets.
The Chari, Kehoe and McGrattan (1998) model assumes complete wage flexibility.
Alternatively, Erceg (1997) shows how including staggered wage setting along with
staggered price setting increases persistence and enables a calibrated optimizing model
with staggered contracts to generate the persistence observed in the data. Bergen and
Feenstra (1998) introduce a more general functional form for the demand curve facing
the monopolistic competitors, which leads to a lower value for 7. The effect of the
constant elasticity demand functions on persistence is also noted by Kimball (1995).
It is also important to note that Rotemberg and Woodford (1999) and King and
Wolman (1998) in a similar type of modeling framework find long persistence of
monetary shocks with relatively short price contracts. Rotemberg and Woodford (1999)
assume price-setting equations which are geometric after a time delay, thereby coming
close to the microeconomic empirical estimates discussed in Section 2 where the most
common length of price contracts seems to be about three or four quarters. Rotemberg
and Woodford (1999) conclude that their model generates realistic macroeconomic
persistence of money shocks. King and Wolman (1998) assume two-period contracts
and also generate realistic macroeconomic persistence.

1042

J.B. Taylor

Another possible resolution of the Chari, Kehoe and McGrattan persistence puzzle is
that the monopolistic competition model used to derive the price adjustment equation
may not be adequate. Recall that Deborah Lucas (1985, 1986) used a competitive
contracting mechanism to derive the price rule (actually a wage rule), and found that
the impacts of shocks were quite persistent. The inconsistency pointed out in the Chari,
Kehoe and McGrattan (1998) study raises issues about monopolistically competitive
pricing that need to be investigated further. As Arrow (1959) argued, the market power
a firm has when setting its price is temporary and may be quite different thar~ the market
power in a full monopolistic competition model. If so, then it is a mistake to tie the
price adjustment parameter to demand-elasticity parameters. As mentioned in the
discussion following Equation (4.1) above, prices may be responding to excess demand
and not simply be moving along a demand curve as is assumed in the monopolistic
model of price setting. Thus, the findings of Chari, Kehoe and McGrattan (1998) may
indicate that the monopolistic competition (stationary market power) model may not
be sufficient as a microeconomic foundation.
6.3. Changes in stability and nominal rigidity over time

One of the great historical puzzles in monetary economics is why economic

fluctuations are smaller now than they were before the World War II. Part of the
explanation has been that economic shocks are smaller, perhaps because of better
monetary and fiscal policy or perhaps because of other changes in the economy such
as dividend policy at firms.
Using the staggered contracts model in Equations (4.1) and (4.2), DeLong and
Summers (1986) argued that the improved economic performance was the result of
a greater degree of price and wage rigidity in the economy. On the other hand, Taylor
(1985) argued just the opposite using the same model, but calibrating the average
size of the price shocks compared to the average size of the demand shocks: if price
shocks are large enough, then greater price and wage rigidity would increase instability
because it takes larger swings in real output and employment to offset price shocks.
Other explanations for the increased economic stability - such as dividend policy or
monetary policy changes - would therefore be needed.
As shown in Driskill and Sheffrin (1986) the different views do in fact boil down to
whether demand shocks or price shocks are more important. They show analytically
that if price shocks are more important, then less rigidity of prices would lead to greater
output stability.

7. Concluding remarks on policy applications and future research

One of the most important reasons to develop detailed models of wage and price
rigidities that explain the effects of money on the economy is to conduct monetary

Ch. 15:

Staggered Price and Wage Setting in Macroeconomics

1043

policy evaluation research. Such policy applications are an appropriate place to

conclude this survey for they suggest where future research may be going.
Econometric evaluation of monetary policy is now well-established and increasingly
used in policy research. The most common strategy is to build and estimate a dynamic
econometric model of the economy and then simulate that model with alternative
feedback rules for monetary policy. Among the alternative rules, the policy which leads
to the best, or at least a reasonably good, outcome is the optimal policy, and presumably
the one recommended to policymakers. The general approach was developed by Lucas
(1976) building on work by Marschak (1953) and others at the Cowles Commission
where the need for structural econometric models for policy was a major motivation
for the development of simultaneous equation methods. Improvements in rationalexpectations solution algorithms and estimation techniques have made it possible to
perform such policy evaluations in large scale non-linear systems, in which stochastic
simulations are essential. Without these newly developed algorithms, the large number
of required replications would not be feasible.
Examples of the use of econometric models for policy evaluation include Taylor
(1979a) and McCallum (1988) which have focussed on small models. In Taylor (1979a)
I derived an optimal feedback rule for the money supply in a rational expectations
model with staggered price setting. McCallum (1988) simulated policy rules for several
different models, including nonstructural models. This research is summarized in the
chapter by McCallum (1999) in this H a n d b o o k .
More recently it has been possible to carry out such policy simulation exercises in
large scale open economy models. These international models incorporate uncovered
interest-rate parity assumptions as in the Mundell and Fleming framework as well
as staggered price and wage setting, following the lead of Dornbusch (1982). For
example, in Taylor (1993a) a multicountry model with rational expectations and
staggered wage setting was used to search for good interest rate and/or exchange
rate policy rules. Comparative simulations of several other large scale models - many
within the rational-expectations, staggered price- and wage-setting framework - are
presented in Bryant, Hooper and Mann (1993). Using these results ! suggested a
policy rule for monetary policy [Taylor (1993b)], which has been useful for practical
monetary policy discussions, illustrating the usefulness of this whole approach to
policy.
The Federal Reserve Board has developed and started using a new econometric
model which incorporates both rational expectations and a form of staggered wage and
price setting. As described by Brayton, Levin, Tryon and Williams (1997) the model is
used mostly for policy evaluation, including the evaluation of monetary policy rules.
More recently researchers such as Rotemberg and Woodford (1997) and King and
Wolman (1998) have begun to use estimated or calibrated general equilibrium optimizing models with staggered price setting to evaluate alternative monetary policy rules.
Further developments along these lines are bound to be interesting and useful in policy
work. For example, what are the policy implications of combining time-dependent
pricing with state-dependent pricing as in Dotsey, King and Wolman (1996)?

1044

J.B. Taylor

A n important advantage o f the newer models that include both utility maximization
and staggered price setting is that monetary policy can be evaluated using the standard
tools o f public finance. Welfare measures such as compensating variations or equivalent
variations thus replace cruder quadratic loss functions in terms o f aggregate output or
inflation. Rotemberg and Woodford (1999) evaluate the effect o f different monetary
policy rules using the welfare function o f the representative agents in their model.
They find that the parameters o f the staggered price-setting equations in their model
have a significant effect on their welfare calculations.
In sum, the form, interpretation, and parameter values o f staggered price and wage
setting models are highly relevant not only for explaining the impact o f monetary
policy, but also for evaluating its welfare consequences. Understanding these models
more thoroughly takes one well beyond macroeconomics into the heart o f the price
discovery and adjustment process in competitive and imperfectly competitive markets.
Further research on the empirical robustness and microeconomic accuracy o f staggered
contracts models is thus both interesting and practically important.

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of the business cycle", in: W. Brainard, W. Nordhaus and H. Watts, eds., Money, Macroeconomics,
and Economic Policy:Essays in Honor of James Tobin (MIT Press, Cambridge, MA).
Arrow, K. (1959), "Toward a theory of price adjustment", in: M. Abramovitz et al., The Allocation
of Economic Resources: Essays in Honor of Bernard Francis Haley (Stanford University Press,
Stanford, CA).
Ascari, G. (1998), "Optimizing agents, staggered wages and persistence in the real effects of money
shocks", unpublished paper (University of Warwick).
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Economic Review 67:101-115.

Ch. 15:

Staggered Price and Wage Setting in Macroeconomics

1045

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manufacturing", Journal of Labor Economics, 5:391-412.

1046

J.B. Taylor

Cecchetti, S.G. (1986), "The frequency of price adjustment: a study of newsstand prices of magazines",
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Monetary Economics 19:87-105.

Ch. 15." Staggered Price and Wage Setting in Macroeconomies

1047

Fischer, S. (1977), "Long-term contracts, rational expectations, and the optimal money supply rule",
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Lau, S.H.E (1996), "Aggregate pattern of time-dependent adjustment rules I: a game-theoretic analysis
of staggered versus synchronized wage setting", Economic Journal 106:1645-1658.

1048

J.B. Taylor

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paper (Carnegie Mellon University).

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Staggered Price and Wage Setting in Macroeeonomics

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Ohanian, L.E., and A.C. Stockman (1994), "Short run effects of money when some prices are sticky",
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ch. 1, this Handbook.

1050

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Monetary Economics 37:345-70.

Chapter 16

T H E C Y C L I C A L B E H A V I O R OF P R I C E S A N D C O S T S
JULIO J. ROTEMBERG
Harvard Business School
MICHAEL WOODFORD
Princeton University

Contents

Abstract
Keywords
1. Introduction: Markups and the Business Cycle
2. The cyclical behavior of markups
2.1. Cyclical behavior of the labor share
2.2. Corrections to the labor-share measure of real marginal cost
2.2.1. A non-Cobb-Douglas production function
2.2.2. Overhead labor
2.2.3. Marginal wage not equal to the average
2.2.4. Costs of adjusting the labor input
2.2.5. Labor hoarding
2.2.6. Variable utilization of capital
2.3. Alternative measures of real marginal cost
2.3.1. Intermediate inputs
2.3.2. Inventory fluctuations
2.3.3. Variation in the capital stock
2.4. The response of factor prices to aggregate shocks
2.5. Cross-sectional differences in markup variation

3. Implications of markup variations for business fluctuations

3.1. Explaining cyclical variation in productivity and profits
3.1.1. Cyclical productivity
3.1.2. Cyclical profits
3.2. Identifying the output fluctuations due to markup variation

4. Models of variable markups

4.1. Sticky prices
4.2. Variations in desired markups
4.2.1. Varying elasticity of demand
4.2.2. Customer markets
Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford
1999 Elsevier Science B.V All rights reserved
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4.2.3. Implicit collusion

4.2.4. Variableentry
4.3. Interactionsbetween nominal rigidities and desired markup variations
5. Conclusions
Acknowledgment
References

1123
1125
1126
1129
1131
1131

Abstract

Because inputs are scarce, marginal cost is an increasing function of output.

Diminishing returns, costs of increasing employment as well as the increasing marginal
disutility of working when hours worked and effort rise all contribute to make this
function steep. Without changes in this function relating marginal cost to output,
aggregate output can vary if and only if the markup of price to marginal cost
(the inverse of real marginal cost for typical filmS) varies. We first study whether,
empirically, real marginal cost does rise in cyclical expansions. Average real labor
cost is not very procyclical but, for several reasons, marginal labor cost is more
procyclical than average labor cost. These include the presence of overhead labor and
adjustment costs as well as differences between the marginal and the average wage.
These corrections results in procyclical measures o f real marginal cost. Measures of
marginal costs based on materials costs and inventories also appear procyclical. We
show that these procyclical movements in marginal cost may, depending on how costs
are modeled, account for a substantial fraction of cyclical output movements. Finally,
we survey models of variable markups. These include both models of sticky prices (in
which markups vary because firms cannot all costlessly charge the markup they desire)
and models in which firms' desired markup varies over time. This set of models allows
a rich set of variables to affect output even if these variables do not shift the marginal
cost schedule.

Keywords
JEL classification: E3, D4, D3

Ch. 16: The Cyc~calBehaviorofPr~es and Cos~

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1. Introduction: Markups and the Business Cycle

In this chapter, we consider the role of variations in the relationship between the prices
at which goods are supplied and the marginal cost o f supplying them in accounting
for observed fluctuations in economic activity and employment. We shall argue that
there exists a great deal of evidence in support of the view that marginal costs rise
more than prices in economic expansions, especially late in expansions. Thus real
marginal cost (MC/P) rises, for the typical firm; and alternatively, the markup of
price over marginal cost (which we shall define as the ratio P/MC 1) declines for the
typical firm. These two ways of describing the feature of business cycles with which
we are concerned are equivalent in the case of a symmetric equilibrium (in which
the costs, output and prices of all goods move exactly together), though they are not
equivalent propositions regarding an individual firm or industry in the asymmetric
case (since the firm's or industry's relative price may vary). Because of our concern
with the explanation of fluctuations in aggregate activity, and because such aggregate
fluctuations are characterized by a striking degree of comovement among sectors, we
will mainly conduct our analysis in terms of a symmetric (aggregative) model, and treat
procyclical movements in real marginal cost as equivalent to countercyclical markup
variations. Discussion of the cyclicality of real marginal cost is most natural when one
is discussing measurement (since the crucial measurement issue is to infer the level of
marginal costs), and so this is how the issue is framed in many empirical studies [such
as Bils (1987) and Bils and Kahn (1996)]. But when we turn to theoretical explanation,
it is most useful to describe the phenomenon in terms of variation in firms' markups,
because the crucial decisions responsible for the phenomenon are firms' decisions
about the prices at which they are willing to supply their products. In fact, in a broad
class of models discussed below, the cyclicality of real marginal costs in equilibrium
turns not upon the nature o f the production technology or the conditions under which
firms can obtain factors of production, but upon the nature of the competition among
firms in their product markets; and so, from an analytical point of view, it seems most
important to emphasize variation in markups.
The observation that costs rise more than do prices, at least late in expansions, is
not a new one. It was emphasized in the work of Wesley Clair Mitchell, for example,
who writes (1941, p. 52) that as activity expands, "equipment of less than standard
efficiency is brought back into use; the price of labor rises while its efficiency falls;
the cost of materials, supplies and wares for resale advances faster than selling prices;
discount rates go up at an especially rapid pace, and all the little wastes incidental to the
conduct of business enterprises grow steadily larger." That real marginal costs should
rise for such reasons is, of course, a simple consequence of the fact that factors of
production are not in unlimited supply. But, as Mitchell notes, from the point of view of

1 Many authors instead define the "markup" or "price-cost margin" as (P- MC)/P. The two quantities
are obviouslymonotonic transformations of one another.

I054

JJ Rotembergand M. WoodJord

theory "a problem still remains: Why cannot businessmen defend their profit margins
against the threatened encroachment of costs by marking up their selling prices?" As
we shall see, a variety of theories of imperfectly competitive behavior by firms explain
why they may choose not to do so. Such imperfectly competitive behavior thus plays
an important role in accounting for the character of aggregate fluctuations.
Fluctuations in markups are an important factor, in our view, for a reason somewhat
different than that emphasized by Mitchell. In Mitchell's analysis, the squeezing of
profit margins late in booms is what brings the boom to an end, as reduced profitability
dampens investment demand and hence sales. This suggests that an improvement in
firms' power to set prices above marginal cost would extend the boom. But this neglects
the fact that firms cannot all raise their relative prices. Let the marginal cost of each
firm i be given by Pc(yi), where Yi is the quantity supplied and P is the general price
level. (Marginal costs are proportional to the general price level because the variable
factors of production are supplied at relative prices that depend upon the quantity
demanded of those factors.) Let us suppose furthermore that c(y) is an increasing
fimction, for the sort of reasons cited by Mitchell. Then an increase in the quantity
supplied by industry i, if not associated with any shift in the marginal cost schedule,
wilt be associated with an increase in marginal cost. In the case of an individual firm
or industry, this need not be associated with any change in markups; it might simply
be associated with an increase in the relative price P i / P 2.
But if we consider a uniform increase in the quantity produced by each sector, all
relative prices Pi/P would have to increase by the same amount and this is not possible.
In fact, in a symmetric equilibrium, one must have

1
-

c(Y),

(1.1)

where Y is the common (and hence aggregate) level of output, and/~ the common
(and hence average) markup. It follows from Equation (1.1) that an increase in output
Y is possible only insofar as either the real marginal cost schedule c shifts, or the
markup falls. If firms allow their markups to decline, this will mean a higher level of
equilibrium output than would otherwise be possible, given the current real marginal
cost schedule. Thus if markups decline in the later stages of economic expansions, as
Mitchell argues, this is not something that brings the expansion to an end; rather, it
makes the expansion stronger (and possibly more prolonged) than is justified by cost
conditions alone 3.
Equation (1.1) suggests that a useful question about fluctuations in aggregate activity
is to ask to what extent they result from variations in average markups, as opposed
2 For example, in the case of a competitive industry, the industry supply curve is simply given by
Pi - Pc(Fi). An increase in industry demand results in a movement up this curve, to a higher relative

price as well as higher output.

3 This view of the role of markup variations in accounting for aggregate fluctuations is also one with
a long history; two early proponents were Robinson (1932) and Kalecki (1938).

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1055

to shifts in the real marginal cost schedule of the typical firm. A related question
that has received more attention in the literature is the extent to which the historical
record actually suggests that markups were indeed low when output was high. This
question is related to the first because, if the data suggested that markups were constant
(or procyclical), independent movements in markups could not possibly account for
a significant portion o f output fluctuations. Thus, our survey o f empirical evidence
starts in Section 2 with the simpler question of the extent to which measured markups
are countercyclical. Since marginal cost cannot be measured directly, all o f these
measures are indirect and rely on theories o f the cost function facing individual firms.
Once one has made these assumptions, however, one need only make a few additional
suppositions to obtain an estimate o f the derivative of the function c with respect to Y.
This then allows one to infer the output fluctuations induced by changes in measured
markups. The result is that one obtains a decomposition of output in terms o f output
movements due to markup changes and output movements due to shifts in the marginal
cost schedule. We consider this decomposition in Section 3.
Section 4 is devoted to a brief survey o f models o f variable markups 4. The above
decomposition makes it clear that these models can serve two separate purposes. First,
they can affect the extent to which shifts in the marginal cost schedule affect output.
If, for example, reductions in marginal cost lower markups, their effect on output is
magnified. What is perhaps more interesting still is that these theories allow shocks
other than shocks to the marginal cost schedule to affect output as long as these
shocks affect markups. In particular, allowing for endogenous markup variations adds
a channel through which demand disturbances may affect output and employment.
This does not mean that the part of output variations that is due to shifts in the
real MC schedule is due to "supply shocks", and the part due to markup variations
with the part due to "demand shocks". There are various ways in which demand
disturbances might, in principle, shift the real MC schedule 5. Similarly, as we have
already mentioned, the models of endogenous markup variation discussed below imply
that "supply shocks" as well as "demand shocks" may cause markups to vary. For
example, in Rotemberg and Woodford (1996b) it is shown how an endogenous increase
in markups following an oil price increase can increase the contractionary impact o f
such a shock, even though the oil shock would also contract output (by shifting up the
real MC schedule) to a lesser extent in a perfectly competitive model.

4 See Rotemberg and Woodfurd (1995) for further discussion of several of the leading models, with
greater attention to the structure of general equilibrium models incorporating these mechanisms, and to
issues such as calibration and numerical solution of such models.
5 Well-knownproposals include nominal wage rigidity, as in Keynes (1936), as a result of which inflation
lowers the real wage and hence real marginal cost; and variations in the household labor supply schedule
due to wealth effects and intertemporal substitution effects, as in Barro's (1981) analysis of the effects
of government purchases. Evaluation of their importance is beyond the scope of this survey, though it
is important to remember that these proposals require that real wages fall (by as much as the marginal
product of labor) for output to expand.

1056

J.J. Rotemberg and M. WoodJbrd

An objection to the usefulness of this decomposition might be that the validity of

Equation (1.1) does not itself imply that output variations are usefully "explained" by
the markup variations that occur at the same time. One might view the markup as
simply the ratio of two quantities (P and M C ) that are each determined by other (and
relatively independent) factors, including output, the causal determination of which
must be understood in other ways. Such a view is possible if one views prices as
evolving without reference to marginal costs (perhaps according a "Phillips curve"
relation that makes the rate of price change a function of the level of real activity),
and output as determined by demand given the current level of prices. In this case,
markups might covary systematically with output [because of Equation (1.1)], but this
would be irrelevant for output determination. Such a crude view, however, is difficult
to take seriously. While we believe that nominal price stickiness plays a role, at least in
short-run fluctuations in activity - and this is one of the reasons for markup variation
taken up in Section 4 below - it is not plausible that the level of marginal costs should
not be a crucial determinant of the evolution of prices. If a firm's price is expected to
remain fixed for a period of time, then the price chosen will depend not solely upon the
current level of marginal cost, but upon (loosely speaking) the average of the expected
levels of marginal cost over the entire period for which the price will be fixed. As a
consequence, the rate of inflation (and expectations regarding future inflation) will be
one of its determinants, as is explained further in Section 4.1 below. In such a model,
the connection between inflation and real activity (i.e., the aggregate supply relation)
can be usefully understood as resulting from the relation between inflation and the
average markup, onthe one hand, and the relationship between the markup and output
determination indicated by Equation (1.1) 6.
Furthermore, it does not seem that nominal rigidities alone can account for all
markup variations. First, some of these variations appear not to be related to inflation
in the way that can be accounted for by the simple hypothesis of prices remaining
fixed for a time. For example, Rotemberg and Woodford (1996b) find that markups
rise following an oil shock; but such shocks have also been associated with increases
rather than decreases in inflation, so that slowness of prices to adjust to changes
in nominal marginal costs might be expected to shrink markups, rather than raising
them. And second, the very slowness of prices to adjust to changes in marginal costs
(following, say, a loosening of monetary policy) is more easily explained if one posits
that decreases in desired markups (i.e., the ratio between price and marginal cost
that would be chosen in the absence of the nominal price rigidity) coincide with
declines in the ratio of actual to desired prices (due to slow price adjustment). If
desired markups decline endogenously at times of temporarily high output, this "real
rigidity" will amplify the effects of nominal rigidities, so that nominal disturbances
have both larger and more persistent real effects. For both reasons, it would seem that

6 The crucial role of markup variations in explainingthe real effects of purely nominal disturbances is
stressed in particular by Kimball (1995).

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1057

variations in desired markups - and not simply variations in markups resulting from a
discrepancy between actual and desired prices - are of some importance in accounting
for aggregate fluctuations. A consideration of the determinants of desired markups is
therefore required.
Our survey proceeds as follows. In the next section, we discuss the evidence on
cyclical variation in markups. Most of the evidence reviewed relates the slightly
procyclical behavior of real wages to cyclical movements in the marginal product o f
labor. The key issue in Sections 2.1 and 2.2 is whether, as a result of technical progress,
the marginal product of labor is as procyclical as real wages. While the marginal
product of labor cannot be measured directly, we provide a number of reasons to believe
that it is substantially more countercyclical than the relevant real wage so that, indeed,
markups are countercyclical. In Section 2.3 we consider measures of markup variation
that are not based on wage variations; these involve cyclical variations in the use of
intermediate inputs and in inventory accumulation. We then proceed to study responses
of markups to particular shocks. Insofar as we are able to identify nontechnological
disturbances, the analysis of markup changes is considerably simplified because we
do not have to worry about the effect of technical progress on the real marginal cost
schedule. Section 2 closes with an analysis of the differences in markup variations
across industries.
Section 3 then turns to the consequences of markup variations for macroeconomic
variables of interest. First we deal with the effect of markup changes on productivity
and profits. We show that, under a variety of circumstances, increases in output that are
caused by reductions in markups are associated with increases in profits and measured
productivity. Since both productivity and profits are known to be procyclical, this is
important in making sure that it is not implausible for changes in markups to be behind
movements in output. Section 3 concludes with a method for decomposing output
movements into those caused by shifts in the marginal cost schedule and movements
due to markup changes (which induce movements along particular marginal cost
curves). Section 4 is devoted to a survey of theories of markup variation, and Section 5
concludes.

2. The cyclical behavior of markups

In this section, we discuss empirical evidence regarding variation in markups over the
business cycle. The main challenge in constructing measures of markup variation is
to find suitable measures of marginal cost; and for this reason, it will often be useful
to think, equivalently, of how one should measure cyclical variations in real marginal
cost 7. It is not easy to obtain measures of marginal cost of which one can be certain.

7 Note, however,that the studies of individual industries discussed in Section 2.4 do attemptto measure
industry markups, rather than levels of real marginal cost.

1058

J.J. Rotemberg and M. Woodford

Nonetheless, a variety o f considerations may be offered, several o f which provide

support for the view that real marginal costs are procyclical, and hence that markups
are countercyclical in the typical sector. I f so, this implies that markup variations play
a role in causing or at least amplifying cyclical fluctuations in economic activity.

2.1. Cyclical behavior o f the labor share

The most common measures o f marginal cost in the literature consider the cost o f
increasing output through an increase in the labor input, holding fixed other inputs.
(Measures o f marginal cost deriving from variation o f production decisions along other
margins are considered in Section 2.7 below. Note that if firms are minimizing cost,
the measure o f marginal cost obtained by considering each possible margin should be
the same, so that it suffices to consider one.) If output is a differentiable function o f the
labor input, and firms are wage-takers, then marginal cost is equal to the wage divided
by the marginal product o f labor. If we assume an aggregate production function o f
the form

Y = F ( K , zH),

(2.1)

where K is the capital stock, H the number o f hours worked, and z an index o f laboraugmenting technical progress, then the markup o f price over marginal cost # is given
by 8

PZFH(K, zH)
/~ -

(2.2)

This equation provides an approach to the measurement of markup (or real marginal
cost) variations. It also highlights two reasons for the real marginal cost schedule
referred to in Section 1 to be upward-sloping. The first is that, holding constant other
determinants o f labor supply, the real wage must presumably rise to induce more people
to work. The second is that, if one makes the standard assumption that the production
function F is concave and one fixes both the capital stock and the state of technology z,
the marginal product FH is a decreasing function o f the labor input.
Whether or not typical increases in employment are in fact associated with markup
declines depends, however, upon whether they are associated with increases in K or z,
or decreases in the real wage W/P, sufficient to offset the effects o f the increase in the
labor input on FH. In general, real wages do not move countercyclically, and in fact,
there is clearlyprocyelical variation in the real wages received by individuals, once one
corrects for cyclical variation in the composition o f the workforce 9. This is the famous

8 Here and below, we use the notation FH to mean the partial derivative ofF with respect to its second
argument, the effective labor input zH, rather than with respect to H.
9 Kydland and Prescott (1988); Solon et al. (1994). This is not true of all industry wages, however. See
Chirinko (1980), Rotemberg and Saloner (1986) and Solon et al. (1994). For a review of this issue, see
Abraham and Haltiwanger (1995).

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1059

criticism raised by Dunlop (1938) and Tarshis (1939) against the theory of aggregate
supply of Keynes (1936), which is essentially just Equation (2.2), under the assumption
of constant technology and a markup equal to one. Keynes (1939) recognized the
appeal of a hypothesis of countercyclical markup variation as a resolution of the puzzle,
which is the interpretation that we propose.
An alternative explanation, of course, is that real wages are procyclical because
fluctuations in activity are caused by variations in technical progress. [Real business
cycle models are sometimes criticized for predicting real wage movements that are t o o
procyclical, so that Kydland and Prescott (1988) take their findings as support for the
technology-shock hypothesis.] The need to correct for possible variations in the rate
of technical progress means that one needs to measure the variation in both the labor
input and in the quantity produced. The required calculation is especially simple if,
following Bils (1987), we specialize the production function (2.1) to the case
Y = g ( K ) ( z H ) a,

(2.3)

where g is a positive increasing function, and a > 0. Marginal cost is then W H / a Y ,

so that the markup is given by
kt = a S H l ,

(2.4)

where SH is the labor share W H / P Y . Under these assumptions, markup variations are
simply the inverse of the variations observed in the labor share. In the case of a
Cobb-Douglas production function (or the slightly more general form assumed above),
marginal cost is proportional to average labor cost so that a valid measure of markup
variations is given by fluctuations in the ratio of price to "unit labor cost" W H / Y - a
measure of variations in price-cost margins often referred to in empirical studies of
business cycles such as those of Moore (1983)10.
We first consider the evidence regarding cyclical variation in this simple measure.
The price P with which firms are concerned is the price they receive for their products.
This means that the relevant labor share is not the ratio of labor compensation to
the value of output conventionally measured in national income accounts, but rather
the ratio to the revenue received by firms, which equals the value of output minus
indirect taxes 11. We consider cyclical variation in three different measures of this
labor share, for the whole economy, the corporate sector and the nonfinancial corporate
sector respectively. The first of these measures is less satisfactory than the others for
two reasons. First, it includes the government, many of whose services are not sold
in markets. Second, it includes income of proprietors in the denominator, and this

10 The ratio of price to unit labor cost is also used as an empirical proxy for the markup in studies such
as Phelps (1994).
11 The denominator is thus obtained by adding depreciation (the difference between GNP and NNP) to
the conventional concept of "national income".

1060

J.J Rotemberg and M. Woodford

0.68

La

0.66

Nonfinancial

/~ v\/~ A

crpirate,
0.64
0.62

- 0.78

Overall

/[~j/!^<2~i ~

'

-I~,

k4,

~2 -C "4

,~

- 0.76

~ A.

~-~J'-~.~,

,:7

"

%,/j

,'.',

,, ~

v"

v.,'

v~',

0,74

- 0~72

0.60

- 0.70

0.58

- 0.68
Corporate

0.56

- 0.66
50

55

60

65

70

75

80

85

90

Fig. 1. The evolution of various labor shares.

contains an element of compensation as well. The use of the narrower measures of the
labor share eliminates both of these problems. Nonetheless, we include some statistics
relating to the overall labor share as well, for comparability with other studies.
Figure 1 plots these three series for the period 1947:1 to 1993:1 12. For future
reference, the figure also plots the Hodrick-Prescott trend in the labor share for the
nonfinancial corporate sector. The figure reveals that the labor share in the corporate
sector is essentially identical to the labor share in the nonfinancial segment. On the
other hand, the overall labor share deviates from the other two shares in the early
1960s and remains above them from then on. All three series show large increases in
the late 1960s. Particularly for the labor share corresponding to the whole economy,
this appears to represent a structural break that cannot be regarded as an example of
business-cycle variation in the series. Hence in considering the cyclical behavior of
the series, we also considered a sample that begins only in 1970.
We next wish to relate the movements in one or another of these labor shares to
those of a variable that measures the business cycle. One attempt to do so is provided
in Figure 2, which plots the labor share in the nonfinancial corporate business sector
against the NBER recessions. For each of these recessions, the first line in Figure 2
represents a business cycle peak while the second represents the trough. At first glance,
this picture might suggest that the labor share is countercyclical because the labor share
series tends to have a local maximum between peaks and troughs. But, it is important

t2 Our sample stops in 1993 because, at the time these calculations were made, the pre-1960 data were
not comparable to the more recent revised NIPA data. The results from 1970 onwards were the same
for the two data sets, however.

Ch. 16:

The Cyclical Behauior o f Prices and Costs

0.78-

0.76 -

1061

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50

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85

F i g . 2. L a b o r s h a r e i n n o n f i n a n c i a l c o r p o r a t e s e c t o r a n d N B E R

90
recessions.

to remember that, for the labor share to be perfectly procyclical, its peaks ought to
be aligned with the business cycle peaks themselves. The labor share ought then to
decline between peak and trough and then increase during the recovery that takes place
after the trough. It is this latest implication of a procyclical labor share that is closest
to being true, as the labor share increases in the recoveries after the 1954, 1974 and
1982 recessions.
The actual correlation between the change in the labor share and a dummy variable
that takes the value of one between peaks and troughs and a value of zero otherwise
is 0.17, which suggests, albeit very weakly, that the labor share rises when output is
declining. However, the correlation between the labor share and the two quarter lagged
value of this dummy variable is -0.28. Thus, as the plot itself suggests, the labor share
tends to rise late in expansions and to fall late in recessions. This basic pattern: a
weak slightly negative relation between the labor share and contemporaneous cyclical
indicators and a much stronger positive relation between the labor share and slightly
lagged indicators of cyclical activity is what comes out of a more formal analysis as
well.
For this slightly more formal statistical analysis, we considered four indicators of
the business cycle. A popular indicator of this sort is obtained by detrending real GDP
using the Hodrick-Prescott filter and then using this detrended series to be a measure
of the business cycle. This is, however, a rather arbitrary procedure (since there is no
obvious reason to choose one value rather than another of the weighting parameter that

1062

J J Rotemberg and M. Woodford

determines the degree to which the trend is smoothed) 13. An alternative that we find
appealing is to follow Beveridge and Nelson (1981) and equate the "cyclical" level of
GDP at time t with the expected decline in GDP from time t onwards. This captures the
intuitive idea that cyclical movements are temporary, so that a cyclically low level of
output corresponds to a high expected rate of growth of output. The difficulty with this
approach is that it only becomes meaningful when one specifies an information set that
can be used to forecast GDP growth. Following on the steps of an extensive literature,
Rotemberg and Woodford (1996a) show that the linearly detrended level of hours spent
working in nonagricultural establishments and the ratio of consumer expenditures on
nondurables and services to GDP are particularly useful in this respect.
A simpler cyclical indicator is the linearly detrended level of hours worked. We
prefer to linearly detrend hours rather than GDR since once a trend is included in the
regression, the Dickey-Fuller test strongly rejects the hypothesis that the logarithm
of hours worked in non-agricultural establishments has a unit root. This measure of
detrended hours is in fact one of the main components of the Rotemberg-Woodford
measure of forecastable output movements; low levels of hours worked (which are
closely related to high unemployment), imply that output can be expected to grow and
are thus a good indicator of recessions. For purposes of comparison, we also consider
an hours series that has been detrended using the Hodrick-Prescott filter.
The first three rows of Table 1 report correlations of our three measures of the
labor share with the various cyclical indicators, over the sample period 1947:1 through
1993:1. The first column shows correlations with the predicted declines in output
over 12 quarters considered in Rotemberg and Woodford (1996a), the second column
shows the correlations with the Hodrick-Prescott filtered level of output, the third
column uses linearly detrended hours while the last uses the hours series detrended
using the H - P filter. Except the correlations with linearly detrended hours (which are
small and positive), the other correlations are small and negative; suggesting weak
countercyclical movements in the labor share.
These results are consistent with Boldrin and Horvath (1995), Gomme and
Greenwood (1995) and Ambler and Cardia (1998) who also report negative correlations
of the labor share with output. The correlations they report are larger in absolute
magnitude because they use the H - P filter to detrend the labor share as well as to
detrend output. Using the H - P filter to detrend the labor share seems problematic,
however, because the large movements at relatively high frequencies of the resulting
"trend" displayed in Figure 1 are difficult to interpret 14.
The last twelve rows of Table 1 report the correlations of the labor share in the
nonfinancial corporate sector with leads and lags of the four cyclical indicators. The
correlations with the lags are uniformly positive and attain their biggest value when the

13 For further discussion of the properties of this filter, see King and Rebelo (1993).
14 We also considered labor shares detrended with a linear trend. This had only a negligible effect on
our results.

Ch. 16:

The Cyclical Behavior of Prices and Costs

1063

Table 1
Correlations of selected variables with cyclical indicators a
Predicted declines
in GDP

H-P filtered
GDP

Linearly
detrended hours

H-P filtered
hours

Share of compensation in after indirect tax gross product

Long sample
Overall

-0.070

0.095

0.055

-0.023

Corporate

-0.080

-0.188

0.031

-0.044

Nonf. Corp.

-0.014

-0.158

0.072

-0.014

Private

-0.009

-0.192

0.178

-0.192

Overall

-0.230

-0.403

-0.189

-0.015

Corporate

-0.077

-0.273

-0.010

0.064

0.066

-0.169

0.103

0.184

-0.334

-0.466

-0.293

-0.156

Sample: 1969:1-1993:1

Nonf. Corp.
Private

Correlation of private labor share with leads and lags of cyclical indicator
Lead six quarters

-0.437

-0.108

-0.218

-0.136

Lead five quarters

-0.521

Lead four quarters

-0.579

-0.176

-0.312

-0.211

-0.270

-0.406

Lead three quarters

-0.276

-0.5828

-0.360

-0.461

-0.314

Lead two quarters

-0.564

-0.429

-0.454

-0.304

Lead one quarters

-0.509

-0.477

-0.407

-0.256

Lagged one quarter

-0.157

-0.283

-0.100

0.015

Lagged two quarters

0.026

0.110

0.063

0.162

Lagged three quarters

0.075

0.023

0.180

0.270

Lagged four quarters

0.149

0.138

0.258

0.346

Lagged five quarters

0.177

0.194

0.303

0.388

Lagged six quarters

0.213

0.222

0.317

0.406

aThe long sample for all correlations except those involving either the labor share in the private sector
or predicted declines in private GDP is 1947:1 to 1993:1. The sample for the correlations involving
the labor share in the private sector starts in 1952:1. That for the correlations of predicted output
declines with the other labor share starts in 1948:3 because these predicted declines are drawn from
Rotemberg and Woodford (1996a). The correlations with leads and lags of output are based on data
from 1969:1 to 1993:1.

1064

J.J. Rotemberg and M. Woodford

cyclical indicator is lagged four quarters. Thus a high level of activity is associated with
subsequent increases in the labor share. Interestingly, this result also extends to the case
where we study the cross-correlogram of H-P filtered output and the H-P filtered labor
share. The correlations of the labor share with the leads of our cyclical indicators are
uniformly negative. This means that the labor share peaks before the peak in hours.
2.2. Corrections to the labor-share measure o f real marginal cost
While the labor share (or equivalently, the ratio of price to unit labor cost) is a familiar
and easily interpretable statistic, it represents a valid measure of markup variations only
under relatively special assumptions. In this section, we briefly discuss a number of
corrections to this measure that would arguably be required to obtain a more realistic
measure of real marginal cost. As we shall see, several of these corrections imply that
real marginal cost is more procyclical than the labor share. For any of several reasons,
then, the measurements discussed above may understate the degree to which cyclical
variations in output and employment are due to markup variations as opposed to shifts
in the real marginal cost schedule. We take the possible corrections up in sequence.
2.2.1. A non-Cobb-Douglas production function
Suppose that the aggregate production function is of the general form (2.1), but that
F is not necessarily of the Cobb-Douglas form [or, more precisely, isoelastic in the
labor input, as in Equation (2.3)]. Equation (2.2) can still equivalently be written
# = t/Hs~1,

(2.5)

where t/H --= zHFH(K, zH)/F(K, zH) is the elasticity of output with respect to the
(effective) labor input. [Equation (2.5) reduces to (2.4) in the case of a constant
elasticity.]
The effect of the additional variable factor in Equation (2.5) depends upon the nature
of cyclical variations, if any, in the elasticity of output with respect to the labor input.
In the case that F exhibits constant returns to scale, the elasticity t/H can be expressed
as a function of the effective labor-to-capital ratio, zH/K, or equivalently as a function
of the output-to-capital ratio:
t/~q = t/H(y),

(2.6)

where y - Y/K. In the case that the elasticity of substitution between capital
and (effective) labor inputs is less than one, the function t/H(y) is monotonically
decreasing. This would seem the most likely direction of deviation from the CobbDouglas case (a constant elasticity of substitution exactly equal to one), as the CobbDouglas specification is widely regarded as a reasonable representation of long-run
substitution opportunities, whereas short-run factor substitutability (which is relevant

Ch. 16." The Cyclical Behavior o f Prices and Costs

1065

for the present calculation) might well be less (for example, because technology is
"putty-clay"). In this case, because y is a procyclical variable (this follows directly from
the fact that the capital stock evolves slowly relative to the length of business-cycle
fluctuations), Equation (2.6) implies that the additional factor t/H in Equation (2.5)
imparts additional countercyclical variation to the implied markup series, roughly
coincident with the cyclical component of output or hours. A correction of this kind
thus leads to the conclusion that markups fall more in booms than is suggested by the
simple labor share measure, and that markup declines coincide more closely in time
with increases in output and hours.
The size of this correction can be quantified as follows. Assuming constant returns
to scale, the elasticity of t/H with respect to y is given by a - (1 - e K 1 ) ( r ] H 1 - - 1), where
c ~ is the (Hicks-Allen) elasticity of substitution between capital and labor inputs. A
log-linear approximation to the markup series implied by Equation (2.5) is then given

by
= @ - s~4,

(2.7)

where hats denote deviations of the logarithm of a stationary variable from its average
value. A quantitative estimate of the elasticity a requires values for exH and for the
average value of OH (i.e., the value of this elasticity in the case of the "steady-state"
factor ratio arotmd which one considers perturbations). Using Equation (2.5), the latter
parameter may be calibrated from the average labor share, given an estimate of the
average markup, resulting in a = (1 - e~q)(l~-lsTi 1 - 1). (In this last expression, all
symbols refer to the average or steady-state values of the variables.) With a markup
kt near one, a labor share of 0.7 and an elasticity o f substitution eK~ of 0.5, this
formula gives a value of a equal to -0.4. Table 2 reports the resulting correlations
between fi and predicted declines in GDP for markups based on both the nonfinancial
corporate and the private labor shares. Not surprisingly, markups are now much
more cotmtercyclical. However, the contemporaneous correlation of the markup with
detrended output is still smaller in absolute value than the correlation with lagged
output. Also, as in the case where we do not adjust the labor share, the correlations with
leads of output are greater than the contemporaneous correlation. These are actually
positive for output led more than 3 quarters 15.
2.2.2.

Overhead

labor

In deriving Equations (2.5)-(2.7), we assume constant returns to scale. An important

reason why this may be inaccurate is the presence of overhead costs. Particularly
relevant to the above calculations would be the existence of overhead labor. Suppose

15 As is true of all the results of Table 2, similar results obtain when we use detrended hours as our
cyclical indicator.

JJ. Rotembergand M. Woodford

1066

Table 2
Correlation of markup based on private labor share with leads and lags of expected declines in GDP a
a = -0.4,
b,c:0

b - -0.4,
a,c=0

c = 4,
a,b=0

c = 8,
a,b=0

Lead six quarters

0.355

0.370

0.136

-0.058

Lead five quarters

0.323

0.342

0.067

-0.169

Lead four quarters

0.256

0.289

0.048

-0.316

Lead three quarters

0.135

0.189

-0.203

-0.478

Lead two quarters

-0.001

0.075

-0.321

-0.594

Lead one quarters

-0.163

-0.050

-0.418

-0.670

Contemporaneous

-0.402

-0.212

-0.372

-0.542

Lagged one quarter

-0.504

-0.312

-0.235

-0.319

Lagged two quarters

-0.522

-0.344

-0.162

-0.181

Lagged three quarters

-0.503

-0.337

-0.124

-0.095

Lagged four quarters

-0.451

-0.301

-0.066

-0.001

Lagged five quarters

-0.355

-0.226

-0.003

0.079

Lagged six quarters

-0.278

-0.164

0.011

0.110

a Markup is based on Equations (2.14) and (2.15) and uses the labor share in the nonfinancial corporate
business sector.
that e a c h f i r m ' s p r o d u c t i o n f u n c t i o n 16 is o f t h e f o r m Y = F(K, z ( H - / z / ) ) , w h e r e F
is h o m o g e n e o u s o f d e g r e e o n e as b e f o r e , a n d f / ~> 0 r e p r e s e n t s " o v e r h e a d l a b o r "
that m u s t b e h i r e d r e g a r d l e s s o f the q u a n t i t y o f o u t p u t that is p r o d u c e d . N o t e that
a n o v e r h e a d l a b o r r e q u i r e m e n t i m p l i e s i n c r e a s i n g r e t u r n s ( a v e r a g e cost e x c e e d i n g
m a r g i n a l cost), a l t h o u g h m a r g i n a l cost r e m a i n s i n d e p e n d e n t o f scale 17.

16 Once we depart from the assumption of constant returns to scale, it is important to distinguish between
firm production functions and the relation that exists between aggregate inputs and outputs. We now
assume that each firm is the sole producer of a differentiated good, so that the overhead costs cannot be
reduced by simply concentrating all production in a single firm. In a symmetric equilibrium, where the
same quantity is produced of each good using the same factor inputs, then this equation also indicates
the relation that exists among aggregate output and aggregate factor demands.
17 There are other ways of modeling increasing returns. In particular, one might suppose that marginal
cost declines with output; an econometric specification of this kind is estimated, for example, by Chirinko
and Fazzari (1994). The notion that marginal cost declines with output is problematic, however. For many
firms, increasing output involves an increase in either the number of machines that are employed or an
increase in the number of hours for which a given number of machines are used. Both of these seem
inconsistent with declining marginal cost since more efficient machines would presumably be used first.
More generally, firms whose technology has a declining marginal cost over some range would benefit by
bunching production so that their plants are idle some of the time, and output, when positive, is always
at a level sufficiently large that marginal cost is not declining in output.

Ch. 16:

The Cyclical Behavior of Prices and Costs

1067

Replacing Equation (2.1) by this, implies that Equation (2.5) should become instead

where t;H now refers to the elasticity of output with respect to the effective nonoverhead labor input. Under this definition, ~,/ is again constant in the case that
F takes the Cobb-Douglas form, and countercyclical if the elasticity o f substitution
between capital and labor is less than one. The new factor in Equation (2.8), H--~' is a
monotonically decreasing function of H i f / 7 / > 018. Allowing for overhead labor thus
provides a further reason to regard markups as more countercyclical than is indicated
by the labor share alone. A similar conclusion is reached if one assumes fixed costs
in production that do not take the form of overhead labor alone, e.g., if one assumes
a production function o f the form
Y= F(K, zH)

45,

where q5 > 0 represents the fixed costs of operation.

The consequences of this correction can be quantified as follows. The elasticity o f
the factor ~
with respect to H is given by b - -so~(1 - So), where So is the average
or steady-state value o f H / H , the share o f overhead labor in the total labor input.
Equation (2.7) may then be generalized to yield
fi = @ + b / 2 / - s ~ .

(2.9)

The elasticity b is obviously non-positive. Its size depends on the average fraction o f
labor which constitutes overhead labor. A useful bound on this can be obtained by
relating So to the degree o f returns to scale. Let the index o f returns to scale p be
defined as the ratio of average cost to marginal cost o f production. Measured at the
steady-state factor inputs, one obtains
p = 1 + t//4
so that instead o f calibrating So, one may equivalently calibrate p. In terms of this
parameter, we obtain t/H = #sH -- (p -- 1) for the steady-state elasticity o f output with
respect to non-overhead labor, and b = - ( / 9 - 1)/[#SH -- (p -- 1)].
It is easily seen that one must have p ~< #, in order for there to exist non-negative
profits in the steady state. This allows one to bound the possible size o f the elasticity

18 Here we assume that the overhead labor requirement is acyclical. This depends upon an assumption
that entry of either firms or plants is slow, as in Rotemberg and Woodford (1995) and Ambler and Cardia
(1998), and so can be neglected at business cycle frequencies. The consequences of variable entry are
considered further below, in Section 3.

1068

J J Rotemberg and M. Woodford

b, given an estimate o f the average markup. On the other hand, the same consideration
provides a reason for supposing that overhead costs are non-negligible, if one believes
that prices do exceed marginal cost on average. For with constant returns to scale,
prices higher than marginal cost would imply the existence of pure profits (in addition
to the competitive return to capital); for example, a markup o f 25% (bt = 1.25) would
imply that pure profits should make up 20% o f total revenues. This is rather large given
the scant evidence for the existence o f pure profits in US industry. Indeed, Hall (1988)
finds (using stock market re~rns to construct a user cost for capital) that pure profits
in US industry are close to zero. It furthermore makes sense that profits should be zero
in the steady state, due to entry, which one should expect to eliminate persistent profits
in the long run, even if entry does not respond quickly enough to eliminate cyclical
fluctuations in profits. If we assume this, we can impose p =/~, so that there is only
a single parameter to calibrate, that describes both the degree o f returns to scale and
the degree o f market power. With # = 1.25 and a labor share o f 0.7, the parameter b
is then -0.4. Table 2 shows that, even letting a equal zero, such a value o f b leads to
markups that are strongly countercyclical though the correlations with lagged output
remain higher in absolute value 19.
The significance that one attaches to such findings obviously depends upon the size
of the average markup (or degree o f returns to scale) that one is willing to assume.
Here it is worth remarking that a value of ~ equal to 1.6 need not mean that any
individual firm marks up its costs by 60%. The reason for this is that firms do not
just mark up their labor costs but also their materials cost. To see what this implies
about the markup, suppose that, as in Rotemberg and Woodford (1995), materials are a
fixed proportion SM o f aggregate output while value added constitutes only a fraction
(1 - S M ) o f total costs. The marginal cost o f producing one unit o f gross output is
then
(1 - sM) W

zFH

q- SM,

and the markup o f the price o f gross output over total marginal cost ktc is given by
1

btGO

- (1

1
--SM)~
+SM,

(2.10)

where tt vA is the "value-added markup" that satisfies Equation (2.2). If the materials
share equals 0.6 (as is typical of US manufacturing), then a/~vA o f 1.6 [the "baseline
19 Rotemberg and Woodford (1991) use a variant of this method to construct series for markup changes
using aggregate US data. Assuming an average markup of 1.6 and an elasticity of substitution equal to 1
(their baseline case), they find that markups fall by about 1% when hours increase by 1%. The constructed
markup series is also strongly negatively correlated with fluctuations in aggregate hours worked. Portier
(1995) uses the same method on French data, and assumes an average markup of 1.373 and an elasticity
of substitution equal to 1. His estimates imply that a 1% increase in GDP is associated with about a
1.5% reduction in markups. Thus markups would appear to be more countercycliealfor France (a finding
that is especially striking given the lower assumed returns to scale).

Ch. 16: The Cyclical Behavior of Prices and Costs

1069

case" o f Rotemberg and Woodford (1991)] requires that the typicalfirm "s price be only
18% higher than its marginal cost.
A related correction would assume, instead o f overhead labor, a "setup cost" for each
employee, as is considered in Basu and Kimball (1997). Suppose that the production
function is Y = F ( K , z(h - h)N)), where now N represents the number of employees
and h the number of hours worked by each. We again assume that F is homogeneous o f
degree one; the "set-up cost" h > 0 represents a sort o f per-employee fixed cost. (The
observed preference for full-time employees observed in many lines o f work makes
the existence o f such costs plausible 20.) If we consider the marginal cost of increasing
output solely on the employment margin (holding fixed hours per week), we again
obtain Equation (2.8), but with H and { / r e p l a c e d by h and h in the first factor. We
correspondingly again obtain Equation (2.9), but with if/replaced by h. Since hours
per employee are also a strongly procyclical variable, the first factor in Equation (2.8)
is again a source of further countercyclical movement in implied markups. Basu and
Kimball suggest that So = 0.25 should be an upper bound on the importance of such
set-up costs (as full-time wage premia should otherwise be larger); but this value would
still allow the elasticity in Equation (2.9) to be as large as b = -0.3.
2.2.3. Marginal wage not equal to the average

Thus far, we have assumed wage-taking behavior on the part o f firms, meaning that
they regard themselves as being able to hire additional hours o f work, at the margin, at
a wage which is also the wage paid for each o f the hours that they do hire - so that the
relevant marginal wage is also the average wage that is paid. Suppose, however, that
this is not true, and that the firm's wage bill is W ( H ) , a function that is increasing, but
not necessarily linear in H 2~. In this case, marginal cost depends upon the marginal
wage, W t ( H ) , so that Equation (2.5) becomes
# = 09-1 tlHS~i1,

(2.1 1)

where o) = H W t ( H ) / W ( H ) is the ratio o f the marginal wage to the average wage. This
might vary cyclically for several reasons.
One reason might be monopsony power in the labor market. Suppose that each firm
faces an upward-sloping firm-specific labor supply curve, and takes this into account
in its hiring and production decisions. (The wage that the firm must pay may also

20 One might ask, if such costs exist, why finns do not minimize costs by hiring all of the time of
those employees that they hire at all. The answer must be that finns face a wage schedule that is not
simply linear in the number of hours worked by a given employee, as discussed below. Note that this
hypothesis about individual wages is of no consequence for the marginal cost calculation considered in
this paragraph.
21 A marginal wage that is increasing in the number of hours hired is, for example, allowed for in such
studies as Abel (1978), Shapiro (1986), Bils (1987), and Basu and Kimball (1997).

1070

J.J Rotembergand M. Woodford

depend upon other variables such as the overall level of employment in the economy,
but these factors are taken as given by the individual firm, and can simply be treated
as time-variation in the location of the firm-specific labor supply curve.) If w(H) is the
wage that the firm must pay if it hires H hours of work, then W(H) = Hw(H), and
-l where CHw is the elasticity of the firm-specific labor supply curve. This
co = 1 +CHw,
might be either increasing or decreasing with increases in hours hired by the firm.
The most plausible assumption, however, would probably be that the elasticity of labor
supply decreases as the hours hired by the firm increase (it is hard to induce people
to work more than a certain number of hours, even at very high wages, while on
the other hand the opportunity cost of their time tends not to fall below a certain
level even when the number of hours worked is small). Under this assumption, the
factor m is an increasing function of H , and Equation (2.9) again holds, with b < 0.
This would imply that real marginal costs would actually be more procyclical (and
markups more countercyclical) than would be suggested by consideration only of the
terms in Equation (2.5).
Alternatively, one might imagine that firms first hire a certain number of employees,
and that they initially contract with them about a wage schedule which determines the
wage as a function of hours worked. Subsequently, perhaps after receiving additional
information about current demand conditions, the firms determine the hours of work.
If all employees are asked to work the same number of hours at this stage, we
may interpret W(H) in Equation (2.11) as the wage schedule negotiated with each
employee. Now if the number of employees is chosen ex ante so as to minimize
the cost of the number of hours that the firm expects to use, then ex ante expected
hours per worker will be the level H* that minimizes the average wage W ( H ) / H 22. At
this point, the marginal wage should equal the average wage, and (assuming a unique
minimum) in the case of small fluctuations in H around the value H*, co should be
increasing in H. Again this would imply markups more countercyclical than would be
suggested by Equation (2.5).
Most observed wage contracts do not involve wages that increase continuously with
the number of hours that the employee is asked to work. On the other hand, if one
supposes that contractual wages are not the true shadow price of additional labor to a
firm, because of the presence of implicit contracts of the kind assumed, for example,
by Hall (1980), then one might suppose that the true cost to the firm rises in proportion
to the employee's disutility of working, even if the wages that are paid in the current
period do not. This would be a reason to expect the effective wage schedule W(H) to
be convex, so that the above analysis would apply.
Bils (1987) observes that in many industries, a higher wage is paid for overtime
hours (i.e., hours in excess of 40 hours per week). He thus proposes to quantify the
extent to which the marginal wage rises as firms ask their employees to work longer

22 This conclusion depends upon an assumption that only person-hours enter the production ftmction,
rather than employmentor hours per employeemattering separately.

Ch. 16: The Cyclical Behavior of Prices and Costs

1071

hours, by measuring the extent to which the average number o f overtime hours per
employee, V, rises with increases in the total number o f hours worked per employee
H , and then assuming that W ( H ) = wo[H + p V ( H ) ] , where w0 is the straight-time
wage a n d p is the overtime p r e m i u m (0.5 according to the US statutory requirement)23.
For example, he finds that when average hours per employee rise from 40 hours p e r
week to 41 hours, the average number o f overtime hours worked per employee rises b y
nearly 0.4 hours, while when they rise from 41 to 42 hours per week, overtime hours
rise by another 0.5 hours. This increase in the fraction o f hours that are overtime
hours as average hours increase means not only that the marginal wage exceeds the
average wage, but that the ratio o f the marginal wage to the average wage rises
as hours increase. A s s u m i n g p = 0.5, Bils finds that an increase in average hours
from 40 to 41 hours increases the average wage b y about 0.5%, but increases the
marginal wage by 4.6%. O n average, he finds that the factor co in Equation (2.11)
has an elasticity o f 1.4 with respect to variations in average hours a4. Thus a loglinear approximation to Equation (2.11) is again o f the form (2.9), where in Bils'
w o r k / 2 / r e f e r s to fluctuations in average hours per worker 25, and b = -1.4.
Since average hours worked in US manufacturing are strongly procyclical, taking
into account this factor m a k e s the implied markup significantly more countercyclical.
Indeed, when Bils regresses his constructed markup series [using Equation (2.9)]
on a measure o f cyclical employment 26, he finds that markups decline, on average,
by 0.33% for each one-percent increase in employment. O f this cyclical variation, a
0.12% decline is implied by the increase in the labor share (which is mildly procyclical
in his sample), while the remaining 0.21% decline comes from the increase in the ratio
o f the marginal wage to the average wage.
One may question whether the statutory premium p a i d for overtime hours represents
a true cost to the firm; some argue, for example, that the opportunity to work overtime
is in fact dispensed as a reward for exemplary behavior at other times. Bils answers

23 The fact that V(H) is modeled as a fraction that rises continuously with H, rather than being zero
for all H ~<40 hours per week and one for all H > 40 hours per week requires that not all employees
work the same number of hours. The nature and consequences of this heterogeneity are not explicitly
modeled.
24 This average elasticity is slightly smaller than the elasticity of 1.6 indicated by the figures given in
the text relating to an increase from 40 to 41 hours per week.
25 Bils studies the variations of production-worker hours in manufacturing, and computes the marginal
cost of increasing output through an increase in production-worker hours only, holding other inputs
fixed, including non-production-worker hours. Thus in Equation (2.9), s~4 refers to fluctuations in the
share of production-worker wages. Because he assumes a production function which is isoelastic in
production-worker hours, holding fixed the other inputs, a = 0 in his calculations.
26 His cyclical indicator is the difference between current production-worker employment and a moving
average of that series. Note that Bils does not assume, as in the simple analysis above, that employment
is fixed in advance and that all short-run variation in hours occurs on the hours-per-employee margin.
In fact, in his "second method" of computing the cyclical variability of the marginal wage, he explicitly
considers substitution between the employment and hours-per-employee margins.

1072

J.J Rotembergand M. Woodford

this objection by pointing out that if one assumes that because of sophisticated implicit
contracts, the true cost to the firm is proportional to the worker's disutility of working
o(H), then one might well obtain estimates of the degree of procyclical movement
in the ratio of the marginal wage to the average that are as large as those obtained
using his method. Under the assumption suggested above about the steady-state level
of hours, the coefficient b in Equation (2.9) would in that case equal -o"/1t*ol, or
-C,w, where eHw is now the Frisch (or intertemporal) elasticity of labor supply by a
wage-taking household in a competitive spot market. A value of b less negative than
Bils' value of -1.4 would then be obtained only if one assumed preferences implying
an elasticity of labor supply greater than 0.7, whereas many microeconomic studies of
labor supply estimate a lower elasticity than that.

2.2.4. Costs of adjusting the labor input

An additional reason why marginal hours may be more expensive in booms is the
presence o f adjustment costs. It is simplest to illustrate this point if we assume,
as, for example, in Pindyck and Rotemberg (1983), that there are convex costs of
changing the labor input H. Suppose that, in addition to the direct wage costs wtHt
of hiring Ht hours in period t, there is an adjustment cost of lctHt(~(Ht/Ht_l). Here
tot represents a price index in period t for the inputs that must be purchased as part
of the adjustment process; we shall assume that the (logarithms of the) factor prices
tc and w are co-integrated, even if each is only difference-stationary. (More specifically,
we shall assume that tc/w is stationary.) The factor HtO(Ht/Ht_l) represents the physical
quantity of inputs that must be expended in order to adjust the labor input; note that
adjustment costs increase in proportion to the quantity of labor used by a given firm.
This specification implies that adjustment costs remain of the same magnitude relative
to direct labor costs, even if both H and w exhibit (deterministic or stochastic) trend
growth. The exposition is simplest if we treat the adjustment costs as "external", in
the sense that the additional inputs that must be purchased are something other than
additional labor, so that both the production function (2.1) and the formula for the
labor share can still be written as before in terms o f a single state variable " H ''27.
Finally, we assume that ~b is a convex function, with q~(1) = Ct(1) = 0; thus adjustment
costs are non-negative, and minimized (equal to zero) in the case of no change in the
labor input.
We can then compute the marginal cost associated with an increase in output at
date t, assuming that production is increased solely through an increase in the labor
input at date t, with no change in the inputs used in production at other dates, except

27 This assumption is more appealing in the case that H is interpreted to refer solely to productionworker hours, as in Bils's (1987) work, rather than total hours.

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1073

for the necessary changes in the inputs used in the adjustment process at both dates
t and t + 1. In this case, Equation (2.5) becomes 28
/x = g2 1 r#HSTs1,

(2.12)

where
2t =

1 + K't {[O(rHt) +
Wt

rHtOt(]lHt)]

-- E t [ R t , t + l

2 10, (]/Ht+l)] },
'Y1ct+l]/~/t+

(2.13)

in which in turn Ym - H t / H t 1, Yrt = tot~tot-1 29, and Rt,t+l is the stochastic discount
factor by which firms discount random income at date t + 1 back to date t. [Here we
have written Equation (2. t 3) solely in terms o f variables that we expect to be stationary,
even i f there are unit roots in both H and w, to indicate that we expect Y2 to be a
stationary random variable.
I f ~b is strictly convex (i.e., i f there are non-zero adjustment costs), the cyclical
variation in the factor g2 changes the nature o f implied markup fluctuations. Because
~ is positive when the labor input is rising and negative when it is falling, 12 should be
a procyclical factor, though with a less exact coincidence with standard business cycle
indicators than the cyclical correction factors discussed thus far. I f we take a log-linear
approximation to Equation (2.13), near a steady-state in which the variables H , to~w, yx,
and R are constant over time, we obtain
D, =

~[~'H, -/3E~9~,+,],

(2.14)

where here the coefficient c > 0 denotes q~"(1) times the steady state value o f to~w,
and fl denotes the steady-state value o f Ryr, the discount factor for income streams
measured in units o f the adjustment-cost input. This can then be substituted into the
log-linear approximation to Equation (2.12),
= a ~ - s 7 4 - {2,

(2.15)

to obtain a formula to be used in computing markup variations. Equation (2.14) makes

it clear that the cyclical variations in the labor input are the main determinant o f the
cyclical variations in f2. The factor Y2 will tend to be high when hours are temporarily
high (both because they have risen relative to the past and because they are expected

28 In this equation, sH refers to wH/PY as before. In order for this to correspond to labor compensation
as a share of value added, one must assume that the adjustment-cost inputs are not purchased from outside
the sector of the economy to which the labor-share data apply. However, to a first-order approximation,
it does not matter whether the adjustment costs are internal or external, as discussed below.
29 More generally, we shall use the notation Yxtto denote the growth rate xt/xt_l, for any state variable x.

1074

J.J Rotemberg and M. WoodJbrd

to fall in the future), and correspondingly low when they are temporarily low. Thus,
it tends to increase the degree to which implied markups are countercyclica130.
More precisely, the factor g2 tends to introduce a greater negative correlation
between measured markups and future hours. Consider, as a simple example, the case
in which hours follow a stationary AR(1) process given by
~It = p~It l -}- ~t,

where 0 < p < 1, and c is a white-noise process. Then ~2t is a positive multiple of
f / t - )~/~t-l, where )~ ~ (1 -fl(1 - p ) ) - l , and cov(g2t, Art+j)is of the form C(1 -)~p)pJ for
all j ~> 0, where C > 0, while it is of the form C(1 - ) , p 1)p4 for all j < 0. One
observes (since p < )~ < 1/p) that the correlation is positive for all leads j ~> 0,
but negative for all lags j < 0. Thus this correction would make the implied markup
series more negatively correlated with leads of hours, but less negatively correlated
with lags of hours. The intuition for this result is that high lagged levels of hours
imply that the current cost of producing an additional unit is relatively low (because
adjustment costs are low) so that current markups must be relatively high. Since, as
we showed earlier, the labor share is more positively correlated with lags of hours
(and more negatively correlated with leads of hours) this correction tends to make
computed markup fluctuations more nearly coincident with fluctuations in hours. To
put this differently, consider the peak of the business cycle where hours are still rising
but expected future hours are low. This correction suggests that marginal cost are
particularly high at this time because there is little future benefit from the hours that
are currently being added.
The last two columns of Table 2 show the effect of this correction for c equal to 4 and
8 while fi is equal to 0.99. To carry out this analysis, we need an estimate of Et~m+l.
We obtained this estimate by using one of the regressions used to compute expected
output growth in Rotemberg and Woodford (1996a). In particular, the expectation at t
of Ht+l is the fitted value of a regression of/~/t+i on the values at t and t - 1 of/~/, the
rate of growth of private value added and the ratio of consumption of nondurables and
services to GDE Subtracting the actual value of/~/t from this fitted value, we obtain
Et)'m+l. This correction makes the markup strongly countercyclical and ensures that
the correlation of the markup with the contemporaneous value of the cyclical indicator
is larger in absolute value than the correlation with lagged values of this indicator. On
the other hand, the correlation with leads of the indicator is both negative and larger
still in absolute value, particularly when c is equal to 8.
The same calculations apply, to a log-linear approximation, in the case that the
adjustment costs take the form of less output from a given quantity of labor inputs.

30 Even though they allow for costs of changing employment, Askildsen and Nilsen (1997) do not
find any industries with countercyclicalmarkups in their study of Norwegian manufacturing industries.
However, their adjustment-cost parameter is often estimated to have the wrong sign and one would
expect the markups computed on the basis of these estimates to be procyclical.

Ch. 16:

The Cyclical Behavior of Prices and Costs

1075

Suppose that in the above description o f production costs, H refers to the hours that
are used for production purposes in a given period, while Hq~ indicates the number o f
hours that employees must work on tasks that are created by a firm's variation o f its
labor input over time. (In this case, t =_ w.) Equations (2.12) and (2.13) continue to
apply, as long as one recalls that H and sH now refer solely to hours used directly in
production. Total hours worked equal AH instead, and the total labor share equals AsH,
where A = 1 + q~(yu). But in the log-linear approximation, we obtain zi = 0, and so
Equations (2.14) and (2.15) still apply, even if )/t and s~r refer to fluctuations in the
total labor inputs hired by firms.
A more realistic specification of adjustment costs would assume costs of adjusting
employment, rather than costs of adjusting the total labor input as above 31. Indeed,
theoretical discussions that assume convex costs o f adjusting the labor input, as above,
generally motivate such a model by assuming that the hours worked per employee
cannot be varied, so that the adjustment costs are in fact costs o f varying employment.
In the data, however, employment variations and variations in total person-hours are
not the same, even if they are highly correlated at business-cycle frequencies. This
leads us to suppose that firms can vary both employment N and hours per employee
h, with output given by F(K, zhN), and that costs o f adjusting employment in period t
are given by lftNtO(Nt/Nt 1)- If, however, there are no costs o f adjusting hours, and
wage costs are linear in the number o f person-hours hired Nh, firms will have no need
ever to change their number o f employees (which is clearly not the case). If, then,
one is not to assume costs o f adjusting hours per employee 32, one needs to assume
some other motive for smoothing hours per employee, such as the sort o f non-linear
wage schedule discussed above. We thus assume that a firm's wage costs are equal to
W(h)N, where W(h) is an increasing, convex function as above.
One can then again compute the marginal cost o f increased output at some date,
assuming that it is achieved through an increase in employment at that date only,
holding fixed the number o f hours per employee h at all dates, as well as other inputs.
One again obtains Equation (2.12), except that the definition o f g2 in Equation (2.13)
must be modified to replace YH by YN, the growth rate of employment, throughout.
[In the modified Equation (2.13), w now refers to the average wage, W(h)/h.]
Correspondingly, Equation (2.15) is unchanged, while Equation (2.14) becomes
~'~t = C[YNt -- ~Et YNt+l ],

(2.16)

31 Bils and Cho (1994) assume a convex cost of adjusting the employee-to-capital ratio, interpreting this
as a cost of changing the organization of production, rather than a cost of hiring and firing employees.
Because most variations in the employment-to-capital ratio at business-cycle frequencies are due to
variations in employment, the consequences of such a specification are similar to those of the more
familiar assumption of convex costs of changing the number of employees.
32 Studies that estimate separate adjustment costs for variations in employment and in the number of
hours worked per employee, such as Shapiro (1986), tend to find insignificant adjustment costs for
hours.

1076

J.J Rotemberg and M~ Woodford

Thus one obtains, as in the simpler case above, a correction to Equation (2.5) that
results in the implied markup series being more countercyclical (since employment is
strongly procyclical, just as with the total labor input).
Alternatively, one could compute the marginal cost o f increased output, assuming
that it is achieved solely through an increase in hours per employee, with no change
in employment or in other inputs. In this case, one obtains again Equation (2.11),
but with H everywhere replaced by h in the first factor on the right-hand side.
There is no contradiction between these two conclusions. For the right-hand sides o f
Equations (2.11) and (2.12) should be equal at all times; cost-minimization requires
that
W'(ht) = wt+tCt[~)(Ymt)+ YNtO'(YNt)] -Et[Rt,t+l~:t+lY~t+l
2
, (YNt+l)]},

(2.17)

which implies that g2 = ~o. Condition (2.17) is in fact the Euler equation that Bils
(1987) estimates in his "second method" of determining the cyclicality of the marginal
wage; he uses data on employment and hours variations to estimate the parameters o f
this equation, including the parameters of the wage schedule W(h)33. An equivalent
method for determining the cyclicality o f markups would thus be to determine the
importance o f employment adjustment costs from estimation o f Equation (2.17), and
compute the implied markup variations using Equations (2.15) and (2.16). Insofar as
the specification (2.17) is consistent with the data, both approaches should yield the
same implied markup series. It follows that Bils' results using his second method give
an indication o f the size o f the correction that would result from taking account o f
adjustment costs for employment, if these are o f the size that he estimated. His estimate
of these adjustment costs imply an elasticity o f 12 even greater than the value o f 1.4
discussed above.
2.2.5. Labor hoarding
Suppose now that not all employees on a firm's payroll are used to produce current
output at each point in time. For example, suppose that o f the H hours paid for by
the firm at a given time, Hm are used in some other way (let us say, maintenance o f
the firm's capital), while the remaining H - H m are used to produce the firm's product.
Output is then given by Y = F ( K , z ( H - H m ) ) rather than Equation (2.1). We can again

33 Bils is able to estimate this equation by assuming parametric ftmctional forms for the functions
W~(h) and O(YN), and assuming that tt is a constant multiple of the straight-time wage. He also notes
that the term wt should refer not simply to the average hourly wage, but to total per-employee costs
divided by hours per employee; the numerator thus includes the costs of other expenses proportional
to employment but independent of the number of hours worked per employee, such as payments for
unemployment insurance. In fact, identification of the parameters in Equation (2.17) is possible only
because wt is assamed not to be given by a time-invariant fimction W(ht)/ht, but rather by (W(ht) + Ft)/ht,
where the shift term F t representing additional per-employment costs is time-varying in a way that is
not a function of h t.

Ch. 16:

The Cyclical Behavior of Prices and Costs

1077

compute the marginal cost o f increasing output by hiring additional hours, holding Hm
fixed (along with other inputs). One then obtains instead of Equation (2.5)
Iz = u ) l tlHS741,

(2.1 8)

where UH ---- ( H - H m ) / H is the fraction of the labor input that is utilized in production.
Note that this conclusion is quite independent o f how we specify the value to the firm
o f the alternative use to which the hours Hm may be put. It suffices that we believe
that the firm is profit-maximizing, in its decision to allocate the hours that it purchases
in this way, as in its other input decisions, so that the marginal cost of increasing
production by shifting labor inputs away from maintenance work is the same as the
cost o f increasing production by hiring additional labor.
The fraction uH is often argued to be procyclical, insofar as firms are said to "hoard
labor" during downturns in production, failing to reduce payrolls to the extent o f the
decline in the labor needed to produce their output, so as not to have to increase
employment by as much as the firms' labor needs increase when output increases again.
For example, the survey by Fay and Medoff (1985) finds that when output falls by 1%,
labor hours used in production actually fall by 1.17%, but hours paid for fall only by
0.82% 34,
Insofar as this is true, it provides a further reason why markups are more
countercyclical than would be indicated by Equation (2.5) alone 35. I f the Fay and
Medoff numbers are correct, and we assume furthermore that nearly all hours paid
for are used in production except during business downturns, they suggest that
UH falls when output falls, with an elasticity o f 0.35 (or an elasticity of about 0.4
with respect to declines in reported hours). Thus this factor alone would justify setting
b = - 0 . 4 in Equation (2.9).
A related idea is the hypothesis that effective labor inputs vary procyclically more
than do reported hours because ofprocyclical variation in work effort. We may suppose
in this case that output is given by Y = F ( K , zeH), where e denotes the level o f effort
exerted. If, however, the cost o f a marginal hour (which would represent e units o f
effective labor) is given by the reported hourly wage W, then Equation (2.5) continues
to apply. Here the presence o f time-variation in the factor e has effects that are no
different than those o f time-variation in the factor z, both of which represent changes
in the productivity o f hours worked; the fact that e may be a choice variable of the

34 Of the remaining hours paid for, according to survey respondents, about two-thirds represent an
increase in employee time devoted to non-production tasks, while the other third represents an increase
in employee time that is not used at all. Fair (1985) offers corroborating evidence.
35 Models in which output fluctuations result from changes in firms' desired markups can also explain
why labor hoarding should be counter-cyclical, as is discussed further in Section 2.3. At least some
models in which fluctuations in output result from shifts in the real marginal cost schedule have the
opposite implication: periods of low labor costs should induce increases both in the labor force employed
in current production and in the labor force employed in maintenance tasks.

1078

J.J. Rotemberg and M. Woodford

firm while z is not has no effect upon this calculation. Note that this result implies
that variations in the relation between measured hours of work and the true labor
input to the production due to "labor hoarding" are not equivalent in all respects to
variations in effort, despite the fact that the two phenomena are sometimes treated as
interchangeable 3 6.
I f we allow for variation in the degree to which the measured labor input provides
inputs to current production (either due to labor hoarding or to effort variations), one
could also, in principle, measure marginal cost by considering the cost of increasing
output along that margin, holding fixed the measured labor input. Consideration of
this issue would require modeling the cost of higher utilization of the labor input
for production purposes. One case in which this does not involve factors other
than those already considered here is if higher effort requires that labor be better
compensated, owing to the existence of an effort-wage schedule w(e) of the kind
assumed by Sbordone (1996). In this case the marginal cost of increasing output by
demanding increased effort results in an expression of the form (2.11), where now
co =_ ew'(e)/w(e). If, at least in the steady state, the number of hours hired are such
that the required level of effort is cost-minimizing, and that cost-minimizing effort
level is unique, then (just as in our discussion above of a schedule specifying the
wage as a function of hours per employee) the elasticity co will be an increasing
function of e, at least near the steady-state level of effort. The existence of procyclical
effort variations would then, under this theory, mean that implied markup variations
are more countercyclical than one would conclude if the effort variations were not
taken into account.
This does not contradict the conclusion of the paragraph before last. For in a
model like Sbordone's, effort variations should never be used by a firm, in the
absence of adjustment costs for hours or employment (or some other reason for
increasing marginal costs associated with increases in the measured labor input, such
as monopsony power). In the presence, say, of adjustment costs, consideration of the
marginal cost of increasing output through an increase in the labor input leads to
Equation (2.12), rather than to Equation (2.5); this is consistent with the above analysis,
since a cost-minimizing choice of the level of effort to demand requires that
co(e) = f2

(2.19)

at all times. It is true (as argued two paragraphs ago) that variable effort requires
no change in the derivation of Equation (2.12). But observation of procyclical effort
variations could provide indirect evidence of the existence of adjustment costs, and
hence of procyclical variation in the factor Q.
A further complication arises if the cost to the firm of demanding greater effort
does not consist of higher current wages. Bils and Kahn (1996), for example, assume

36 For example, models of variable effort are sometimesreferred to as models of "labor hoarding", as
in Burnside et al. (1993).

Ch. 16: The Cyclical Behavior of Prices and Costs

1079

that there exists a schedule w(e) indicating the effective cost to the firm of demanding
different possible effort levels, but that the wage that is actually paid is independent
of the current choice of e, due to the existence of an implicit contract between firm
and worker o f the form considered in Hall (1980). They thus suppose that the current
wage equals w(e*), where e* is the "normal" (or steady-state) level of effort. In this
case, Equation (2.12) should actually be
1

w(e*)

t~ = ~2 ~OHSH w(e)

(2.20)

I f effort variations are procyclical, the factor w(e)/w(e*) is procyclical, and so this
additional correction makes implied real marginal costs even more procyclical. In their
empirical work Bils and Kahn (1996) relate w(e)/w(e*) to variations in the energy
consumption per unit of capital and show that this correction makes marginal cost
significantly procyclical in four of the six industries they study. Interestingly, these
four industries have countercyclical marginal costs when they ignore variations in the
cost of labor that result from variations in effort.

2.2.6. Variable utilization o f capital

It is sometimes argued that the degree of utilization of firms' capital stock is procyclical
as well, and that the production function is therefore properly a function of"effective"
capital inputs that do not coincide with the measured value of firms' capital stocks.
If by this one means that firms can produce more from given machines when more
labor is used along with them, then it is not clear that "variable utilization" means
anything that is not already reflected in a production function of the form (2.1).
Suppose, however, that it is possible for a firm to vary the degree of utilization of
its capital stock other than by simply increasing its labor-to-capital ratio, and that the
production function is actually of the form Y = F(uKK, zH), where uK measures the
degree of utilization of the capital stock K. Even So, the derivation of Equation (2.5)
is unaffected [and the same is true of subsequent variations on that equation, such
as (2.8), (2.11), (2.12) and (2.18)]. The reason is that variation in capital utilization
has no consequences for those calculations different from the consequences of timevariation in the capital stock itself. It is simply necessary to define y in Equation (2.6)
by y/uK. In the case of an isoelastic production function (2.3), the methods of
calculating implied markup variations we discussed above do not need to be modified
at all.
Variable capital utilization matters in a more subtle way if one assumes that capital
utilization depends upon aspects of the firm's labor input decisions other than the total
labor input H . For example, Bils and Cho (1994) argue that capital utilization should
be an increasing function of the number of hours worked per employee; the idea being
that if workers remain on the shop floor for a longer number of hours each week, the
capital stock is used for more hours as well (increasing the effective capital inputs

JJ Rotembergand M. Woodford

1080

used in production), whereas a mere increase in the number o f employees, with no

change in the length o f their work-week, does not change the effective capital inputs
used in production 37. Under this hypothesis, the aggregate production function is given
by Y = F(ux(h)K, zhN). This modification again has no effect upon the validity
o f the derivation o f Equation (2.12) from a consideration of the cost o f increasing
output by varying employment, holding hours per employee fixed [except, again, for
the modification o f Equation (2.6)]. Thus Equation (2.15) becomes
(2.2t)
where ~ is the elasticity o f u~ with respect to h, while Equation (2.16) is unchanged.
If one assumes a = 0 [as Bils (1987) does], this would mean no change in the implied
markup variations obtained using this method (which, as we have argued, is equivalent
to Bils' "second method") 38.
Assuming that uK depends upon h does affect our calculation o f the cost o f
increasing output by increasing hours per employee. In particular, Equation (2.11) must
instead be replaced by

= ~o-l(nH +zox)~h ~,

(2.22)

where OK is the elasticity o f output with respect to the effective capital input. However,
while the presence o f ~ > 0 in Equation (2.20) is o f considerable importance for
one's estimate o f the average level o f the markup (it increases it), it has less dramatic
consequences for implied markup fluctuations. In the Cobb-Douglas case, r/H and r/K
are both constants, and implied percentage variations in markups are independent
of the assumed size o f )~. Thus this issue has no effect upon the computations o f
Bils (1987).
If we maintain the assumption o f constant returns but depart from the Cobb-Douglas
case by supposing that ~//t is countercyclical (because eKH < 1), then allowance for
0 < 3~ ~< 1 makes the factor ~//~+ )o/K less countercyclical. This occurs for two reasons;
first, the factor z/H + )~r/K decreases less with decreases in ~/H (and in the limit of
~, = 1, it becomes a constant), and second, the factor y/uK (upon which 0/4 depends)
is again less procyclical. Nonetheless, even if we assume that all countercyclical

37 They provide evidence of a statistical correlation between hours per worker and other proxies for
capital utilization. Their econometric results are consistent with an assumption that capital utilization is
proportional to hours per employee, a result that also has a simple interpretation in terms of a common
work-week for all inputs. On the other hand, as Basu and Kimball (1997) note, this correlation need not
indicate that firms are forced to vary the two quantities together.
38 More generally, belief that ~. should take a significant positive value, perhaps on the order of 1,
reduces the significance of variations in r/n as a contribution to implied markup variations, since both
y and h are strongly procyclical. It is not plausible, however, to suppose that ~. should be large enough
to make ~ - ,b~ a significantly countercyclicalfactor.

Ch. 16: The Cyclical Behavior of Prices and Costs

1081

variation in this factor is eliminated, implied markup variations will still be as strongly
countercyclical as they would be with a Cobb-Douglas production function.
To sum up, there are a number of reasons why the simple ratio of price to unit
labor cost is likely to give an imprecise measure of cyclical variations in the markup.
As it happens, many of the more obvious corrections to this measure tend to make
implied markups more countercyclical than is that simple measure. Once at least some
of these corrections are taken account of, one may easily conclude that markups vary
countercyclically, as is found by Bils (1987) and Rotemberg and Woodford (1991).
2.3. Alternative measures o f real marginal cost

Our discussion in Sections 2.1 and 2.2 has considered for the most part a single
approach to measuring real marginal cost (or equivalently, the markup), which
considers the cost of increasing output through an increase in the labor input. However,
as we have noted, if firms are minimizing cost, the measures of real marginal cost that
one would obtain from consideration of each of the margins along which it is possible
to increase output should move together; thus each may provide, at least in principle,
an independent measure of cyclical variations in markups. While cyclical variation
in the labor input is clearly important, cyclical variations in other aspects of firms'
production processes are observed as well. We turn now to the implications of some
of these for the behavior o f real marginal cost.
2.3.1. Intermediate inputs

Intermediate input use (energy and materials) is also highly cyclical. Insofar as the
production technology does not require these to be used in fixed proportions with
primary inputs [and Basu (1995) presents evidence that in US manufacturing industries
it does not], this margin may be used to compute an alternative measure of real
marginal cost. Consideration of this margin is especially attractive insofar as these
inputs are not plausibly subject to the kind of adjustment costs involved in varying
the labor input [Basu and Kimball (1997)], so that at least some of the measurement
problems taken up in Section 2.2 can be avoided.
Suppose again that gross output Q is given by a production function Q(V,M),
where V is an aggregate o f primary inputs, and M represents materials inputs. Then,
considering the marginal cost of increasing output by increasing materials inputs alone
yields the measure
-

PQM(V,M)

PM

(2.23)

by analogy with Equation (2.2). [Note that in Equation (2.23),/~ refers to the "grossoutput" markup which we called/~c in Equation (2.10). Also note that P now refers
to the price of the firm's product, and not a value-added price index as before.] Under

1082

J J Rotemberg and M. Woodford

the assumption that Q exhibits constant returns to scale 39, QMis a decreasing function
o f M / V , or equivalently of the materials ratio m = M/Q. In this case, log-linearization
of Equation (2.23) yields
=fr~ -/3v,

(2.24)

where f < 0 is the elasticity of QM with respect to m, and/3~ indicates percentage

fluctuations in the relative price of materials pM =-- PM/P.
Both terms on the right-hand side of Equation (2.24) provide evidence that markups
vary counter-cyclically. Basu (1995) shows that intermediate inputs (energy and
materials) rise relative to the value of output in expansions, at least when these are not
due to technology shocks 4. Basu furthermore assumes thatpM is equal to one because
he views materials inputs as indistinguishable from final output. Under this assumption,
the increase of m in booms immediately implies that markups are countercyclical.
In fact, however, goods can be ranked to some extent by "stage of processing"; all
goods are not used as both final goods and intermediate inputs of other sectors to
the same extent. And it has long been observed that the prices of raw materials rise
relative to those of finished goods in business expansions, and fall relative to those
of finished goods in contractions [e.g., Mills (1936), Means et al. (1939)]. Murphy,
Shleifer and Vishny (1989) show that this pattern holds up consistently both when
they consider broad categories of goods grouped by stage of processing, and when they
consider particular commodities that are important inputs in the production of other
particular goods. Hence it would seem that for the typical industry, PM is a procyclical
variable. Because of Equation (2.24), this would itself be evidence of countercyclical
markup variation, even if one regarded QM as acyclical. The combination of these two
facts clearly supports the view that real marginal costs are procyclical, and hence that
markups are countercyclical.
Note that in the case that the production function Q ( V , M ) is isoelastic in M,
Equation (2.23) implies that/~ should be inversely proportional to the share of materials
costs in the value of gross output, Sm = pMm. Thus in this case the materials share
would directly provide a suitable proxy for variations in real marginal cost, just as
in our previous discussion of the labor share. However, this specification (implying
a unit elasticity of substitution between intermediate and primary inputs) is hardly
plausible. Rotemberg and Woodford (1996b) estimate elasticities of substitution for
20 two-digit manufacturing sectors, and find an average elasticity less than 0.7. Basu's

39 This assumption allows for increasing returns, but requires that they take the form of increasing
returns in the value-addedproduction function V(K, zH).
40 This is shown in the fourth row of his Table 5. He regresses the percentage change in m on the
percentage change in Q, for each of 21 two-digit US manufacturing industries. He instruments output
growth using the Ramey-Hall instntments for non-technological aggregatedisturbances. He also shows
that intermediate inputs rise more than does a cost-weightedaverage of primaryinputs (labor and capital),
using the same instruments; as one should expect, the regression coefficientin this case is much larger.

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1083

(1995) estimate of the response o f m to changes in the relative price o f primary and
intermediate inputs suggests an elasticity o f substitution half that size 41. Thus it seems
most likely that i n s t e a d f < - 1 in Equation (2.24). If the materials ratio rn is procyclical
as found by Basu, it follows that real marginal costs are actually more procyclical than
is indicated b y the materials share alone.
A related measure is used by Domowitz, Hubbard and Petersen (1986), who measure
"price-cost margins" defined as the ratio o f price to "average variable cost". They
measure this as a the ratio o f industry revenues to the sum o f labor and materials costs,
which is to say, as the reciprocal o f the sum o f the labor and materials shares. This
should correspond to the markup as we have defined it only under relatively special
circumstances. I f the production function is isoelastic in both labor inputs and materials
inputs, then real marginal cost is proportional to the labor share (as explained in
Section 2.1), and also proportional to the materials share (as explained in the previous
paragraph). It then follows that these two shares should move in exact proportion to one
another, and hence that their s u m is a multiple o f real marginal cost as well. Domowitz
et al. report that this sum is somewhat countercyclical for most industries, and as a
result they conclude that p r i c e - c o s t margins are generally procyclical. However, the
conditions under which this measure should correspond to variations in the markup o f
price over marginal cost are quite restrictive, since they include all o f the conditions
required for the labor share to be a valid measure o f real marginal cost, a n d all o f
those required for the materials share to be a valid measure. We have reviewed in
Section 2.2 a number o f reasons why the labor share is probably less procyclical than
is real marginal costs. Similar considerations apply in the case o f the materials share,
although the likely quantitative importance o f the various corrections is different in
the two cases; in the case o f materials, the elasticity o f substitution below unity is
probably a more important correction, while adjustment costs are probably much less
important. Nonetheless, one must conclude, as with our previous discussion o f the
labor share alone, that real marginal cost is likely to be significantly more procyclical
than is indicated by the Domowitz et al. measure o f "average variable cost" 42.

41 The last line of his Table 5 indicates an increase in rn of only 0.12% for each 1% increase in the
relative price of primary and intermediate inputs. His estimates of the cyclicality of materials input use
indicate three times as large an elasticity for M/V as for M/Q (comparing lines 2 and 4 of that table),
though the estimated elasticity of M/V is reduced when labor hoarding is controlled for. This would
suggest an increase in M/V of at most 0.36% for each percent increase in the relative price of inputs.
42 Similar issues arise with the study of Felli and Tria (1996) who use the price divided by overall
average cost as a measure of the markup. They compute this by dividing total revenue by total cost
including an imputed cost of capital (which depends on a measure of the real interest rate). Leaving
aside the difficulties involved in measuring the cost of capital, it is hard to imagine that adding together
the shares of labor, materials and capital is appropriate for computing markups unless each share in
isolation is appropriate as well. In addition, the existence of adjustment costs of capital probably make
the marginal cost that results from producing an additional unit by adding capital considerably more
procyclical than average capital cost. These adjustment costs may also rationalize the dynamic relation
they find between their ratio of average cost to output and output itself.

J.J Rotemberg and M. Woodford

1084

2.3.2. Inventory fluctuations

Another margin along which firms may increase the quantity of goods available for
sale in a given period is by drawing down inventories of finished goods. For a costminimizing firm, the marginal cost of drawing down inventories must at all times
equal the marginal cost of additional production, and thus measurement of the costs
of reduced inventories provides another potential (indirect) measure of the behavior of
marginal cost.
The following simple framework will clarify what is involved in such an analysis.
Inventories at the end of period t, It+l, equal It + Qt - S t , where Qt is production at t
and St are sales at t. It is thus possible for a firm to keep its path of sales (and hence
revenues) unchanged, increasing production and inventories at time t by one unit while
reducing production by one unit at time t + 1. If the firm's production and inventoryholding plan is optimal, such a marginal deviation should not affect the present value
of its profits. For the typical firm, the proposed deviation raises nominal costs by the
marginal cost of production at t, ct, while lowering them by the present value o f the
marginal cost of production at t + 1, and also raising profits by the marginal benefit of
having an additional unit of inventory at the end of t. Denoting the real value o f this
latter marginal benefit by b(It, Zt), where Zt denotes other state variables at date t that
may affect this benefit, we have
Ptb(It, Zt) + Et {Rt,t+~ct+l } = ct
as a first-order condition for optimal inventory accumulation by the firm, where Pt is
the general price level at date t (not necessarily the price of the firm's output), and
Rt,t+l is a stochastic discount factor for nominal income streams. This may equivalently
be written
Ct

Ct+l

b(It, Zt) = Ptt - LtPt,t+l Pt+----l'

(2.25)

where now Pt,t+~ is the corresponding discount factor for real income streams. Given an
assumption about the form of the marginal benefit function b(I, Z), observed inventory
accumulation then provides evidence about real marginal costs in an industry - more
precisely, about the expected rate o f change in real marginal costs.
The early studies in this literature [e.g., Eichenbaum (1989), Ramey (t991)] have
tended to conclude that real marginal cost is countercyclical. The reason is that they
assume that the marginal benefit of additional inventories should be decreasing in
the level of inventories (or equivalently, that the marginal cost of holding additional
inventories is increasing); the finding that inventories are relatively high in booms
then implies that b is low, from which the authors conclude that real marginal costs

Ch. 16: The Cyclical Behavior of Prices and Costs

1085

must be temporarily low 43. Eichenbaum interprets the countercyclical variation in real
marginal costs as indicating that output fluctuations are driven by cost shocks, while
Ramey stresses the possibility that increasing returns to scale could be so pervasive
that marginal cost could actually be lower in booms. Regardless o f the explanation,
if the finding o f countercyclical real marginal costs is true for the typical sector, it
would follow that markups in the typical sector must be procyclical. This is indeed
the conclusion reached by Kollman (1996).
Bils and Kahn (1996) argue, instead, that real marginal cost is procyclical in
each o f the six production-for-stock industries that they investigate. The differing
conclusion hinges upon a different conclusion about cyclical variation in the marginal
benefits of additional inventories. They begin by observing that inventory-to-sales
ratios do not vary secularly. This suggests that the function b is homogeneous o f
degree zero in inventories and sales; specifically, they propose that b is a decreasing
function, not o f I alone, but o f I/S 44. A similar conclusion follows from noticing that
inventory-to-sales ratios are fairly constant across different models o f automobiles at
a given point in time, even though these models differ dramatically in the volume o f
their sales.
But this implies that b is actually higher in booms. The reason is that, as Bils
and Kahn show, the ratio o f inventories to sales is strongly countercyclical; while
inventories rise in booms, they rise by less than do sales. Thus, the marginal value
o f inventories must be high in booms and, as a result, booms are periods where real
marginal costs are temporarily high.
This conclusion is consistent both with the traditional view that diminishing returns
result in increasing marginal costs, and with the view that business cycles are not
primarily due to shifts in industry cost curves. As noted earlier, Bils and Kahn also
show that their inventory-based measures of real marginal cost covary reasonably
closely with a wage-based measure of the kind discussed above, once one corrects the
labor cost measure for the existence ofprocyclical work effort as in Equation (2.20). If
their conclusion holds for the typical industry, and not just the six that they consider,
it would have to imply countercyclical markup variations 45.

43 This aspect of inventory behavior has been much discussed as an embarrassment to the "production
smoothing" model of inventory demand, which implies that inventories should be drawn down in booms
[e.g., Blinder (1986)]. That prediction is obtained by adjoining to Equation (2.25) the assumptions that
b is decreasing in I and that real marginal cost is increasing in the level of production Q.
44 A theoretical rationale for this is provided in terms of a model of the stockout-avoidance demand for
inventories.
45 The price data for the particular industries considered by Bils and Kahn are ambiguous in this regard;
they find that (given their measures of variations in marginal cost) markups are countercyclical in some
industries but procyclical in others. This means that certain of their sectors have strongly procyclical
relative prices for their products - something that cannot be true of industries in general.

1086

JJ. Rotemberg and M. Woodford

2.3.3. Variation in the capital stock

A final way in which output can be increased is by increasing the stock o f capital 46.
Thus
t~ -

PFK(K, z H )
E(r)
'

(2.26)

where E ( r ) is the expected cost o f increasing the capital stock at t by one unit while
leaving future levels o f the capital stock unchanged. Assuming that the capital stock
at t can actually be changed at t but also letting there be adjustment costs, rt equals
PK,t + CI,t - Rt,t+l(1 - 6)(PK,t+I + cI,t+l)

where PK,t is the purchase price o f capital at t, c~,t is the adjustment cost associated
with increasing the capital stock at t by one unit, 6 is the depreciation rate. It then
becomes possible to measure changes in/~ by differentiating Equation (2.26). This is
somewhat more complicated than the computation o f marginal cost using either labor
or materials because the rental rate o f capital r cannot be observed directly; it must
be inferred from a parametric specification for c~.
A related exercise is carried out by Galeotti and Schiantarelli (1998). After
specifying a functional form for Cl and making a homogeneity assumption regarding F,
they estimate Equation (2.26) by allowing/~ to be a linear function of both the level
of output and o f expected changes in output. Their conclusion is that markups fall
when the level of output is unusually high and when the expected change in output is
unusually low. As we discuss further in Section 3, this second implication is consistent
with certain models o f implicit collusion.
2.4. The response o f Jhctor prices to aggregate shocks

Thus far we have discussed only the overall pattern o f cyclical fluctuations in markups.
Here we take up instead the degree to which markup variations play a role in the
observed response o f the economy to particular categories of aggregate shocks. We are
especially interested in shocks that can be identified in the data, that are known to be
non-technological in character and that are thus presumptively statistically independent
of variations in the rate o f technical progress 47. These cases are o f particular interest

46 We have considered separately each of these different ways in which firms can increase their output
and their associated marginal cost. An alternative is to postulate a relatively general production (or cost)
function, estimate its parameters by assuming that firms minimize costs, and thereby obtain estimates
of marginal cost that relate to many inputs at once. One could then compare this "average" estimate of
marginal cost to the price that is actually charged. Morrison (1992) and Chirinko and Fazzari (1997)
follow a related approach.
47 In taking this view, of course, we assume that variations in technical progress are essentially
exogenous, at least at business-cycle frequencies.

Ch. 16: The Cyclical Behavior of Prices and Costs

1087

because we can then exclude the hypothesis o f shifts in supply costs due to changes
in technology as an explanation for the observed response o f output and employment.
This allows us to make judgments about the nature o f markup variations in response
to such shocks that are less dependent upon special assumptions about the form of the
production function than has been true above (where such assumptions were necessary
in order to control for variable growth in technology).
In particular, in the case o f a variation in economic activity as a result of a nontechnological disturbance, if markups do not vary, then real wages should move
countercyclically. In our basic model, this is a direct implication o f Equation (2.2),
under the assumption o f a diminishing marginal product of labor 48. For in the short
run, the capital stock is a predetermined state variable, and so increases in output
can occur if and only if hours worked increase, as a result o f which the marginal
product of labor must decrease; this then requires a corresponding decrease in the real
wage, in order to satisfy Equation (2.2). In the case o f such a shock, then, the absence
o f countercyclical real wage movement is itself evidence of countercyclical markup
variation.
Before turning to the evidence, it is worth noting that the inference that procyclical
(or even acyclical) real wages in response to these shocks imply countercyclical
markups is robust to a number o f types of extension o f the simple model that leads to
Equation (2.2). For example, the presence of overhead labor makes no (qualitative)
difference for our conclusion, since the marginal product o f labor should still be
decreasing in the number o f hours worked. A marginal wage not equal to the average
wage also leads to essentially the same conclusion. If, in particular, we assume that
the firm's wage bill is a nonlinear function o f the form W(H) = woo(H), where the
function o(H) is time-invariant though the scale factor w0 may be time-varying 49, then
w(H), the ratio of the marginal to the average wage, is a time-invariant function. Since
the denominator of Equation (2.2) should actually be the marginal wage, when the
two differ, our reasoning above actually implies that/~o must be countercyclical. But
as we have explained above, w(H) is likely to be an increasing function (if it is not
constant), so that/~ should vary even more countercyclically than does the product/too
(which equals the ratio o f the marginal product o f labor to the average wage). If there
are convex costs of adjusting the labor input, one similarly concludes that #f2 must
be countercyclical. But since the factor (2 [defined in Equation (2.13)] will generally

48 Note that the latter assumption is necessary for equilibrium, if we assume that markups do not vary
because product markets are perfectly competitive. In the case of market power but a constant markup
(as in a model of monopolistic competition with Dixit-Stiglitz preferences and perfectly flexible prices see below), a mildly increasing marginal product of labor schedule is theoretically possible, but does
not seem to us appealing as an empirical hypothesis.
49 For example, Bils (1987) assumes a relationship of this kind, where w0 represents the time-varying
straight-time wage, while the function v(H) reflects the nature of the overtime premium, which is timeinvariant in percentage terms.

J.J Rotembergand M. Woodford

1088

vary procyclically, this is again simply a reason to infer an even stronger degree of
countercyclical variation in markups than is suggested by Equation (2.2).
I f there is labor hoarding, it can still be inferred in the case of an increase in output
due to a non-technological disturbance that H - H m must have increased; and then, if
real wages do not fall, Equation (3.8) implies that markups must have declined. In the
case of variable capital utilization, the situation is more complicated. Condition (2.2)
generalizes to
/~ =

PzFH(uI(K, zH)
W

(2.27)

If we assume as above that F is homogeneous degree one, FH is a decreasing function

of zH/uirK. But the mere fact that output and the labor input increase will not settle
the question whether the ratio of labor inputs to effective capital inputs, zH/uirK, has
increased or not. Hence it may not be clear that the marginal product of labor must
decline in booms.
Suppose, however, that the cost of higher capital utilization consists of a faster rate
of depreciation of the capital stock. Let the rate of depreciation be given by 6(uir),
and let V(K') denote the value to the firm of having an undepreciated capital stock
of K ' at the end of the period. The usual assumption of diminishing returns makes it
natural to suppose that 6 should be an increasing, convex function, while P should be
an increasing, concave function s0. Then if we consider the marginal cost of increasing
output solely by increasing the rate of utilization of the capital stock, we obtain the
additional relation

F1((uxK, zH)
# = V'((1 - 6(ux))K)6'(uir)"

(2.28)

Now if zH/uKK decreases when output expands, it follows that Fir declines.
Furthermore, this requires an increase in uK, so that, under our convexity assumptions,
both ~-/ and 6 ~ must increase. Thus Equation (2.28) unambiguously requires the
markup to decrease. Alternatively, if zH/uirK increases, FH declines, and then, if there
is no decline the real wage, Equation (2.27) requires a decline in the markup. Thus
under either hypothesis, markup variations must be countereyclical, if real wages are
not 51"
We turn now to the question of whether expansions in economic activity associated
with non-technological disturbances are accompanied by declines in real wages. There
are three important examples of identified non-technological disturbances that are often
used in the literature. These are variations in military purchases, variations in the world

so See Appendix 2 in Rotembergand Woodford (1991).

51 Which case is actually correct will depend upon the relative degrees of curvature of the various
schedules that enter into the right-hand sides of Equations (2.27) and (2.28).

Ch. 16.. The Cyclical Behavior o f Prices and Costs

1089

oil price, and monetary policy shocks identified using "structural VAR" methods. At
least in the USA, the level of real military purchases has exhibited noticeable variation
over the post-World War II period (as a result of the Korean conflict, Vietnam, and the
Reagan-era military build-up). The causes of these variations are known to have had to
do with political events that have no obvious connection with technical progress. (We
consider military purchases rather than a broader category of government purchases
exactly because this claim of exogeneity is more easily defended in the case of military
purchases.) Similarly, the world oil price has been far from stable over that period
(the two major "oil shocks" of the 1970s being only the most dramatic examples of
variation in the rate of increase in oil prices), and again the reasons for these variations,
at least through the 1970s, are known to have been largely external to the US economy
(and to have had much to do with political dynamics within the OPEC cartel)52. In
the case of monetary policy shocks, the identification of a time series for exogenous
disturbances is much less straightforward (since the Federal funds rate obviously
responds to changes in economic conditions, including real activity and employment,
as a result o f the kind of policies that the Federal Reserve implements). However,
an extensive literature has addressed the issue of the econometric identification of
exogenous changes in monetary policy 53, and we may therefore consider the estimated
responses to these identified disturbances. In each of the three cases, the variable in
question is found to be associated with variations in real activity, and these effects are
(at least qualitatively) consistent with economic theory, so that it is not incredible to
suppose that the observed correlation represents a genuine causal relation.
We turn now to econometric studies of the responses to such shocks, using relatively
unrestricted VAR models of the aggregate time series in question. Rotemberg and
Woodford (1992) show that increases in real military purchases raise private value
added, hours worked in private establishments and wages deflated by the relevant value
added deflator. Ramey and Shapiro (1998) show that the effect on this real wage is
different when revised NIPA data are used and that, with revised data, this real wage
actually falls slightly. They argue that this response can be reconciled with a two-sector
constant markup model. Whether a one-sector competitive model can be reconciled
with their evidence remains an open question.
Christiano, Eichenbaum and Evans (1996) show, using a structural VAR model to
identify monetary policy shocks, that output and real wages both decline in response to
the increases in interest rates that are associated with monetary tightening. This again
suggests that the contraction in output is associated with an increase in markups. An
increase in the federal funds rate by one percent that leads to a 0.4% reduction in
output reduces real wages by about 0.1%. I f one supposes that hours fall by about the
same percent as output, the effective increase in the markup is about 0.2%.

52 These first two series have been widely used as instruments for non-tectmologicalsources of variation
in US economic activity, following the precedent of Hall (1988, 1990).
53 For a recent survey, see Leeper, Sims and Zha (1996).

1090

J.J Rotemberg and M. Woodford

Rotemberg and Woodford (1996b) look instead at the response of the US economy
to oil price increases. They show that during the pre-1980 OPEC period, such increases
lowered private value added together with real wages. Specifically, a one percent
unexpected increase in oil prices is shown to lead to a reduction of private value added
by about a quarter of a percent after a year and a half, and to a reduction of the real
wage (hourly earnings in manufacturing deflated by the private value-added deflator)
by about 0.1%, with a similar time lag. This combination of responses again suggests
that markups increase, especially during the second year following the sfiock.
The inference is, however, less straightforward in this case; for one might think that
an increase in oil prices should have an effect similar to that of a negative technology
shock, even if it does not represent an actual change in technology. In fact, Rotemberg
and Woodford show that this is not so. Let us assume again the sort of separable
utility function used to derive Equation (2.23), but now interpret the intermediate input
"M" as energy. In this case, consideration of the marginal cost of increasing output by
increasing labor inputs yields
/~ =

PQv(V,M) VH(K,zH)
w

(2.29)

Comparison of Equation (2.29) with (2.23) allows us to write a relation similar in form
to Equation (2.2),

PVH(K,zH)
-

Vl

'

(2.30)

where the price index/5 is defined by

/5 =

P Y - ~PMM
V(K, zH)

(2.31)

Thus if we deflate the wage by the proper price index P, it is equally true of an energy
price change that a decrease in labor demand must be associated with an increase in
the real wage, unless the markup rises. [Note that the situation is quite different in the
case of a true technology shock, since the relation (2.30) is shifted by a change in z.]
Under the assumption of perfect competition (/~ = 1), the price index defined in
Equation (2.31) is just the ideal (Divisia) value-added deflator. Thus a competitive
model would require the value-added-deflated real wage to rise following an oil
shock, if employment declines 54; and the observation that real wages (in this sense)
decline would suffice to contradict the hypothesis of perfect competition. The results
of Rotemberg and Woodford do not quite establish this; first, because their privatevalue-added deflator is not precisely the ideal deflator, but more importantly, because

54 This result is discussed extensively by Bruno and Sachs (1985), who use it to assert that the
unemploymentfollowingthe oil shocks was due to real wage demands being too high.

Ch. 16: The Cyclical Behavior of Prices and Costs

1091

their measure of private value added includes the US energy sector, whereas the
above calculations refer to the output of non-energy producers (that use energy as
an input). Still, because the energy sector is small, even the latter correction is not too
important quantitatively; and Rotemberg and Woodford show, by numerical solution
of a calibrated model under the assumption of perfect competition, that while small
simultaneous declines in their measure of output and of the real wage would be possible
under competition, the implied declines are much smaller than the observed ones 55
Similar reasoning allows us to consider as well the consequences of changes in the
relative price of intermediate inputs other than energy. We ignored materials inputs in
our discussion above of the inferences that may be drawn from the response of real
wages to identified shocks. As before, however, Equation (2.2) [and similarly (2.27)]
can be interpreted as referring equally to a production technology in which materials
inputs are used in fixed proportions with an aggregate of primary inputs, under the
further assumption that the relative price of materials is always one, because materials
and final goods are the same goods. But the relative prices of goods differing by "stage
of processing" do vary, and so a more adequate analysis must take account of this.
When one does so, however, one obtains Equation (2.30) instead of (2.2). It is still the
case that the failure of real wages to rise in the case of a non-technological disturbance
that contracts labor demand indicates that markups must rise, as long as the real wage
in question is w/fL
What, instead, if one observes only the behavior o f w/P? Then the failure of this
real wage to rise might, in principle, be explained by a decline in P/P, consistent with
a hypothesis of constant (or even procyclical) markups. However [referring again to
Equation (2.29)], this would require a decline in Qv(V, M). Under the assumption that
Q is homogeneous degree one, this in turn would require a decline in M/V, hence an
increase in QM (V, M). I f markups are constant or actually decreasing, this would then
require an increase in the relative price of materials, PM/P, by Equation (2.23). Thus
we can extend our previous argument to state that if one observes that neither w/P
nor PM/P increases in the case of a non-technological disturbance that leads to reduced
labor demand, one can infer that markups must increase. In fact, Clark (1996) shows,
in the case of a structural VAR identification of monetary policy disturbances similar
to that of Christiano et al., that a monetary tightening is followed by increases in the
price of final goods relative to intermediate goods and raw materials. This, combined
with the evidence of Christiano et al. regarding real wage responses, suggests that a
monetary tightening involves an increase in markups.
A possible alternative explanation of declines in real wages and the relative price
of materials inputs at the same time as a contraction of output and employment is an
increase in some other component of finns' marginal supply cost. Christiano et al.

55 Finn (1999), however,finds larger declines in the case of a competitivemodel that allows for variable
utilization of the capital stock.

1092

JJ Rotemberg and M. Woodford

propose that an increase in financing costs may be the explanation o f their findings 56.
As they show, in a model where firms require bank credit to finance their wage bill, the
interest rate that must be paid on such loans also contributes to the marginal cost o f
production; and it is possible to explain the effects o f a monetary tightening, without
the hypothesis o f markup variation, as being due to an increase in marginal cost due
to an increase in the cost o f credit. But while this is a theoretical possibility, it is
unclear how large a contribution financing costs make to marginal costs o f production
in reality 57. This matter deserves empirical study in order to allow a proper'quantitative
evaluation o f this hypothesis.
2.5. Cross-sectional differences in markup variation
In this subsection we survey the relatively scant literature that investigates whether
markups are more countercyclical in industries where it is more plausible a priori that
competition is imperfect. This issue is of some importance because countercyclical
markups are less plausible in industries where there is little market power. For markups
below one imply that the firm can increase its current profits by rationing consumers
to the point at which marginal cost is no higher than the firm's price. But if markups
never fall below one, there is little room for markup variation unless average markups
are somewhat above one. In addition, the theoretical explanations we present for
cotmtercyclical markups in section 3 all involve imperfect competition. A consideration
of whether the measures o f markup variation that we have proposed imply that markup
variation is associated with industries with market power is thus a check on the
plausibility o f our interpretation o f these statistics. Quite apart from this, evidence
on comparative markup variability across industries can shed light upon the adequacy
of alternative models o f the sources o f markup variation.
The most straightforward way o f addressing this issue is to compute markups for
each sector using the methods discussed in section 2, and compare the resulting markup
movements to output movements. In Rotemberg and Woodford (1991), we carry out
this exercise for two-digit US data, treating each o f these sectors as having a different
level o f average markups and using Hall's (1988) method for measuring the average
markup in each sector 58. We show that the resulting markups are more negatively

56 The same explanation is offered by Clark for the behavior of the relative prices of goods at different
stages of processing.
57 Interruptions of the supply of bank credit certainly can significantly affect the level of economic
activity, but the most obvious channel through which this occurs is through the effects of financing costs
upon aggregate demand. Financing costs are obviously important determinants of investment demand,
the demand for consumer durables, and inventory accumulation; but a contraction of these components
of aggregate demand can easily cause a reduction of equilibrium output, without the hypothesis of an
increase in supply costs.
58 For a more elaborate analysis of the evolution of cyclical markups in four relatively narrowly defined
(four digit) industries, see Binder (1995). He finds that these four industries do not have a common
pattern of markup movements, though none of them has strongly countercyclical markups.

Ch. 16: The Cyclical Behaoior of Prices and Costs

1093

correlated with GNP in sectors whose eight-digit SIC sector has a higher average
four-firm concentration ratio. Thus, assuming this concentration is a good measure
of market power, these results suggest that sectors with more imperfect competition
tend to have more countercyclical markups.
One source of this result is that, as shown earlier by Rotemberg and Saloner
(1986), real product wages Wi/Pi are more positively correlated with GNP, and even
with industry employment, in more concentrated industries. By itself, this is not
sufficient to demonstrate that markups are more countercyclical since zFH could be
more procyclical in these sectors. However, the analysis of Rotemberg and Woodford
(1991) suggests that this is not the explanation for the more procyclical real product
wages in more concentrated sectors.
As we discussed earlier, Domowitz, Hubbard and Petersen (1986) measure markup
changes by the ratio of the industry price relative to a measure of "average variable
cost". They show that this ratio is more procyclical in industries where the average
ratio of revenues to materials and labor costs is larger, and see this as suggesting that
markups are actually more procyclical in less competitive industries. As we already
mentioned, this method for measuring markup variation imparts a procyclical bias
for a variety of reasons. This bias should be greater in industries with larger fixed
(or overhead) costs [because of Equation (2.8)], and these are likely to be the more
concentrated industries. In addition, the ratio of revenues to labor and materials costs
is a poor proxy for the extent to which a sector departs from perfect competition,
because this indicator is high in industries that are capital-intensive, regardless of the
existence of market power in their product markets.
Domowitz, Hubbard and Petersen (1987) use a different method for measuring
industry markup variations and obtain rather different results. In particular, they run
regressions of changes in an industry's price on changes in labor and materials cost as
well as a measure of capacity utilization. Using this technique, they show that prices
are more countercyclical, i.e., fall more when capacity utilization becomes low, in
industries with higher average ratios of revenues to materials and labor costs. If the
relation between capacity utilization and marginal cost were the same across industries,
and if one accepted their method for deciding which industries are less competitive,
their study would thus show that markups are more countercyclical in less competitive
industries.

3. Implications of markup variations for business fluctuations

In this section, we study whether it is empirically plausible to assign a large role on
markup fluctuations in explaining business fluctuations. We first take up two related
aspects of the observed cyclical variation in the relation between input costs and the
value of output, that are sometimes taken to provide prima f a c i e evidence for the
importance of cost shifts (as opposed to markup changes) as the source of fluctuations
in activity. These are the well-known procyclical variation in productivity and in

1094

J.J Rotemberg and M. WoodJbrd

profits. We show that these procyclical variations contain very little information on
the importance of markup changes because markup variations induce such procyclical
responses.
We next take up a more ambitious attempt at gauging the role of markup fluctuations
in inducing cyclical fluctuations in economic activity. In particular, we study the extent
to which the markup changes that we measured in Sections 2.1 and 2.2 lead to output
fluctuations. Any change in output that differs from that which is being induced by
changes in markups ought naturally to be viewed as being due to a shift in real marginal
costs (for a given level of output). Thus, this approach allows us to decompose output
changes into those due to markup changes and those due to shifts in the marginal
cost curve. What makes this decomposition particularly revealing is that, under the
hypothesis that markups are constant all output fluctuations are due to shifts in real
marginal costs.

3.1. Explaining cyclical variation in productivity and profits

3.1.1. Cyclical productivity
Standard measures of growth in total factor productivity (the "Solow residual" and
variants) are highly positively correlated with growth in output and this fact is cited in
the real business cycle literature [e.g., Plosser (1989)] as an important piece of evidence
in favor of the hypothesis that business cycles are largely due to exogenous variations
in the rate of technical progress. It might seem that variations in economic activity
due to changes in firms' markups (in the absence of any shift in the determinants
of the real marginal cost schedule) should not be associated with such variations
in productivity growth, and that the close association of output variations with
variations in productivity growth therefore leaves little role for markup variations in the
explanation of aggregate fluctuations - or at least, little role for disturbances that affect
economic activity primarily through their effect upon markups rather than through their
effect on production costs.
In fact, however, there are a number of reasons why variations in markups should be
expected to produce fluctuations in measured total factor productivity growth, that are
strongly and positively correlated with the associated fluctuations in output growth.
Thus observation of procyclical productivity growth does not in itself provide any
evidence that markup variations do not play a central role in accounting for observed
aggregate fluctuations. (Of course, procyclical productivity is not in itself conclusive
evidence of markup variation either, since other explanations remain possible. For
this reason productivity variations are a less crucial statistic than those discussed in
Sections 2.1 and 2.2.)
One reason is simply that standard measures of total factor productivity growth may
use incorrect measures of the elasticities of the production function with respect to
factor inputs. If these elasticities are assigned values that are too small (in particular,
the elasticity ~/H with respect to the labor input), then spurious procyclical variation in

Ch. 16: The Cyclical Behavior of Prices and Costs

1095

total factor productivity growth will be found. As Hall (1988) notes, the Solow residual
involves a biased estimate of just this kind, if firms have market power. Consider a
production function of the form (2.1), where F is not necessarily homogeneous of
degree 1. Differentiation yields
(3.1)
As noted before, Equation (2.2) implies that r/,q = /~sH; similar reasoning (but
considering the marginal cost of increasing output by increasing the quantity of capital
used) implies that ~/K = #Sx. Thus under perfect competition (so that # = 1), the
elasticities correspond simply to the factor shares, and a natural measure of technical
progress is given by the Solow residual
e slw -

5'~ - s K p ~ -

s.5,..

More generally, however, substitution of Equation (3.1) (with the elasticities replaced
by/* times the corresponding factor income share) yields
eSolow = # - 1 Yr +sH#/>
/Z

(3.2)

In the case of perfect competition, only the second term is present in Equation (3.2),
and the Solow residual measures growth in the technology factor z. But in the presence
of market power (# > 1), increases in output will result in positive Solow residuals
(and decreases in output, negative Solow residuals), even in the absence of any change
in technology. In particular, output fluctuations due to changes in the markup will result
in fluctuations in the Solow residual, closely correlated with output growth.
Hall (1990) points out that in the case that the production function exhibits constant
returns to scale, this problem with the Solow residual can be eliminated by replacing
the weights sK,sH by the shares of these factor costs in total costs, rather than their
share in revenues. Thus he proposes a "cost-based productivity residual"
C a l l -= ~?r - ~K ~?K - ~,v 9H,

where ~/~ = SH/(SK + sH), and sK = 1 - ~H. In terms of these factor shares, the
production function elasticities are given by ~/H = p~H, ~/x = p~,v, where p = ~K + r/~/
is the index of returns to scale defined earlier. Similar manipulations as are used to
derive Equation (3.2) then yield
cHal I

p-

1^
. ^
Yr + s~/yz.

(3.3)

P
Even if kt > 1, as long as p = 1, Hall's "cost-based" residual will measure the growth
in z. One can show, in fact, that this measure of productivity growth is procyclical

1096

J.J Rotemberg and M. Woodford

to essentially the same degree as is the Solow residual 59. But again this need not
indicate true technical change. For if there are increasing returns to scale (p > 1), due
for instance to the existence of overhead labor as discussed above, then increases in
output will result in positive Solow residuals even without any change in technology.
This explanation for the existence of procyclical productivity in the absence of cyclical
changes in technology is closely related to the previous one, since we have already
indicated that (given the absence of significant pure profits) it is plausible to assume
that/~ and p are similar in magnitude.
The quantitative significance of either of these mechanisms depends upon how
large a value one believes it is plausible to assign to /~ or p. Hall (1988, 1990)
argues that many US industries are characterized by quite large values o f these
parameters. He obtains estimates of/~ that exceed 1.5 for 20 of the 26 industries for
which he estimates this parameter. Within his 23 manufacturing industries, 17 have
estimates of/~ above 1.5 while 16 have estimates of p that are in excess of 1.5. His
evidence is simply that both productivity residuals are positively correlated with output
movements, even those output movements that are associated with non-technological
disturbances. In effect, he estimates the coefficients on the first terms on the righthand sides of Equations (3.2) and (3.3) by instrumental-variables regression in using
military purchases, a dummy for the party of the US President, and the price of oil
as instruments for non-technological disturbances that affect output growth. However,
even assuming that the correlations with these instruments are not accidental, this
merely establishes that some part of the procyclical productivity variations that are
observed are not due to fluctuations in true technical progress; since explanations
exist that do not depend upon large degrees of market power or increasing returns,
one cannot regard this as proving that # and p are large.
A second possible mechanism is substitution o f intermediate for primary inputs,
as discussed by Basu (1995). Suppose that materials inputs are not used in fixed
proportions, but instead that each firm's gross output Q is given by a production
function Q = Q ( V , M ) , where M represents materials inputs and V is an index of
primary input use (which we may call "economic value added"), and the function Q is
differentiable, increasing, concave, and homogeneous of degree 1. As before, economic
value added is given by a value-added production function V = F ( K , z H ) . Now
consider a symmetric equilibrium in which the price of each firm's product is the same,
and this common price is also the price of each firm's materials inputs (which are the
products of other firms). Consideration of the marginal cost of increasing output by
increasing materials inputs alone then yields
t~ = Q M ( V , M ) .

(3.4)

59 Because, as Hall notes, pure profits are near zero for US industries, sK + SH has a value near one for
a typical industry; hence the two types of factor shares, and the two types of productivity residuals, are
quantitatively similar in most cases.

Ch. 16:

The Cyclical Behavior of Prices and Costs

1097

Because of our homogeneity assumption, (3.4) can be solved for

M/V = m(#),

where m is a decreasing function. Then defining accounting value added as Y - Q - M,

one obtains
Y / V = Q(1, m(g)) - m(/~).

(3.5)

Furthermore, as long as firms have some degree o f market power (~ > I),
Equation (3.4) implies that QM > 1. Hence Q(1, m) - m will be increasing in m, and
Equation (3.5) implies that Y / V , the ratio of measured value added to our index o f
"economic value added", will be a decreasing function of g.
This implies that a decline in markups would result in an increase in measured value
added Y even without any change in primary input use (and hence any change in V).
This occurs due to the reduction of an inefficiency in which the existence of market
power in firms' input markets leads to an insufficiently indirect pattern of production
(too great a reliance upon primary as opposed to intermediate inputs). I f one's measure
of total factor productivity growth is based upon the growth in Y instead of V, then
markup variations will result in variations in measured productivity growth that are
unrelated to any change in technology. Since a markup decline should also increase
the demand for primary factors of production such as labor, it will be associated
with increases in employment, output, and total factor productivity - where the latter
quantity increases because of the increase in Y / V even if the measurement problems
stressed by Hall (relating to the accuracy of one's measure of the increase in V that
can be attributed to the increase in primary factor use) are set aside.
The quantitative importance of such an effect depends upon two factors, the
elasticity of the function m and the elasticity of the function Q(1, m) - m. The first
depends upon the degree to which intermediate inputs are substitutable for primary
inputs. Basu (1995) establishes that materials inputs do not vary in exact proportion
with an industry's gross output; in fact, he shows that output growth is associated
with an increase in the relative use of intermediate inputs, just as Equation (3.4)
would predict in the case of an output increase due to a reduction in markups. The
second elasticity depends upon the degree of market power in the steady state (i.e.,
the value o f / t around which we consider perturbations), because as noted above,
the derivative of Q(1, m) - m equals/t - 1. Thus while Basu's mechanism is quite
independent of Hall's, it too can only be significant insofar as the typical industry
possesses a non-trivial degree of market power.
An alternative mechanism is "labor hoarding"; indeed, this is probably the most
conventional explanation for procyclical productivity variations. I f only H - Hm hours
are used for current production, but productivity growth is computed using total payroll
hours H as a measure of the labor input, then a tendency of Hm to decline when
H - Hm increases will result in spurious proeyclical variations in measured productivity

1098

J.J Rotemberg and M. Woodford

growth. Furthermore, this is exactly what one should expect to happen, in the case o f
fluctuations in activity due to markup variations.
Suppose that the value to a firm (in units o f current real profits that it is willing
to forego) of employing Hm hours on maintenance (or other non-production) tasks is
given by a function v(Hm). It is natural to assume that this function is increasing but
strictly concave. Then if the firm is a wage-taker, and there are no adjustment costs for
varying total payroll hours H , the firm should choose to use labor for non-production
tasks to the point at which
(3.6)

v' (Hm) = w/P.

Let us suppose furthermore that the real wage faced by each firm depends upon
aggregate labor demand, according to a wage-setting locus of the form
(3.7)

w/P = v ( H ) ,

where v is an increasing function 6. Since v' is a decreasing function while v is

increasing, Equations (3.6) and (3.7) imply that H and Hm should move inversely with
one another, assuming that the source of their changes is not a shift in either of the
two schedules. Finally, allowing for labor allocated to non-production tasks requires
us to rewrite Equation (2.2) as
/~ =

PZFH (K, z ( H - Hm))

(3.8)

Substituting for Hm in the numerator the decreasing function of H just derived, and
substituting for w in the denominator using Equation (3.7), the right-hand side o f
Equation (3.8) may be written as a decreasing function of H. It follows that a reduction
in the markup (not associated with any change in the state of technology, the value
of non-production work, or the wage-setting locus) will increase equilibrium H and
reduce equilibrium Hm. The result will be an increase in output accompanied by an
increase in measured total factor productivity.
If the firm faces a wage that increases with the total number of hours that it hires
(due to monopsony power in the labor market, the overtime premium, or the like), then
the resulting procyclical movements in measured productivity will be even greater. In
this case, Equation (3.6) becomes instead
J ( H m ) = og(H)w/P,

(3.9)

where ~o(H) is the ratio of the marginal to the average wage, as in Equation (2.11). We
have earlier given several reasons why ~o(H) would likely be an increasing function,
60 If we imagine a competitive auction market for labor, then Equation (3.6) is just the inverse of the
labor supply curve. But a schedule of the form (3.6) is also implied by a variety of non-Walrasian models
of the labor market, including efficiency wage models, union bargaining models, and so on. See, e.g.,
Layard et al. (1991), Lindbeck (1993), and Phelps (1994) for examples of discussions of equilibrium
employment determination using such a schedule.

Ch. 16: The Cyclical Behavior of Prices and Costs

1099

at least near the steady-state level of hours. Hence the specification (3.9) makes the
right-hand side an even more sharply increasing function of H than in the case of (3.6).
Similarly, if there are convex costs of adjusting the total number of hours hired by the
firm, Equation (3.6) becomes instead
ot (Hm) = g-2w/P,

(3.10)

where g2 is again the factor defined in Equation (2.13). Again, this alternative
specification makes the right-hand side an even more procyclical quantity than in
the case of (3.6). Thus either modification of the basic model with labor hoarding
implies even more strongly countercyclical movements in Hm, and as a result even
more procyclical variation in measured productivity.
A related explanation for cyclical variation that results from markup variations in
measured productivity is unmeasured variation in labor effort. If, as in the model of
Sbordone (1996), the cost of increased effort is an increase in the wage w(e) that must
be paid, and there are convex costs of varying hours, then the cost-minimizing level
of effort for the firm is given by Equation (2.19). As discussed earlier, this implies
that effort should co-vary positively with fluctuations in hours (albeit with a lead),
since the factor 2 will be procyclical with a lead, while the function ~o(e) will be
increasing in e. Furthermore, consideration of the marginal cost of increasing output
by demanding increased effort implies that 61
PzFL,(K,zeH)
-

(3.11)

w'(e)

Since wt(e) must be increasing in e (at least near the steady-state effort level, as
a consequence of the second-order condition for minimization of the cost w/e of
effective labor inputs), Equation (3.11) requires that a reduction in markups result in an
increase in e H (to lower the numerator), an increase in e (to increase the denominator),
or both. Since e and H should co-vary positively as a consequence of Equation (2.19),
it follows that a temporary reduction of markups should be associated with temporary
increases in effort, hours, and output. Countercyclical markup fluctuations would
therefore give rise to procyclical variations in measured productivity.
Another related explanation is marneasured variation in the degree of utilization
of the capital stock. The argument in this case follows the same general lines. I f
markups fall, firms must choose production plans that result in their operating at a
point of higher real marginal costs (which quite generally means more output). Costminimization implies that real marginal costs increase apace along each of the margins
available to the firm. Thus if it is possible to independently vary capital utilization, the
real marginal cost of increasing output along this margin must increase; under standard

61 As noted earlier, this implies that Equation (2.11) holds with co replaced by co(e).

1100

JJ.. Rotemberg and M. WoodJord

assumptions, this will mean more intensive utilization o f the firm's capital. But the
resulting procyclical variation in capital utilization will result in procyclical variation
in measured productivity, even if there is no change in the rate o f technical progress.
Similar conclusions are obtained when capital utilization is a function o f hours
worked per employee. Consider again the case in which there is an interior solution
for hours because the wage schedule W(h) is nonlinear in hours per employee, and in
which hours per employee nonetheless vary because o f convex adjustment costs for
employment. Then the cost-minimizing decision regarding hours per employee satisfies
the first-order condition 62

O=~o(h)( ~/~ nH
)
+ )~/K "

(3.12)

If we assume both a Cobb-Douglas production function Y = ( u x K ) l - a ( z h N ) a and

an isoelastic capital utilization function ux = h ~ with 0 < )~ <~ 1, the expression
in parentheses is a constant, and Equation (3.12) implies that hours per employee h
must covary positively with g2. This means that fluctuations in hours will accompany
temporary fluctuations in employment (but with a lead). Furthermore, Equation (2.22)
implies that

t~ =

[ a + ~,(1 - a)] P z a K l-a

W,(h)hO_a)O_,~)Nl_ a

Thus a decline in/~ must be accompanied by an increase in W'(h)h (l-a~(l-z) (hence an

increase in h), an increase in N 1-a (hence an increase in N), or both. Since employment
and hours must co-vary positively, there will be an increase in both. As a result,
capital utilization will increase along with output and employment, again resulting
in procyclical variation in measured productivity.
3.1.2. Cyclical profits

Business profits are also well-known to vary procyclically [e.g., Hultgren (1965)];
corporate profits after taxes have long been a component of the NBER's index o f
coincident business cycle indicators. This is sometimes thought to make it implausible
that business expansions are associated with declines in markups, since reduced
markups should lower profits. Indeed, Christiano, Eichenbaum and Evans (1996) report
calculations intended to show that a model in which expansions are due to markup
declines will almost inevitably make the counterfactual prediction that profits must
decline when output expands 63.

62 Note that this follows from the fact that both Equations (2.12) and (2.22) apply in this case.
63 They present their analysis as a criticism of sticky-price models of the effects of monetary policy;
but in fact their criticism relates simply to the fact that the model is one in which output increases due
to a reduction in markups.

Ch. 16:

The Cyclical Behaoior o f Prices and Costs

1101

This implication is, however, less direct than it might at first seem. There are a
number of reasons why profits might well rise when markups fall. Many of these
have been introduced above as reasons why the inverse of the labor share need not
move countercyclically to the same extent as the markup. The connection between
these two issues is simple. The cyclical variation in (real) profits is essentially
determined by the cyclical variation in the amount by which the value of output
exceeds the wage bill, Y - ( w / P ) H . (This is because the remaining deductions
involved in the calculation of accounting profits, such as interest payments and
depreciation allowances, are relatively less cyclical.) Now if the labor share w H / P Y
is n o t procyclical, it follows that when output increases, w H / P increases no more
than proportionally to output, which surely means l e s s in absolute magnitude, since
labor compensation is on average only three-quarters of the value of output. Hence
Y - ( w / P ) H will increase. Thus any model that does not predict a procyclical labor
share will a f o r t i o r i not predict countercyclical profits. And indeed, parameter values
that imply procyclical variation in profits in response to markup variations are not hard
to find.
Consider first our simplest model, in which firms pay the same wage regardless of
the number of hours they hire, there are no adjustment costs, and the measured capital
and labor inputs are all that matter for a firm's output. Then equilibrium output Y ,
hours t l , and real wage w / P are determined by Equations (2.1), (2.2), and (3.7), given
the capital stock K, the state of technology z, and the markup #. Let us consider the
effects of markup variations, holding fixed the other two parameters (and the functions
F and v). If we neglect changes in interest and depreciation, the change in profits is
given by
d H = d(Y - v H ) = (ZFH - v) d H - H d v
= (t~ - 1 - c , , ) v d H ,

(3.13)

where v = w / P is the real wage, and e~ - H v l / v is the elasticity of the wage-setting

locus in Equation (3.7). It follows that profits increase along with employment and
output if and only if
kt > 1 + cv.

(3.14)

Now this is certainly possible; under the hypothesis of market power in the product
market (which we require in order to suppose that markup variations are p o s s i b l e ) ,
/~ > 1, so it is simply necessary that e~ be small enough.
This may not, however, seem empirically plausible; essentially, Christiano et al.
argue that it would require a greater degree of market power than is plausible for
most US industries. Their proposed value for e,, however (their "baseline" calculation
assumes e~ = 1), is based not upon the observed degree of cyclicality of wages, but
upon what they regard as a plausible specification of household preferences, given
an interpretation of Equation (3.7) as the labor supply schedule of representative

J.J Rotemberg and M. WoodJbrd

1102

household. In fact, the average wage is observed to be relatively acyclical, and even i f
this is a puzzle for the theory o f labor supply, there is no reason to assume a stronger
real wage response to increases in labor d e m a n d in calculating the effect on profits
o f an increase in output associated with a decline in markups. For example, Solon,
Barsky and Parker (1994) find an elasticity o f the average real wage with respect to
hours worked o f about 0.3 64; thus an average markup in excess o f 1.3 would suffice to
account for procyclical profit variations. A n d again, this is the "value-added markup"
that must exceed 1.3; for this, the typical supplier's markup need not be' much more
than 10 percent.
In any event, procyclical profits do not require even as large an average markup
as this, i f we make the model more realistic, in any o f the several ways discussed
above. Consider first the possibility that the marginal wage paid by a firm varies
with the number o f hours that it hires, and not only with aggregate labor demand
(as assumed above), due, for example, to m o n o p s o n y power in the labor market. Let
us write the firm's wage bill as W(Hi;H), where H i represents hours hired b y firm i,
and H represents aggregate hours hired. Then in a symmetric equilibrium, the average
wage v is given by W(H; H)/H, and the ratio co o f the marginal wage to the average
wage is given by HWI(H; H)/W(H; H). In this case, Equation (3.13) generalizes to
dH = d(Y-

W ( H ; H ) ) = (zFi~ - W1 -

W2)dH

= (l~- 1 - W2/W1)W1 d H = (cot~ - 1 - e v ) v d H ,

so that Equation (3.14) becomes
cog > 1 + ev.

(3.15)

Since, as explained earlier, there are a number o f reasons for co to be larger than one,
the markup need not be as large as is required b y Equation (3.14) in order for profits
to be procyclical. If, for example, we assume that co = 1.2, as Bils (1987) estimates 65,
and c~ = 0.3, it suffices that/~ = 1.1 (which means a gross-output markup o f 4%).

64 Solon et al. find a considerably larger elasticity for the wage of individuals, once one controls for
cyclical changes in the composition of the workforce. However, for purposes of the cyclical profits
calculation, it is the elasticity of the average wage that matters; the fact that more hours are low-wage
hours in booms helps to make profits more procyclical.
65 This is what Bils' estimates imply for the ratio of marginal wage to average wage when the margin
in question is an increase in weekly hours per employee, and the derivative is evaluated at a baseline of
40 hours per week. (As noted above, Bils finds that this ratio rises as hours per employee increase.) In
applying this ratio to Equation (3.15), we assume that the marginal cost of additional hours is the same
whether they are obtained by increasing hours per employee or by increasing the number of employees,
as must be true if firms are cost-minimizing.

Ch. 16:

1103

The Cyclical Behavior o f Prices and Costs

Alternatively, suppose that some labor is used for non-production purposes, as in

our above discussion of "labor hoarding". Then Equation (3.13) becomes instead
d H = d(Y -

vii) = zFH(dH - dHm) - v dH - H dv

= (0# - 1 - e~)v dH,

where 0 denotes the derivative of labor used in production

total labor H . Thus Equation (3.14) becomes

H - Hm

O/z > 1 + cv.

with respect to

(3.16)

If labor hoarding is countercyclical, 0 > 1, and Equation (3.16) also requires a smaller
markup than does Equation (3.14). The findings of Fay and Medoff (1985), discussed
above, would suggest a value of 0 on the order of 1.4. This would be enough to satisfy
Equation (3.16) regardless o f the size o f the markup.
Similar results are obtained in the case of variable labor effort or variable capital
utilization. The implied modification of Equation (3.14) is largest if the costs of
higher effort or capital utilization do not show up in accounting measures of current
profits. For example, suppose that effective capital inputs are given by u x K , where
the utilization rate uK is an independent margin upon which the firm can vary its
production process, and suppose that the cost of higher utilization is faster depreciation
of the capital stock (but that this is not reflected in the depreciation allowance used
to compute accounting profits). As explained above, we should expect a decline in
markups to be associated with a simultaneous increase in real marginal costs along
each margin, so that firms choose to increase ux at the same time that they choose to
increase labor inputs per unit of capital. Let )~ denote the elasticity o f uK with respect
to H as a result of this cost-minimization on the part o f firms 66. Then Equation (3.13)
becomes instead
d H = d(Y -

vii)

= zFHdH + KFK dux - v dH - H dv

= (#+ ~/Ks~- 1 - e~)vdH,

and Equation (3.14) again takes the form (3.16), where now 0 - (t/H + ,~K)/~7~I. If
capital utilization and hours co-vary positively (as we have argued, and as is needed
in order to interpret procyclical productivity variations as due to cyclical variation
in capital utilization), then 0 > 1, and again a smaller markup than is indicated by
Equation (3.14) will suffice for procyclical profits. If, for example, ;~ = 1, as argued

66 Note that we do not here assume a structural relation between the two variables.

1104

J J Rotemberg and M. Woodford

by Bils and Cho (1994), then 0 > 1:3, and Equation (3.16) is satisfied no matter how
small the average markup may be.
3.2. Identifying the output fluctuations due to markup variation

We now describe the consequences of alternative measures of marginal costs for one's
view of the sources of aggregate fluctuations. We propose to decompose the log of
real GDP Yt as
Yt = Y t +Yt~,

(3.17)

where the first term represents the level of output that is warranted by shifts in the
real marginal cost curve introduced in Section 1 (for a constant markup), while the
second is the effect on output of deviations of markups from their steady-state value,
and hence represents a movement along the real marginal cost schedule. We then use
this decomposition to investigate the extent to which changes in y are attributable
to either term. Because there is no reason to suppose that changes in markups are
independent of shifts in the real marginal cost curve, there is more than one way in
which this question can be posed. First, one could ask how much of the fluctuations in
aggregate activity can be attributed to the fact that markups vary, i.e., would not occur
if technology and labor supply varied to the same extent but markups were constant
(as would, for example, be true under perfect competition). Alternatively, one might
ask how much of these fluctuations are due to markup variations that are not caused
by shifts in the real marginal cost schedule, and thus cannot be attributed to shifts in
technology or labor supply, either directly or indirectly (through the effects of such
shocks on markups).
The first way of posing the question is obviously the one that will attribute the
greatest importance to markup variations. On the other hand, the second question
is of particular interest, since, as we argued in Section 1, we cannot attribute much
importance to "aggregate demand" shocks as sources of business fluctuations, unless
there is a significant component of output variation at business-cycle frequencies that
can be attributed to markup variations in the more restrictive sense.
Mere measurement of the extent to which markup variations are correlated with the
cycle - the focus of our discussion in Section 2, and the focus of most of the existing
literature - does not provide very direct evidence on either question. I f we pose the first
question, it is obviously necessary that significant markup variations exist, if they are
to be responsible for significant variation in economic activity. But the relevant sense
in which markup variations must be large is in terms of the size of variations in output
that they imply. The size of the correlation of markup variations with output is thus
of no direct relevance for this question. Moreover, markup variations could remain
important for aggregate activity in this first sense even if markups were procyclical
as a result of increasing whenever real marginal costs decline. In this case, markup
variations would dampen the effects of shifts in real marginal costs.

Ch. 16." The Cyclical Behavior o f Prices and Costs

1105

If, instead, we ask about the extent to which markup variations contribute to output
movements that are independent of changes in real marginal cost, the correlation of
markups with output plays a more important role. The reason is that these orthogonal
markup fluctuations lead output and markups to move in opposite directions and thus
induce a negative correlation between output and markups. However, markups could
be very important even without a perfect inverse correlation since, as we show below,
the dynamic relationship between markup variations and the employment and output
variations that they induce is fairly complex in the presence of adjustment costs.
Furthermore, even neglecting this, a strong negative correlation between markups
and activity would be neither necessary nor sufficient to establish the hypothesis that
orthogonal movements in markups contribute a great deal to output fluctuations. The
negative correlation might exist even though the business cycle is mainly caused
by technology shocks, if those shocks induce countercyclical markup variations that
further amplify their effects upon output and employment. And the negative correlation
might be weak or non-existent even though shocks other than changes in real marginal
cost are important, if some significant part of aggregate fluctuations is nonetheless due
to these cost shocks, and these shocks induce procyclical markup variations (that damp,
but do not entirely eliminate or reverse, their effects upon output).
In this section, we try to settle these questions by carrying out decompositions
of the sort specified in Equation (3.17) and analyzing the extent to which y*, ~
and the part o f ~ ~ that is orthogonal to y* contribute to movements in y. We do this
for two different measurements of/Tt, which imply different movements in ~ . The first
measurement of/Tt we consider is based on Equation (2.9) while the second is based
on the existence of a cost of changing the level of hours worked. Because of space
constraints, we are able to give only a cursory and illustrative analysis of these two
cases.
We start with the case where markups are given by Equation (2.9), for which we
gave several interpretation above. To compute how much output rises when markups
fall, we must make an assumption about the extent to which workers demand a higher
wage when output rises. We thus assume that, in response to changes in markups,
wages are given by
~t = t/w/2/,.

(3.18)

Thus, t/v/ represents the slope of the labor supply curve along which the economy
moves when markups change. Obviously, this simple static representation is just a
simplification. We again let t/H represent the elasticity of output with respect to hours
when hours are being changed by markup movements. Using Equation (3.18) in (2.9)
together with the assumption that changes in output induced by markup changes equal
t/H times [/, it follows that
=-

(1-b-~H(1-a) *Iw)~
~H

~-H Y '

(3.19)

where the term in parentheses is positive because ~/H is smaller than one and a and b
are nonpositive. This formula allows us to compute #~ once we have measured/~ as

1106

J.J. Rotemberg and M. Woodford

above. In other words, it allows us to go from the measurement of markups to the

measurement of output movements implied by markups. Once we have obtained)3~ in
this manner, we subtract this from y to obtain y*, as required by Equation (3.17). To
do all this, we need three parameters, namely a and b (to construct the markup) and
the expression in parentheses in Equation (3.19). Our illustrative calculation is based
on setting a equal to zero, b equal to -0.4 (which we saw guarantees that the markup is
quite countercyclical) and setting the expression in parentheses equal to 1/0.7. Given
these values for a and b, this last parameter can be rationalized by supposing that
~/H = 0.7 and t/v/= 0.3. This elasticity of labor supply is broadly consistent with the
estimates of Solon, Barsky and Parker (1994).
I f we use these parameters and compute ~ in the way that we did in Section 2,
however, the variance of ~ and, in particular, the movements in ~ that are orthogonal
to movements in )3 are rather large. These orthogonal movements in )3~ must then be
matched by equal and opposite movements in y*. One interpretation of this is that
shifts in the marginal cost curve would lead to much larger output swings than those
we actually observe if it weren't for procyclical markup movements that dampen these
shifts. Another interpretation is that there are large errors in the measurement of the
wage that lead the labor share to be measured with error. These random movements in
the labor share then lead to offsetting movements in the two terms of Equation (3.17),
)3# and y*.
To deal with this possibility, we modify the analysis somewhat. Instead of using
actual wages in computing ~, we use the projection of the ratio of per capita
compensation to per capita output, ( w - y), onto the cyclical variables that we used
in Rotemberg and Woodford (1996a). In other words, we make use of the regression
equation
w t - Yt = cI)wZt,

(3.20)

where Zt now represents the current and lagged values of the change in private value
added, the ratio of nondurables and services consumption to output, and detrended
hours worked in the private sector. To obtain the ratio of per capita compensation to per
capita output that we use in Equation (3.20) we divided the labor share by the deviation
of hours from their linear trend. Since this same deviation of hours is an element of
the Zt vector, we would have obtained the same results if we had simply projected the
labor share itself. For this included level of hours (and output) to be comparable to the
labor share we use to construct (w - y ) , this labor share must refer to the private sector
as a whole. We thus use only this particular labor share in this section. Because of the
possibility that this labor share does not follow a single stationary process throughout
our sample, we estimated Equation (3.20) only over the sample 1969:1 to 1993:1.
Equation (3.20) allows us to express ( w - y) as a linear fimction of Z. Given that
a is zero, the only other determinant of the markup in Equation (2.9) is the level
of hours/2/, which is also an element of Z. Thus, our estimate of ~ is now a linear
function of Z. Equation (3.19) then implies that fit~ is a linear function of Zt as well.

Ch. 16: The Cyclical Behavior of Prices and Costs

1107

It is not the case, however, that y[ is a linear function o f Zt. The reason for this is that
Z includes only stationary variables and therefore does not include y. On other hand,
the change in private value added, Ay, is an element of Z. This means that, armed with
the stochastic process for Z that we estimated in Rotemberg and Woodford (1996a),
Zt =AZt 1 +et,

(3.21)

we can construct the innovations in ~u and in y*. These are linear functions of the
vector et which, given Equation (3.21), equals (Zt - A Z t - 1 ) so that these innovations
depend only on the history of the Z's. Similarly, the vector (Zt - A Z t - l ) together with
the matrix A in Equation (3.21) determines how the expectation of future values of Z is
revised at t. This means that we can use Equation (3.21) to write down the revisions at t
^u and y*t+k as linear functions of the history of the Z's.
in the expectations of Yt+k, Yt+k
Finally, the variance covariance matrix of the c's (which can be obtained from A and
the variance covariance matrix of the Z's) then implies variances and covariances for
both the innovations and revisions in the y's, the ~U's and the y*'s.
Table 3 focuses on some interesting aspects o f these induced variances and
covariances. Its first row focuses on innovations so that it shows both the variance of
the innovation in y* and in ~u as ratios of the innovation variance in y. The subsequent
rows focus on revisions at various horizons. The second row, for example, gives the
population variances of the revisions at t of y[+s and ~ut+5 as ratios to the variance of
the revision of yt+s. All these revisions correspond to output changes one year after
the effect of the corresponding et's is first felt. The next row looks at innovations two
years after the innovations first affect output and so on.
We see from Table 3 that this measure of the markup has only a very modest effect
on one's account of the source of aggregate fluctuations in output. The variances
of revisions in y* are almost equal to the corresponding variances of y for all the
horizons we consider. The innovation variance of y* is actually bigger which implies
that innovations in ~u that are negatively correlated with y* dampen the effect of these
short-run movements of y* on y. The last column in Table 3 looks at the variances of
the component o f ) u that is orthogonal to y*. This variance is equal to the variance of
flu times (1 -/3 2) where p represents the correlation between flu and y* and where this
correlation can easily be computed from Equation (3.21). To make the results clearer,
we again present the variance of this orthogonal component of flu as a fraction of
the corresponding variance of y. It is apparent from this column that this orthogonal
component explains very little of the variance o f y at any of the horizons we consider.
Thus, even though this measure of the markup is negatively correlated with our cyclical
indicators, it induces movements in output that are much smaller than the actual ones.
Overturning this finding appears to require implausible parameters. To make
output more responsive to markup changes requires that the term in parenthesis in
Equation (3.19) be smaller. We could achieve this by making r/r1 smaller or t/w bigger
but, given the values that we have chosen, large changes of this sort would be
unreasonable. An alternative way of lowering this coefficient is to make b smaller

J.J Rotemberg and M. Woodford

1108

Table 3
Fractions of the variance o f y accounted by fi~ and y* a

varAy*
VarAy

varA))t~
VarAy

varAfig orthogonalto Ay*

Innovation variances

1.43

0.05

0.01

Revisions over 5 quarters

0.88

0.06

0.,06

Revisions over 9 quarters

0.86

0.08

0.08

Revisions over 13 quarters

0.90

0.07

0.07

Revisions over 17 quarters

0.90

0.05

0.05

Revisions over 21 quarters

0.91

0.05

0.05

Revisions over 25 quarters

0.91

0.04

0.04

Val'dy

b = -0.4, a , c = O

c=8, a , b - O
Innovation variances

2.38

2.89

0.97

Revisions over 5 quarters

0.55

1.28

0.97

Revisions over 9 quarters

0.65

1.13

0.89

Revisions over 13 quarters

0.66

1.13

0.90

Revisions over 17 quarters

0.61

1.03

0.86

Revisions over 21 quarters

0.59

0.91

0.81

Revisions over 25 quarters

0.58

0.81

0.75

Revisions over 81 quarters

0.84

0.21

0.21

a Calculations based on projecting ( w - y ) on Z for period 1969:1 1993:1 and using properties of
stochastic process in Equation (3.21) where this stochastic process is estimated from 1948:3 to 1993:1.

in absolute value. The problem is that, as we saw before, this makes the markup less
cyclical. Thus, it does not help in making ~ track more of the cyclical movements
in output. By the same token, setting a equal to a large negative number makes the
markup more countercyclical but raises the term in parenthesis in Equation (3.19)
thereby reducing the effect of the markup on 3~.
We now turn to the case where adjustment costs imply that deviations of the markup
from the steady state are given by Equation (2.15). We follow Sbordone (1996) in that
we also let output vary with employee effort and this, as we saw, is consistent with
Equation (2.15). Letting a be zero and using Equation (2.14), Equation (2.15) can be
rewritten as
(3.22)
Allowing for variable effort is useful because it relaxes the restriction that the short run
output movements induced by markup variations are perfectly correlated with changes

Ch. 16." The Cyclical Behavior o f Prices and Costs

1109

in hours. Thus, as in our earlier discussion of her model, we suppose that output is
given by Y = F(K, zeH). As a result, we have
f = t/H(/2/+ b).

(3.23)

We suppose as before that the wage bill is given by Hfvg(e), where ~ captures all the
determinants of the wage that are external to the firm and g is an increasing ftmction.
This leads once again to Equation (2.19) which, once linearized, can be written as
et = c

[(f/t -/2L 1 ) -

Et(Iqt+l-/2/t)]

(3.24)

Finally, we assume that average wages are given by

#t = #or + Ow/2/t+ ~POt.

(3.25)

It is important to stress that the parameters ~ and ~p do not correspond to the

elasticities of the average wage paid by an individualfirm with respect to the individual
firm's hours and effort level. Rather, they are the elasticities of the economy-wide
average wage with respect to aggregate changes in hours and average work effort.
Note also that fVot is the exogenous component of the wage, i.e., the one that is not
affected by changes in markups. Using Equations (3.23) and (3.25) to substitute for
fit and #t respectively in Equation (3.22) and then using Equation (3.24) to substitute
for ~t in the resulting expression we obtain
c

2, + #or = (t/H-- 1-- t/W)/2/,+ (t/H -- ~P-- e o ) ~ [(/?/t - - / ) t - , ) - Et(H,+, - ~r)].

This difference equation in i2/can be written as

Et Lfi-(1-

- }~2L)/~, = -~(fi, -

i1L)(1

trot),

where L is the lag operator while ~.1 and ~.2 are the roots of
/3/~,2 _ [l + / 3 +

013,+ 1 = 0

and
0--

1 + t/w - t/n e~o

~P+e~-t/H c'

~=

ca)

~P+e~o--t/H c

Noting that ~.1/3 is equal to 1/~.2 and letting ~. be the smaller root (which is also smaller
than one as long as 1 + t/v/ > 0H and ~p + e,o > 0), the solution of this difference
equation is
OO

OO

I2It = -~ Z Z ~'k(/3~')JEt-k[fit+J k -- Vot+jk]

(3.26)

k=0j-0

The deviations of hours from trend that are due to changes in markups,/~/~', can
then be obtained by simply ignoring the movements in Wo in Equation (3.26). We can

J.J Rotemberg and M. Woodford

1110

then compute the deviations o f output from trend that are due to markup variations,
~ , by combining Equations (3.23) and (3.24) to yield

~t = I]1-!(~l~tt.q- C.~COI(~1~__/~t~1) _Et(~t~+l _

A~)]) .

(3.27)

This implies that, as before, )3~ is a linear function o f current and past values Zt. To
see this, note first that Equation (3.22) implies that we can write/2t as a function of Zt.
The reason for this is that (w - y) is a function o f Zt, Ht is part of Zt and, as a
result o f Equation (3.21), Et/2/t+l is the corresponding element o f AZt. Therefore,
using Equation (3.21) once again, the expectation at t o f future values of/~ must be a
ftmction o f Zt. Past expectations of markups which were, at that point, in the future are
therefore fimctions of past Z's. The result is that we can use Equation (3.26) to write
) ~ as a fimction of the history o f the Z's 67. Finally, we use Equation (3.27) to write
the component of output that is due to markup changes as a function of the Z's.
We require several parameter values to carry out this calculation. First, we set c equal
to 8 to calculate ~t in Equation (3.22). To compute the connection between y~ and the
Z's we need three more parameters. It is apparent from Equations (3.26) and (3.27)
that this calculation is possible if one knows ~, ~ and cr~ in addition to c (which
is needed to compute markups anyway). For illustrative purposes, we set these three
parameters equal to 0.79, 0.13 and 3 respectively. The parameters ~ and ~ are not as
easy to interpret as the underlying economic parameters we have used to develop the
model. In addition to c and co) these include t/v, t/w, ~. Because the number o f these
parameters is larger than the number o f parameters we need to compute .~, there is a
one dimensional set of these economically meaningful parameters that rationalizes our
construction of33~. In particular, while this construction is consistent with supposing
that t/H, t/w, and ~0 equal 0.7, 0.25 and 0.1, respectively, it is also consistent with
different values for these parameters 6s.
We use our knowledge o f the relationship between ~ and the Z's for two purposes.
As before, we compute the variances o f the innovations and revisions in )3~ as well as
of y*. Second, we look at the resulting sample paths of)3~ and y*. The second part o f
Table 3 contains the variances, which correspond to the ones we computed before. The
results are quite different, however. In particular, the variance of the component of33 ~
that is orthogonal to y* now accounts for about 90% o f the variance of the revisions in
output growth over the next two years. Thus, independent markup movements are very
important in explaining output fluctuations over "cyclical" horizons. Moreover, if one

67 Because we later want to compute the sample values of~ ~ we truncate k so that it rtms only between
zero and eighteen. Given that our ,~ equals 0.79, this truncation should not have a large effect on our
results.
68 Note that we have made t/w, the elasticity of the wage with respect to hours along the aggregate
labor supply curve, somewhat smaller than before because our use of a positive ~p implies that wages
rise with output not only because hours rise but also because effort rises.

Ch. 16." The Cyclical Behavior o f Prices and Costs

1111

8.6
8.5
8.4
8.3
8.2
8.1

"~jl eli

8.0
Fig. 3. Constant-markupand actual output.
takes the view that the movements o f y that are genuinely attributable to y* are those
which are not due to the component offi ~ that is orthogonal to y*, the movements in y*
account for only about 10% of the movements in y. Movements in y* have essentially
no cyclical consequences. It is not that the revisions in the expectations of y* are
constant. Rather, upwards revisions in y* over medium-term horizons are matched
by increases in markups that essentially eliminate the effect of these revisions on y.
This cannot be true over long horizons since the markup is assumed to be stationary
so that flu is stationary as well. Thus, changes in y* that are predicted 20 years
in advance account for about 80% of the revisions in output that are predicted
20 years in advance.
An analysis of the sample path o f ~ ~ (and the corresponding path of y*) delivers
similar results. Such sample paths can be constructed since ~ depends on the Z's which
are observable. Admittedly, Equation (3.26) requires that the entire history of Z's be
used. Data limitations thus force us to truncate k at 18 as explained in footnote 67. The
result is that ~ depends on 18 lags of Z. To make sure that the lagged expectations
of markups which enter Equation (3.26) are computed within the period where the
labor share remains a constant stationary function Zt, we construct this sample path
starting in 1973:2. The resulting values of y* and the log of output y are plotted in
Figure 3. It is apparent from this figure that the episodes that are usually regarded as
recessions (which show up in the Figure as periods where y is relatively low) are not
reflected in movements of y*. Figure 4 plots instead y~ against the predicted declines
of output over the next 12 quarters. These series are nearly identical so that, according
to this measure of the markup, almost all cyclical movements in output since 1973

1112

J J Rotemberg and M, Woodford

0.06
Predicted decline
f~

0.04
0.02

!"i

0.00

"-\/

i~,
i_

-0.02
-0.04-

[.i
/

-0.06 -

-0.08-0.10-

74

76

78

80

82

84

86

88

90

92

Fig. 4. Markup-induced output gap and predicted output declines.

are attributable to markup variations. This second measure of markups is thus much
more successful in accounting for cyclical output movements. This result is probably
partly due to the fact that this method of estimating 33~' recognizes the possibility that,
in booms, output expands more than is suggested by the labor input as a result of
increases in effort 69.

4. M o d e l s o f variable m a r k u p s

We now briefly review theoretical models of markup variation. We give particular

attention to models in which markups vary endogenously, and thus affect the way the
economy responds to shocks. The shocks of interest include both disturbances that shift
the marginal cost schedule and other sorts of shocks, where these other shocks would
not have any effect on equilibrium output in the absence of an effect upon equilibrium
markups.
Before reviewing specific models, it is perhaps worth commenting upon the kind of
theoretical relations between markups and other variables that are of interest to us. It
is important to note that an explanation for countercyclical markups need not depend
upon a theory that predicts that desired markups should be a decreasing function of the
level of economic activity. If the real marginal cost schedule c(Y) is upward-sloping,

69 For another setting where inferences regarding markups are significantly affected by supposing that
there are costs of adjusting labor, see Blanchard (1997).

Ch. 16: The Cyclical Behavior of Prices and Costs

1113

then any source of variations in the markup that are independent of variations in the
marginal cost schedule itself will result in inverse variations in the level of output, and
so a negative correlation between the markup and economic activity. Thus theories of
why markups should vary as functions of interest rates or inflation (rather than of
the current level of economic activity) might well be successful explanations of the
cyclical correlations discussed in Section 2. In fact, a theory according to which the
markup should be a function of the level of economic activity is, in some respects,
the least interesting kind of theory of endogenous markup variation. This is because
substitution of/~ =/~(Y) into Equation (1.1) still gives no reason for equilibrium output
Y to vary, in the absence of shifts in the marginal cost schedule. (Such a theory, with
/~ a decreasing function o f Y, could however serve to amplify the output effects of
shifts in that schedule.)
Care is also required in relating theories of pricing by a particular firm or industry,
as a function of conditions specific to that firm or industry, to their implications for
aggregate output determination. For example, a theory according to which a firm's
desired markup is an increasing function of its relative output, /d = /t(yi/y) with
/~ > 0, might be considered a theory of "procyclical markups". But in a symmetric
equilibrium, in which all firms price according to this rule, relative prices and outputs
never vary, and there will be no cyclical markup variation at all. If instead (as discussed
in section 4.3 below) not all firms continuously adjust their prices, the fact that
adjusting firms determine their desired markup in this way can reduce the speed of
overall price adjustment; and this increase in price stickiness can increase the size
of the countercyclieal markup variations caused by disturbances such as changes in
monetary policy.
The models we look at fall into two broad categories. In the first class are models
where firms are unable to charge the price (markup) that they would like to charge
because prices are sticky in nominal terms. Monetary shocks are then prime sources of
discrepancies between the prices firms charge and the prices they would like to charge.
This leads to changes in markups that change output even if desired markups do not
change. In the second class of models, real factors determine variations in desired
markups, even in the case of complete price flexibility. Finally, we briefly consider
interactions between these two types of mechanisms.
4.1. Sticky prices

We do not provide a thorough survey of sticky price models since that is taken up in
Taylor (1999). Rather, our aim is threefold. First, we want to show how price stickiness
implies markup variations, and so may explain some of the findings summarized in
our previous sections. Second, we want to argue that markup variations are the crucial
link through which models with sticky prices lead to output variations as a result
of monetary disturbances. In particular, such models imply a link between inflation
and markups which is much more robust than the much-discussed link between
inflation and output. Thus viewing these models as models of endogenous markup

J.J Rotembergand M. Woodford

1114

variation may help both in understanding their consequences and in measuring the
empirical significance of the mechanisms they incorporate. Finally, we discuss why
sticky prices alone do not suffice to explain all o f the evidence, so that other reasons
for countercyclical markups also seem to be needed.
It might seem at first peculiar to consider output variations as being determined by
markup variations in a model where prices are sticky. For it might be supposed that if
prices are rigid, output is simply equal to the quantity demanded at the predetermined
prices, so that aggregate demand determines output directly. However, this' is true only
in a model where prices are absolutely fixed. It is more reasonable to suppose that
some prices adjust, even over the time periods relevant for business cycle analysis.
The issue then becomes the extent to which prices and output adjust, and, as we shall
see, this is usefully tmderstood in terms of the determinants of markup variation.
We illustrate the nature of markup variations in sticky-price models by presenting a
simple but canonical example, which represents a discrete-time variant of the model of
staggered pricing of Calvo (1983), the implications of which are the same (up to our
log-linear approximation) as those o f the Rotemberg (1982) model of convex costs of
price adjustment. First, we introduce a price-setting decision by assuming monopolistic
competition among a large number o f suppliers o f differentiated goods. Each firm i
faces a downward-sloping demand curve for its product of the form

Y/=D(P~Yt,
\PtJ

(4.1)

where Pj is the price of firm i at time t, Pt is an aggregate price index, I(t is an index o f
aggregate sales at t, and D is a decreasing function. We suppose that each firm faces
the same level of (nominal) marginal costs Ct in a given period 7. Then neglecting
fixed costs, profits of firm i at time t are given by

( e; ) r,.
\PtJ

Following Calvo, we assume that in each period t, a fraction (1 - a) of firms are

able to change their prices while the rest must keep their prices constant. A firm that
changes its price chooses it in order to maximize

Et ~-" j~ .1-1i+j
2._., a ~xt,t+1Pt+j'
j=0

where Rt,t+j is the stochastic discount factor for computing the present values at t of
a random level of real income at date t +j. (The factor ctJ represents the probability
70 Note that we have discussed above reasons why this need not be so, for example when a firm's
marginal wage differs from its average wage. As Kimball (1995) shows, deviations from this assumption
may matter a great deal for the speed of aggregate price adjustment, but we confine our presentation to
the simplest case here.

Ch. 16." The Cyclical Behavior o f Prices and Costs

1115

that this price will still apply j periods later.) Denoting by Xt the new price chosen
at date t by any finns that choose then, the first-order condition for this optimization
problem is

e,

aJe,,.
j=o

O'
t+J

X,

p~+j ~

eD(Xt/Pt+j)

C,./]
Xt J = O,

(4.2)

where eD(x) =-- - x D ' ( x ) / D ( x ) is the elasticity of the demand curve (4.1).
For now, we further simplify by assuming that the elasticity of demand is a positive
constant [as would result from the kind of preferences over differentiated goods
assumed by Dixit and Stiglitz (1977)]. This means that a firm's desired markup, in the
case of flexible prices, would be a constant,/~* = eo/(eo - 1). In this way we restrict
attention to markup variations due purely to delays in price adjustment. It is useful to
take a log-linear approximation of the first-order condition (4.2) around a steady state
in which all prices are constant over time and equal to one another, marginal cost is
similarly constant, and the constant ratio of price to marginal cost equals g*. Letting
xt, ~t and ct denote percentage deviations of the variables Xt/Pt, Pt/Pt i and Ct/Pt,
respectively, from their steady-state values, Equation (4.2) becomes

j=0

, -

O,

(4.3)

k=l

where/3 < 1 is the steady-state discount factor. Here the factor

J
k-I

represents the relative price in period t + j of the firm that chooses new price Xt in
period t, and so Equation (4.3) says, essentially, that the firm's price is expected to be
proportional to its marginal cost of production on average, over the time that the price
chosen at date t applies. This equation can be solved for the relative price ~t of firms
that have just changed their price, as a function of expected future inflation and real
marginal costs. The resulting relation can be quasi-differenced to yield
2ct = ot[3Etfrt+l + (1 - ot[3)~t + ot[3Et~t+b

(4.4)

We suppose that the price index Pt is a symmetric homogeneous degree one function
of the prices of the individual goods. Then near the steady state, it can be approximated
to first order by the geometric average of the prices. Since each period a fraction a

1116

JJ. Rotemberg and M. Woodford

of the prices remain unchanged, while the others all change to the common value Xt,
the rate of increase of the index satisfies

in our log-linear approximation. Substituting this into Equation (4.4), we obtain

f6 =/3Et}ct+, - tcftt,

(4.5)

where t = (1 - a/3)(1 - a ) / a and fit = -ct denotes the percentage deviation of the
average markup ktt =- Pt/Ct from its steady-state value of/~*.
This equation relates the average markup at any date to current and expected future
inflation. To obtain the behavior of equilibrium output, one must use Equation (1.1)
along with this. If we log-linearize the real marginal cost schedule as ~t = z/c~t, where
~'t denotes the percentage deviation of output from trend, then Equation (1.1) implies
- f t t = ~/~Yt. Substitution of this into Equation (4.5) then yields an aggregate supply
relation of the form
frt = OYt +/3Et~t+l,

(4.6)

where 0 -- t~c. This equation specifies an upward-sloping relation between inflation

and output variations, for any given level of expected inflation. Roberts (1995),
who specifies /3 = 1, calls this "the New Keynesian Phillips Curve," and provides
econometric evidence that (when extended to allow for stochastic shifts in the real
marginal cost schedule) US output and inflation data are consistent with a relation of
this kind.
Combined with a specification of the evolution of aggregate nominal spending
[which is often taken, as for example in Rotemberg (1996), to be an exogenous
process determined by monetary policy], Equation (4.6) allows us to solve for
equilibrium fluctuations in output. Because variations in inflation must be associated
with deviations of output from trend, monetary policy disturbances affect equilibrium
output. It will be observed that the output fluctuations in response to such shocks are
associated with countercyclical variations in the average markup.
The endogenous markup variations affect the predicted response of output to other
shocks as well. For example, technology shocks may be considered, by allowing for a
stochastic shift term in the real marginal cost schedule. Such shocks may be associated
with procyclical markup variations: a technological improvement lowers marginal cost,
but because prices do not fall immediately in proportion to the decline in costs,
markups rise, while (because prices do fall some) output increases. This is consistent
with Equations (4.5) and (4.6) if prices fall faster immediately than they are expected
to in the future. In such a case, the markup variation damp the output effects of the

Ch. 16:

The Cyclical Behavior of Prices and Costs

1117

technology shocks relative to what would happen under perfect competition; as a result,
input demand may actually decline in response to a favorable technology shock 71 .
We have seen that a sticky-price model of this kind involves endogenous variation
in the average markup. But is it useful to think of the endogenous markup variations as
central to the way that nominal variables have real effects in this model? We believe
that there are several advantages to viewing the model in this way (in addition, of
course, to the fact that it helps one in relating the predictions o f the sticky-price
model to the kinds o f facts discussed in Sections 2 and 3). First, if one is willing (as
seems reasonable) to abstract from the effects of monetary frictions upon the relations
(labor supply, labor demand, and so on) that underlie the real marginal cost schedule,
then the effects of monetary policy upon the determination o f real variables may be
reduced entirely to its effects upon the average markup. A general equilibrium model
of the effects o f monetary policy may then be usefully decomposed into three distinct
parts, each derived from largely separate microeconomic foundations: (i) a theory of
equilibrium output determination given the markup, essentially a more elaborate
version of Equation (1.1); (ii) an equation relating the markup to inflation variations,
Equation (4.5); and (iii) a theory of how monetary policy affects nominal aggregate
demand. An advantage o f viewing the structure of one's macroeconomic model this
way is that part (i) of the model involves no specifically monetary elements, and may
(except for the allowance for a time-varying markup) be identical to the equations
o f a real business cycle model, while part (iii) does not involve the specification
o f aggregate supply relations, and so may be directly adapted from conventional
Keynesian or monetarist models of the effects o f monetary policy on aggregate
demand. The theory of endogenous markup variation thus provides the crucial link
that allows the concerns o f real business cycle models and conventional monetary
models to be synthesized 72.
Second, understanding the markup variations that are associated with variations in
real activity in a sticky-price model is important to understanding when and how those
fluctuations in activity are inefficient, since the markup directly measures the extent to
which a condition for efficient resource allocation fails to hold. This perspective can
be a source o f important insights into the welfare losses from price-level instability
and the nature of optimal monetary policy.
And third, recognizing that Equation (4.5) is a more fundamental prediction of
the model o f price-setting than is a relation such as (4.6), which also depends upon
one's specification of wage-setting behavior and the like, may allow more accurate

71 This is what Gali (1999), Basu, Fernald and Kimball (1998) and Kiley (1996) find to be true in
US data, using a variety of quite different methods. Shea (1998), who identifies productivity shocks
from data on R&D spending and patents, does not find this contractionary effect upon input demand,
though his identified shocks also have little impact on long run output.
72 See Kimball (1995) and Goodfriend and King (1997) for more detailed sketches of this program,
which the latter authors term "the New Neoclassical Synthesis". Goodfriend (1997) also stresses the
importance of markup variations in accounting for the real effects of monetary policy.

1118

J.J Rotemberg and M. Woodford

empirical estimation of the speed of aggregate price adjustment. Sbordone (1998) tests
the accuracy of Equation (4.5) as a model of aggregate price dynamics in the USA by
first estimating the evolution of unit labor cost (assumed to be proportional to marginal
cost) using a VAR. Using this evolution of unit labor costs, she then computes the
equilibrium path of the price index implied by Equation (4.5). She finds that this simple
model accounts quite well for the evolution of the private GDP deflator in the USA,
at the quarterly frequency, over the period 1960-1997. In the case of her best-fitting
value for a 73, the variance of the discrepancy between the actual price aeries and the
one that would be predicted on the basis of the unit labor cost process is reduced to
only 12% of what it would be in the absence of price rigidity 74, while the variance
of the discrepancy between the actual and predicted inflation series is reduced to
only 4% of what it would be according to the flexible-price (constant-markup) model.
It is especially striking that the model fits this well without any need for complications
such as stochastic disturbances to the pricing equation; this suggests that Equation (4.5)
is indeed more descriptive of the data than the aggregate supply relation (4.6). This
would suggest that the stochastic disturbances to this aggregate supply relation, which
require Roberts (1995) to add additional terms to his estimated equation and to estimate
it using instrumental variables, represent mainly disturbances to the real marginal cost
schedule, rather than disturbances to the pricing relation (4.5).
Despite the impressive success of this simple model as an explanation of much of
the cyclical variation in prices relative to labor costs, there is some reason to doubt that
this model of markup variation is completely adequate. In particular, the implication
that the output effect of supply shocks is muted in sticky-price models is problematic
given that, as suggested by Hamilton (1983) economic activity has tended to fall in the
aftermath of pre-1986 oil-price increases. If the principal effect of oil-price increases is
to increase marginal costs, then a sticky-price model (by implying that prices should
rise less than the increase in marginal costs, so that markups fall) will imply even
less of a contraction of equilibrium output than one should expect in the case of
a flexible-price model. However, the size of the observed contractionary effects of
oil-price shocks on the US economy is already rather larger than makes sense under
competitive pricing, owing to the relatively small share of energy costs in total marginal
costs of production. For this reason, Rotemberg and Woodford (1996b) propose that
oil price increases lead to increases in desired markups. With this motivation, we turn
to a brief review of models where desired markups vary.

73 This value is about 0.75 for her quarterlymodel, which implies an averagetime betweenprice changes
of approximately 14 months. This represents less frequent price adjustment than is observed in most
sectors of the US economy, according to the survey evidence presented in Blinder et al. (1998). The
coefficient I estimated by Sbordone can be reconciled, however, with more frequent price adjustments
if one hypothesizes variations in desired markups, as discussed in Section 4.3.
74 This means that the model of markup variation (4.5), combined with the simple measure (2.4) of
marginal costs, can account for 88% of the observed variability of the log ratio of price to unit labor
cost (or equivalently, of the log labor share) over this period.

Ch. 16: The Cyclical Behavior of Prices and Costs

1119

4.2. Variations in desired markups

For simplicity, in this section we assume completely flexible prices. We also simplify
by making all firms fully symmetric so that, in equilibrium, they all charge the same
price. A number of types of theories of this kind have been considered in the literature.
4.2.1. Varying elasticity o f demand

Probably the simplest and most familiar model of desired markup variations attributes
them to changes in the elasticity of demand faced by the representative firm. There
are two important ways in which one might allow for variations in the elasticity of
demand at a symmetric equilibrium where all relative prices are equal to one.
The first is to suppose that the utility and/or production functions that define buyers'
preferences over differentiated goods are not homothetic, so that changes in aggregate
purchases Yt change the elasticity of demand. This is not an entirely satisfactory
assumption, however, because it is unappealing to assume that growth should lead
to secular changes in the elasticity of demand and in markups. One may, however,
avoid this implication by complicating the model, for example by assuming that growth
is associated with an increase in the number of differentiated goods rather than any
secular increase in the scale of production of any individual goods
A more appealing way of obtaining changes in thi s elasticity is to follow Gali (1994)
and Heijdra (1995) and assume that there are several different kinds of purchasers 75.
Each of these purchases all of the goods that are produced, but the different types
each have different preferences over differentiated goods. Suppose, for example, that
two groups 1 and 2 each care only about the amount they obtain of a composite good
defined by a symmetric, homogeneous degree 1 aggregate of all goods purchases, but
that the aggregator functions H~ and H2 are different for the two groups. Then the
demand for good i by groupj can be written as Yj,tDj(P[/pj,t), where Yj,t is the quantity
purchased by group j of its composite good, and pj,t is the price of that composite
good (a homogeneous degree 1 index of the individual goods prices). Total demand
for good i is then

r/= D1 kPl,t ]

\P2,t J

y2,,

(4.7)

where Dj(1) = 1 for both groups. At a symmetric equilibrium, all prices are the
same and the amount purchased of each good is the same, so that Yj,t is simply the

75 See Bils (1989) for a related idea.

1120

JJ. Rotemberg and M. Woodford

amount purchased of each good by group j. The elasticity of demand at a symmetric

equilibrium is then found to be

ZtO11(1)+(1 -Zt)D~2(1)

where

Zt -

Yl,t

Yl,t + Y2,t"

Therefore, an increase in the share o f group 1 purchases in total purchases makes the
overall elasticity of demand more similar to D~, the elasticity of the demand by group 1.
An important feature of business cycles is that, as noted in Campbell (1987) and
Cochrane and Sbordone (1988), the ratio of consumption to GDP is high in recessions
and low in booms. Exactly the converse behavior applies to the ratio of investment
to GDE Thus, as Gall (1994) points out, the assumption that firms have more elastic
demands than consumers can provide one explanation for countercyclical markups.
Moreover, an exogenous increase in the fraction of output demanded for investment
purposes would increase yU.
Another variable that varies more cyclically than GDP is the purchase of durables.
This has led Bils (1989) and Parker (1996) to argue that increased purchases of
durables in booms reduce markups in these periods. This idea is closely related to
a proposal of Robinson (1932), who argued that people who purchased durables in
downturns were predominantly replacing durables that had ceased functioning and
that, as a result, demand in downturns was less elastic than demand in booms, which
consisted largely of demand by new purchasers.
To ensure that a story of this sort also leads to reduced markups when the
government expands its own purchases of goods and services, as would be needed
in order to account for the expansionary effects of government purchases other than
through an effect on labor supply, one must assume that the government has a relatively
elastic demand 76. The main disadvantage of this general type of explanation is that
aggregate demand, as such, has no direct role in lowering markups and thereby
increasing output. Rather, it is the composition of demand that affects aggregate output;
increases in aggregate demand only raise output if they happen to shift demand towards
sectors with more elastic demand. This means that at least some kinds of disturbances
that increase some important component of current spending must be contractionary
rather than expansionary (e.g., an increase in consumer demand, in Gali's model). It
is hard to think of empirical support for this kind of prediction.

4.2.2. Customer markets

An alternative class of models, that gives variations in aggregate demand a more direct
role, is intertemporal models of markup variation, in which what matters is not the
composition of demand at present, but rather how current sales compare to expected

76 See Heijdra (1995) for an analysis where government purchases may affect markups through this
channel.

1121

Ch. 16: The Cyclical Behavior of Prices and Costs

future sales. Probably the best-known model of this type is the "customer market"
model of Phelps and Winter (1970).
The customer market model is a model of monopolistic competition, in that each
firm maximizes profits with respect to its own price (markup) taking the price (markup)
of all other firms as given. But it differs from the standard model of monopolistic
competition [e.g., the model of Dixit and Stiglitz (1977)] in introducing a dynamic
element into the response of demand to prices. A firm that lowers its current price not
only sells more to its existing customers, but also expands its customer base. Having a
larger customer base leads future sales to be higher at whatever price is charged then.
One simple formulation that captures this idea involves writing the demand for firm i
at time t as
k t ~ t l mr

< 0,

t/(1) = 1,

(4.8)

where/~ is the markup of price over marginal cost implicit in the price charged by
firm i at time t, and the "market share" m~ is the fraction of average demand Yt that
goes to firm i if it charges the same price as all other firms. The market share depends
on past pricing behavior according to the rule

mt+l = g \[At I m t

< 0,

g(1) = 1,

(4.9)

so that a temporary reduction in price raises firm i's market share permanently.
Equations (4.8) and (4.9) are intended to capture the idea that customers have
switching costs, in a manner analogous to the models of Gottfries (1986), Klemperer
(1987), and Farrell and Shapiro (1988)77. A reduction in price attracts new customers
who are then reluctant to change firms for fear of having to pay these switching costs.
One obvious implication of Equations (4.8) and (4.9) is that the long-run elasticity
of demand, i.e., the response of eventual demand to a permanent increase in price, is
larger than the short-run elasticity of demand. In our case, a firm that charges a higher
price than its competitors eventually loses all its customers, though this is not essential
for our analysis.
The firm's expected present discounted value of profits from period t onward is
thus

j=O

-ff--+j/mHg
z=O

77 For a survey of much of this theoretical literature and its applications, see Klemperer(1995).

1122

JJ. Rotemberg and M. Woodford

Firm i chooses/~ to maximize this expression, taking as given the stochastic processes
{/~t} and {Yt} that define aggregate demand conditions. Therefore

(4.10)
I r~t+y I

Fir

= O,

where subscripts denote partial derivatives. At a symmetric equilibrium where all firms
charge the same price, each has a share mI = 1, and g equals 1 in all periods. So the
expectation term in Equation (4.10) is equal to the common present discounted value
of future profits, which we denote by Xt. Solving Equation (4.10) for the markup, we
obtain
/~t=/t

X
~ t ) ---

rf(1)

(4.11)

1 + ~/'(1) + g ' ( 1 ) ~

Because ~(1) and g~(1) are both negative, the derivative of/~ with respect to X / Y
is negative 7s. An increase in X / Y means that profits from future customers are high
relative to profits from current customers so that each firm lowers its price in order
to increase its market share. Thus, in this model, expansionary fiscal policy (which
raises real interest rates and thus lowers X/Y) raises markups and lowers output 79. On
the other hand, this is a model that can potentially amplify the expansionary effects
of loose monetary policy in the presence of sticky prices. The reason is that loose
monetary policy lowers real interest rates if prices are rigid and this raises X / Y s0.
A rather different view of the determinants of markups and output is obtained if
the customer market model is combined with the assumption that financial markets
are imperfect, as in Greenwald, Stiglitz and Weiss (1984) and Gottfries (1991). With
imperfect capital markets, shocks that raise the shadow cost of funds by making it
more difficult to borrow (such as reductions in asset values that lower the value of
firm's collateral) can lower X / Y and thereby lower output.
Chevalier and Scharfstein (1995, 1996) provide some evidence for this financeconstrained version of the customer market model. Chevalier and Scharfstein (1996)
consider pricing by supermarkets and pay particular attention to the prices charged
in states hit hard by the oil-price decline of 1986. They ask whether, within these

78 Felli and Tria (1996) argue that their proposed markup series is consistent with this implication.
79 Phelps (1994) emphasizes that this can be overturned in open economies under flexible exchange
rates. Expansionary fiscal policies then tend to appreciate the exchange rate, thereby forcing domestic
firms to lower their markups in order to compete effectivelywith foreign firms.
80 The model as expounded here and in the literature, however, involvesflexibleprices. The extension
of the theory to allow for delays in price adjustment would seem a high priority for future research.

Ch. 16:

The Cyclical Behavior of Prices and Costs

1123

oil states, supermarkets that belonged to national chains (and who thus could rely
on externally provided cash to some extent) lowered their prices relative to those of
local supermarkets, who were presumably more strapped for cash. They find that they
do, suggesting that national supermarkets were more willing to invest in customers
at this point, presumably because they had lower discount rates as a result of their
access to cash. Chevalier and Scharfstein (1995) shows more generally that industries
with a relatively large fraction of output produced by small firms tend to have more
countercyclical markups if one controls for total concentration. The idea is that small
firms have less access to capital markets and so should be more strapped for cash in
recessions. This induces them to invest less in customers and raise their markups in
recessions. Controlling for concentration creates problems of interpretation because, as
discussed further below, highly concentrated sectors (in which large firms are clearly
important) have more countercyclical markups.
4.2.3. Implicit collusion

An alternative intertemporal model, where the same variable X / Y again turns out to
be the crucial determinant of the equilibrium markup, is the implicit collusion model
presented in Rotemberg and Woodford (1992). We consider an economy with many
industries, each of which consists of n firms. The n firms in each industry collude
implicitly in the sense that there is no enforceable cartel contract, but only an implicit
agreement that firms that deviate from the collusive understanding will be punished.
On the other hand, the firms in each industry, even when acting in concert, take
other industries' prices, the level of aggregate demand, and the level of marginal cost
as given. Abusing the language somewhat, we can view industries as monopolistic
competitors in the usual sense, while the firms within each industry collude implicitly.
Keeping this distinction in mind, we write the demand for firm i in industry j as

The function

D i

is syrmnetric in its first n arguments except the ith, and the functions

D i (for i = 1 , . . . , n) are all the same after appropriate permutation of the arguments.

The resulting profits of firm i in industry j if all other firms in the economy charge a
markup/h and it charges a markup #ij are

rt;

)= \

,I

j .

(4.13)

If the firm goes along with the collusive agreement at t and charges the same
iJ
markup as all other firms, it gets H~ (#t,/h) which we denote by H~(th)Yt. I f it
deviates and the punishment is as strong as possible, it earns some higher profits at t

1124

J.J. Rotemberg and M. Woodford

but it can expect to earn a present value of zero thereafter. In this case, a deviating
firm simply maximizes Equation (4.13) with respect to #y and its resulting profits
are /-/ta(#t)Yt. It is easy to show that the difference Hta(/zt) - / ( f ( / ~ ) is increasing
in #t. Intuitively, it should be clear that this difference is zero at the markup that
corresponds to the equilibrium where each firm behaves like a monopolistic competitor
and takes other firm's prices as given. If firms in the industry charge higher markups,
deviating by cutting prices is more attractive. Because this difference is increasing in
the markup, a profit-maximizing collusive oligopoly which is unable to sustain the
monopoly outcome for the industry will agree upon a markup that keeps firms just
indifferent between charging the collusive markup and deviating. Such a collusive
optimum implies that

z/f(~t)-/V(~,)

- x,.

(4.14)

This equation can again be solved for an equilibrium markup function of the form
~t = # ( x # r t ) .

In Rotemberg and Woodford (1992) we give the conditions under which there exists
an equilibrium where Equation (4.14) is binding near a deterministic steady state.
Because the left-hand side of Equation (4.14) is increasing in the markup #t the
equilibrium markup is increasing in X / Y . An increase in X, the expected present value
of future collusive profits, makes firms want to go along with the collusive price so
that this price can be higher. An increase in current output, by contrast, tends to reduce
the markup that can be sustained without breaking the collusive agreement. The result
is that tight fiscal policy, which raises real interest rates, raises markups and lowers
output. Temporary oil-price increases also raise X relative to Y and thus also reduce
output according to this model.
Rotemberg and Woodford (1991) provide evidence that, if asset price data are used
to compute X, markups are not just decreasing in Y but are also increasing in X. This
fits well with the finding of Galeotti and Schiantarelli (1998) that markups fall when
the expected rate of growth of output is high. Such a high rate of growth raises X
since profits are procyclical and this should lead to an increase in markups according
to this model.
A striking confirmation that high levels of X raise current markups is provided
by Borenstein and Shepard (1996) in their analysis of retail gasoline markets. Their
analysis looks at retail gasoline prices in 59 cities over 72 months and takes advantage
of the fact that the relationship between expected future demand and current demand
varies across cities because they experience different seasonal cycles. Similarly, there
are cross-city differences in expected future costs. Borenstein and Shepard show that,
consistent with this model, high expected future demand and low expected future costs,
both of which raise X, raise current markups. A similar finding, though the evidence
in this ease is so weak that one cannot reject the hypothesis of no effect, is reported
by Ellison (1994). He shows that a railroad cartel operating in the 1880s, the Joint

Ch. 16: The Cyclical Behavior of Prices and Costs

1125

Executive Committee, tended to have low prices when demand was low relative to
expected future demand.
The dependence of markups on X leads Bagwell and Staiger (1997) to conclude
that this model actually implies procyclical markups. This conclusion follows from
identifying booms with periods where the rate of growth of output is high and
identifying recessions with periods where the rate of output growth is low. Given
that the rate of growth of output is positively serially correlated, periods where output
growth is high are actually periods where a crude computation of X/Y (one that only
took note of the positive serial correlation of output growth) is high and the conclusion
follows. As noted by several authors [see Evans and Reichlin (1994), Rotemberg and
Woodford (1996a) and the papers cited therein] there are variables other than current
output growth that are useful for forecasting future output growth. As Evans and
Reichlin (1994) and Rotemberg and Woodford (1996a) show, once these other variables
are taken into account when computing expected output growth, recessions as defined
by the NBER are actually periods where expected output growth is high. Once this is
recognized, the model does indeed predict that markups should be high in periods that
are generally regarded as recessions.
Because past output growth is nonetheless also somewhat useful in forecasting future
output growth, it follows that expected output growth just after business-cycle troughs
(when output has already started to increase) is higher than expected output growth
just before these troughs. Thus, X / Y is higher just after business-cycle troughs than just
before. The model is thus consistent with some interesting observations made by Baker
and Woodward (1994). They compare the price charged by firms some time before an
industry trough (the reference month) with the price charged after the trough in the first
month in which output is no smaller than output in the reference month. They report
that, for some industries, the latter price is much higher than the former. Moreover,
the size of this price increase is larger in more concentrated industries. This suggests
that concentrated industries, where this theory is more likely to apply, are ones where
the markup is more likely to vary positively with X / Y .
One open question about this model (and the customer market model) is whether
they can explain the reduction in inputs that seems to accompany periods of genuine
technical progress. What determines which of these two models can explain this fact
is whether genuine technical progress raises or lowers X/Y. If the progress raises
mainly output in the future, one might expect X to rise relative to Y except that this
effect might be offset by an increase in the rate of interest (which reduces the present
value X ) . I f X / Y nonetheless rises with technical progress, the implicit collusion would
also imply that such shocks tend to raise markups and reduce output relative to what
would occur under frictionless perfect competition.
4.2.4. Variable entry

A final theoretical reason for markups to vary with cyclical variables is that entry
is procyclical. An advantage of this explanation is that it is undoubtedly true that

1126

J.J Rotemberg and M. WoodJbrd

more new firms incorporate in booms, as noted by Chatterjee, Cooper and Ravikumar
(1993) for the USA, and documented by Portier (1995) for France. Moreover, as long
as profits are procyclical, it makes sense that entry should be procyclical. As we saw in
Section 3, such proeyclical profits are possible even if output fluctuations are entirely
due to changes in markups, rather than to shifts in the real marginal cost schedule.
Suppose that, as in Chatterjee, Cooper and Ravikumar (1993) or Pottier (1995)
firms behave in Cournot fashion so that each industry contains several firms producing
perfect substitutes and these firms take the output of all other firms as'given when
deciding on their own level of output. In this model, the addition of new firms
cause markups to fall 81. The biggest problem with this explanation for countercyclical
markups is that technical progress would lead markups to fall both in the short run and
in the long run. As long a technological progress does not increase the fixed cost q~,
such long term progress increases the number of firms and thereby reduces markups.
One way of avoiding this difficulty is to assume that entry simply leads to an
increased number of goods being produced by monopolistically competitive firms, as
in Devereux, Head and Lapham (1996) or Heijdra (1995). These authors assume that
the monopolistically competitive finns produce intermediate goods that are purchased
by firms which combine them into final goods by using a Dixit-Stiglitz (1977)
aggregator. The result is that increased entry does not change the ratio of price to
marginal cost. It does, however, reduce the price of final goods relative to the price of
intermediate goods, because final goods can be produced more efficiently when there
are more intermediate goods. This reduction in the price of final goods effectively
raises real wages and, particularly if it is temporary, leads to an increase in labor supply.
Thus, Devereux, Head and Lapham (1996) show that, in their model, an increase in
government purchases raises output together with real wages. The increase in output
comes about because the increased government purchases make people feel poorer and
this promotes labor supply; this results in a shift out of the real marginal cost schedule.
The real wage in terms of final goods then rises because of the increase in the number
of intermediate goods firms.
4.3. Interactions between nominal rigidities and desired markup variations

Finally, we briefly consider the possibility that markups vary both because of delays in
price adjustment and because of variations in desired markups, for one or another of
the reasons just sketched. The possibility that both sources matter is worth mentioning,
since interactions between the two mechanisms sometimes lead to effects that might
not be anticipated from the analysis of either in isolation.
For example, variations in desired markups may amplify the effects of nominal
rigidities, making aggregate price adjustment even slower, and hence increasing the

81 Portier (1995) also considers a model where markups fall not only because entry occurs in booms
but also because the threat of entry leads incumbentfirms to lower their prices.

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1127

output effects of monetary policy, even if the model of desired markup variation would
not imply any interesting effects of monetary policy in the case of flexible prices. To
illustrate this, let us consider again the discrete-time Calvo model of Section 4.1, but
now drop the assumption that the function D has a constant elasticity with respect to
the relative price. In this case, log-linearization of Equation (4.2) yields

Et

j=0

[ ^ des

+ ct+j]

(4.t5)

= 0,

k=l

as a generalization of Equation (4.3), where /)des denotes the percentage deviation of

the desired markup
(-D,t

~,/des - -

CD,t -- 1
from its steady-state value. The elasticity CD, and hence the desired markup, is a
function of the relative price of the given firm i, or equivalently of the firm's relative
sales yi/y. Letting the elasticity of the desired markup with respect to relative sales
be denoted ~, we obtain

t --

f'gt+k

[ ^ des

k=l

- c , +^j ,

= (1

(4.16)

k=l

as a consequence of which Equation (4.15) implies an equation of the same form

as (4.3), but with the variable ct replaced by (1 + ~eD)-l~t each period. This in turn
allows us to derive again an equation of the form (4.5), except that now
1
(1 - aft)(1 - a)
t ~_ - 1 +~eD
a

(4.17)

A number of authors have proposed reasons why one might have ~ > 0, i.e., an
elasticity of demand decreasing in the firm's relative price. Kimball (1995) shows how
to construct aggregator functions that lead to arbitrary values of ~. Thus, this model can
rationalize extreme price stickiness even when the fraction of firms that change prices
is relatively high. Woglom (1982) and Ball and Romer (1990) suggest that search costs
provide an alternative rationale for a positive ~. The idea is that search costs imply
that relatively small price increases lead many customers to depart while small price
reductions only attract relatively few customers. A smoothed version of this kinked
demand curve gives the variable elasticity just hypothesized.
Equation (4.17) implies that ~ > 0 makes t~ a smaller positive quantity, for any
given assumed average frequency of price changes. This affects the quantitative form
of the markup equation (4.5), and hence the aggregate supply curve (4.6), in the same

1128

JJ Rotemberg and M. Woodford

way as would a larger value of a 82. In particular, it implies that a given size permanent
increase in nominal aggregate demand (due, for example, to a monetary policy shock)
will result in both a larger and a more persistent increase in output. Thus allowing
for variation in desired markups of this kind can increase the predicted real effects of
monetary policy (including the size of the countercyclical markup variations caused
by monetary shocks).
To gain some intuition for this result, imagine an increase in aggregate demand
which increases marginal cost by increasing the demand for labor by >firms whose
prices are fixed. A firm which is free to change its prices would thus normally choose
a price above that charged by other firms. If, however, having a price that is relatively
high implies that demand is relatively elastic then such a firm would have a relatively
low desired markup and would thus choose a relatively low price. The effect of this
is that prices do not rise by as much on impact so that output increases by more.
In subsequent periods, the same logic leads those firms who can change their prices
to raise them to only a limited extent. Thus, the effects of the increase in nominal
aggregate demand are drawn out.
This occurs despite the fact that the hypothesis of a demand elasticity decreasing
in a firm's relative price does not, in itself, provide any reason for monetary policy to
have real effects. Indeed, under the hypothesis that all prices are perfectly flexible, it
provides no reason for equilibrium markups to vary at all. For with flexible prices, we
would expect a symmetric equilibrium in which all firms' prices are always the same,
so that the elasticity of demand faced by a firm (and hence its desired markup) would
never vary in equilibrium. Thus this hypothesis is much more interesting, both as an
explanation of markup variations and as a channel for real effects of shocks other than
cost shocks, when combined with the hypothesis of nominal price rigidity than it is
on its own.
It is also interesting to note that this hypothesis requires that desired markups be
low when the firm's relative price is high, i.e., when its own sales are low relative to
those of its competitors. Thus, its desired markups are positively correlated with its
own output relative to that of its competitors. At the firm or industry level, one might
well observe procyclical markups, if one measures the correlation with own output; yet
as shown above, the hypothesis is one that can increase the size of the countercyclical
markup variations at the aggregate level that occur as a result of aggregate demand
variations.
Inflation, search and markups are also linked in the work surveyed in Benabou
(1992). The idea in this research is that price rigidity in the face of inflation leads to
more price dispersion and this price dispersion makes search generally more valuable
to consumers. This, in turn, makes demand more elastic for all producers and thus

82 Thus it may help to reconcile the estimate of t by Sbordone (1998), based on the comovementof
aggregate indices of prices and labor costs, with microeeonomic evidence on the frequency of price
changes.

Ch. 16:

The Cyclical Behavior o f Prices and Costs

1129

exerts downwards pressure on markups. This theory implies that inflation ought to be
generally negatively related to markups. As Benabou (1992) shows, this implication
is confirmed in US data on the retail trade sector.
Variations in desired markups that are uniform across goods (rather than depending
on firms' relative demands) also interact in interesting ways with nominal rigidity.
For example, Kiley (1997) develops a model which combines staggered price-setting
with Gali's (1994) assumption of differential demand elasticities for consumption and
investment purchases. Monetary expansions then increase investment disproportionately and this temporarily lowers desired markups for all firms. This means that firms
that revise their prices do not raise them as much as they otherwise would (given the
increase in marginal cost) so that output rises more. This mechanism increases the
degree of strategic complementarity among different firms' pricing decisions. If other
firms raise their prices less, a given change in nominal rates (or in the money supply)
has a bigger effect on real rates of interest thereby affecting investment demand more.
This, in turn, implies that any given firm wants to raise its price by less. The greater
degree of strategic complementarity implies a slower adjustment of the aggregate price
level and hence a more persistent effect of the monetary expansion. Thus, while Gali's
(1994) model of markup variation does not directly imply that monetary shocks affect
output, it increases both the size and the persistence of the output effects of monetary
disturbances in the presence of sticky prices.
These illustrations demonstrate that a combination of endogenous variation in
desired markups and price stickiness can yield further channels through which
disturbances other than cost shocks affect the level of economic activity. This relatively
unexplored topic surely deserves further research.

5. Conclusions

The main benefit of allowing for markup variations is that it expands the range of
types of disturbances that can affect aggregate economic activity s3. Without variable
markups, output can only increase if real marginal cost falls, for example due to a
change in the effective labor supply to firms, or as a result of technological progress.
With variable markups, monetary and fiscal shocks can have effects other than those
that result from changes in the real wages at which workers are willing to work.
In addition, the output effects of certain supply shocks (like variations in the rate
of technical progress) may be muted, while other supply shocks (such as oil-price
increases) can lead to larger output movements.

83 In focusing on the effect of markup variations (rather than the effect of the average level of the
markup) we are assigning to imperfect competitiona role in macroeconomicsthat is quite different from
the one which Carlton (1996) argues is unimportant. For a discussion of the effect of the markup level,
see also Rotemberg and Woodford (1995) and the references cited therein.

1130

JJ. Rotemberg and M. Woodford

This rich set of possibilities arises from consideration of a number of different

models of variable markups. But it is not clear yet whether there is a single
unified model that can make sense of the way all the major macroeconomic shocks
affect output. Each of the models we have considered, on its own, seems unable
to account for all the facts. In particular, as we have already suggested, the pure
sticky price model cannot easily explain the strong effects of oil-price increases.
The implicit collusion model, on its own, tends to imply that insofar as monetary
contractions raise real rates of interest, they should raise rather than reduce output.
The customer market model seems to require financial market imperfections to explain
the expansionary effects of fiscal stimuli. And it is not clear even then whether it is
able to explain the effect of oil and technology shocks on the economy. Thus, the
task of constructing a unified model of variable markups that explains the effect of
all the shocks we have considered remains to be carried out. Models that allow for
interaction between sources of variation in desired markups with additional variation
in actual markups due to delays in price adjustment would seem an important area for
further study.
Much research remains to be done on the measurement of markup variations as
well. First, as we have seen, measurements of markup variations and of the extent
to which output fluctuations can be attributed to them depend on the details of the
production structure. For example, they are extremely sensitive to the presence of
adjustment costs for employment. While the existence of such adjustment costs is
probably not controversial, their exact form and precise magnitude is far from having
been settled.
One's estimate of markup variations also depends on aspects of labor markets about
which we are less certain. In particular, we do not know precisely how compensation
of existing employees varies when there is less work to do in recessions. Indeed, one
of our better estimates of this derivative of compensation with respect to productive
effort [due to Bils (1987)] is based upon an estimate of the cost of adjusting
employees (together with the assumption that firms minimize costs so that the cost
of an additional effective hour of effort is equalized across these two margins).
But perhaps the hardest problem is that, particularly outside the USA, we are not
sure to what extent firms can simply take the wage that they pay per unit of effort
as a parameter outside their control and to what extent this wage is the result of
bargaining between workers and employees. In this latter case, the connection between
the real wage and the marginal product of labor depends also on the character of
this bargaining, as emphasized by Blanchard (1997) in his discussion of markups in
Europe. Thus, while we have treated the ratio of the marginal product of labor to the
(marginal) wage as equal to the markup, this inference is not necessarily correct if
workers and firms bargain over both the level and the terms of employment. Product
market considerations of the sort we have emphasized would still play a role in
such a setting, but measuring the effect of these product market distortions becomes
much harder.

Ch. 16:

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1131

Acknowledgment
We w i s h to thank M a r k Bils, Susanto Basu, R o b e r t Chirinko, M i l e s Kimball, and
A r g i a S b o r d o n e and J o h n Taylor for c o m m e n t s , and the N S F and the H a r v a r d Business
School D i v i s i o n o f R e s e a r c h for research support.

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Ch. 16." The Cyclical Behavior o f Prices and Costs

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Chapter 17

LABOR-MARKET FRICTIONS AND

EMPLOYMENT FLUCTUATIONS
ROBERT E. HALL
Hoover Institution and Department of Economics, Stanford University
National Bureau of Economic Research

Contents
Abstract
Keywords
1. Introduction
2. The baseline neoclassical model
2.1. Failure of amplification in the baseline neoclassical model
2.2. Evidence about technology impulses
2.3. Failureof the baseline neoclassical model to explain persistence
2.4. Absence of unemployment from the baseline neoclassical model
3. Amplification
3.1. Elastic conventionallabor supply
3.2, Empirical research
3,3. Unemployment
3.3.1. Mechanism design and labor contracts
3.3.2. The modem strategic view of the employmentrelationship
3,3,3. Efficiencywages
3.3.4. Job destruction
3.3.5. Reorganizationand reallocation
4. Persistence
4.1. Time-consumingmatching in the labor market
4.2. The importance of secondary job loss for persistence
5. Conclusion
Acknowledgments
References

Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford

1999 Elsevier Science B.V. All rights reserved
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Abstract
The labor market occupies center stage in modern theories of fluctuations. The most
important phenomenon to explain and understand in a recession is the sharp decline in
employment and jump in unemployment. This chapter considers explanations based on
frictions in the labor market. Earlier research within the real business cycle paradigm
considered frictionless labor markets where fluctuations in the volume of work effort
represented substitution by households between work in the market and activities at
home. A preliminary section of the chapter discusses why frictionless models are
incomplete - they fail to account for either the magnitude or persistence of fluctuations
in employment. And the frictionless models fail completely to describe unemployment.
The evidence suggests strongly that consideration of unemployment as a third use of
time is critical for a realistic model. The two elements of a theory of unemployment
are a mechanism for workers to lose or leave their jobs and an explanation for the time
required from them to find new jobs. Theories o f mechanism design or of continuous
re-bargaining of employment terms provide the first. The theory of job search together
with efficiency wages and related issues provides the second. Modern macro models
incorporating these features come much closer than their predecessors to realistic and
rigorous explanations of the magnitude and persistence of fluctuations.

Keywords

JEL classification: E24

Ch. 17:

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1139

1. Introduction

The bulk of modern fluctuations theory fits into the broad framework of impulsesamplification-persistence. In this framework, fluctuations begin with a random
impulse. These can be shifts in technology or preferences, shifts in monetary or fiscal
policy, or spontaneous movements in consumption, investment, or other components
of spending. Most impulses of realistic size have small effects on employment in a
standard neoclassical model. To explain the observed volatility of employment and
other important aggregates, some form of amplification must occur. Modern thinking
about sources of amplification has focused primarily on highly elastic labor supply.
Labor supply is elastic because workers have economically valuable alternative uses of
their time. Though non-market alternatives lie behind the standard view of labor supply
and the view of labor supply in the original real business cycle model, the alternative
that is most prominent in recent models is job search. In fact, more than anything
else, this chapter is about the successful integration of unemployment theory into
formal dynamic general-equilibrium models. Not only do the new general-equilibrium
models comprehend the important phenomenon of unemployment, but it turns out that
unemployment is key to amplification and persistence.
Without consideration of unemployment, earlier dynamic general-equilibrium models explained persistence in employment largely through persistence in driving forces.
The models themselves did not contain much in the way of persistence mechanisms.
Where unemployment is considered explicitly, persistence arises naturally from the
time-consuming process o f placing unemployed workers in jobs following an adverse
impulse.
This chapter does not consider the origins of impulses, nor the propagation of
fluctuations across industries, though that propagation may interact with amplification
and persistence. The chapter focuses on frictions in the labor market, some of
which amplify impulses and others of which result in persistence, especially of
unemployment.
Most of the research I will consider here is developed within dynamic stochastic
general equilibrium (DSGE) models. By placing amplification and persistence mechanisms in formal general equilibrium models, contributors to modern fluctuations
research achieve a degree of clarity missing from earlier macroeconomics. Confusing
notions from earlier work, such as "aggregate demand" and "supply shocks," are giving
way to clearer general equilibrium counterparts, such as monetary and fiscal impulses
and shifts in the terms of trade. Moreover, research in the impulses-amplificationpersistence mode has come close to eliminating the traditional polarization of macro
researchers. Impulses come from technology, policy, and spontaneous shifts, a list
broad enough to include almost any earlier idea about the sources of fluctuations.
Old-fashioned Keynesian ideas such as wage rigidity, new Keynesian ideas such as
efficiency wages, and ideas about imperfect information all compete on an equal
footing to explain amplification, and are no longer assigned to warring schools of
thought.

R.E. Hall

1140

2. The baseline neoclassical model

For several decades, a baseline neoclassical model has anchored macroeconomics.

Because the baseline model is successful neither as a model of fluctuations nor of
growth, both of the major branches of the field have explored alternatives to the
baseline. For the purposes of this chapter, it is useful to lay out the baseline model
and explain its failure as a model of fluctuations. Lack of amplification of impulses
and lack of persistence of the resulting responses are the symptoms of the failure. In
the baseline model, workers choose between two activities, work and leisure; there is
no consideration of unemployment.
The baseline model is so well known that it will suffice to describe it mainly
verbally - see Campbell (1994) and Romer (1996, chapter 4) for more extensive
discussions along this line. A single type of output is consumed or invested. It is
produced by a Cobb-Douglas technology with constant returns to scale. Labor and
capital are the inputs. Consumers' preferences are ordered by the time integral of log
consumption plus weighted log leisure - that is, the intertemporal utility fimction is
OQ

f e-/3t [log c(t) + )~log(~ -

n(t))] dt.

(2.1)

Log consumption insures that static labor supply has zero wage elasticity - models
typically adopt this specification to match the positive trend in real wages to the zero
trend in annual hours per worker 1.
In principle, the baseline model could be driven by almost any kind of impulse shifts in technology or preferences, changes in policy regimes, or random elements
of policy. Kydland and Prescott's (1982) pioneering exploration of fluctuations using
the baseline model and alternatives focused on vibrations of the aggregate production
function as the single driving force. Much o f the ensuing literature retained that
focus, though changes in government purchases - an important topic before Kydland
and Prescott's formalization of the baseline model - remain a second important
driving force in that literature [see, for example, Aiyagari, Christiano and Eichenbanm
(1992)].
Empirical measures of aggregate technology - generally obtained by calculating the
Solow (1957) residual - suggest that changes in technology are quite persistent. In fact,
a random walk is not a bad approximation to the stochastic properties of aggregate
technology or for the technologies of particular industries. To put it differently, the
year-to-year Solow residual, which measures the change in technology, is close to
white noise. The custom has developed in the literature on DSGE models to model the
stochastic process of aggregate technology as first-order autoregressive with a serial

J See King and Rebelo (1999) for further discussion of this point.

Ch. 17: Labor-MarketFrictions and Employment Fluctuations

1141

correlation parameter of 0.95. In that case, an innovation in technology in one period is

followed by small movements in the opposite direction for many succeeding periods, as
the level of technology gradually (at a rate of 5 percent per period) returns to normal.
In this setting, a rough description of the perturbation in general equilibrium
following, say, a negative shock to technology is the following: Immediately,
employment falls. Output falls both because of the direct effect of the decline in
productivity and because o f the decline in employment. Since the capital stock is
unaffected, the marginal product of capital and thus the interest rate fall. Consumption
rises and investment declines by more than the decline in output. There follows an
extended period of gradual rises in the interest rate and real wage back to their normal
levels. As a result, consumption - governed by its Euler equation - falls back to normal
and, similarly, employment rises back to normal.
2.1. Failure of amplification in the baseline neoclassical model
As I noted earlier, a central problem of fluctuations theory is that small impulses seem
to result in large movements, especially those we call recessions. Can the baseline
neoclassical model explain the actual magnitude of observed fluctuations based on the
likely magnitude of technology shifts? From the starting point in Kydland and Prescott
(1982), the answer has been no. Some form of amplification beyond what is found in
the baseline model is needed.
Campbell (1994) investigates this issue carefully. His Table 3 shows that a l-percent
decline in technology that is reversed at 5 percent per quarter lowers employment by
only 0.45 percent in the baseline model. In other words, to explain the 3-percent decline
in employment typical of a recession, the model has to invoke a decline in technology
of about 7 percent! The challenge to fluctuations theory is to change the baseline model
in a reasonable way that overcomes this small response. The next section considers a
number of attempts along this line.
2.2. Evidence about technology impulses
Empirical work shows that the standard measure of technology shifts - the Solow
residual - is correlated somewhat positively with employment and more positively with
output. For example, in Hall (1997), the correlation of the Solow residual with hours of
work at business-cycle frequencies is 0.32 while the correlation with real GDP is 0.75.
The interpretation of the correlation is a disputed issue, however. A path of research
whose origin was wholly apart from measuring macro impulses has suggested that
the correlation is the result of the failure of assumptions underlying Solow's method.
Hall (1988, 1990) observed that one form of the Solow residual could be used to test
the assumption of competition in output markets and to measure the ratio of price
to marginal cost. The resulting corrected Solow residual is hardly correlated with
employment. Another form of the Solow residual can be used to test the assumption
of constant returns to scale and to measure an index of increasing returns. Again, the

1142

R.E. Hall

Solow residual corrected for increasing returns is less correlated with output and is
hardly correlated with employment.
A substantial subsequent literature has questioned Hall's finding of high markups
matched by equally high returns to scale. New work has substituted better measures
of labor and capital input [Basu (1996), Burnside, Eichenbaum and Rebelo (1993)]
and corrected aggregation bias [Basu and Fernald (1997)]. With all corrections in
place, there is no remaining evidence of a correlation of the Solow residual with
employment. Thus, there are two reasons to question the existence of teclinology shifts
that are correlated with employment changes. First, what appears to be shifts in the
simple Solow residual are actually artifacts of imperfect competition or increasing
returns. Second, the correlation is the result of errors of measurement. Either finding
is troublesome for the view that technology shocks are an important driving force.
Hall (1997) investigates the role of the technology impulse in a semi-econometric
general equilibrium framework. The model adopts the premise of the baseline model
mentioned in the previous section - by making the kernel of utility depend on the
log of consumption, the model excludes any direct effect of a technology shift on
labor supply. A direct effect is one that occurs even in an economy without capital
or other methods for shifting resources between time periods. The absence of direct
effects occurs when the income and substitution effects in the corresponding static
labor supply function offset each other.
Hall observes that all of the effects of the technology impulse on employment must
operate through the intertemporal channel, that is, through investment - a positive
technology innovation sets off an investment boom. Hours of work rise, GDP rises,
and consumption falls, as the economy moves quickly to take advantage of higher
productivity. Hall examines the empirical relation between the investment/GDP ratio
and the simple uncorrected Solow residual. He finds a robust positive relation a one-percent shift of the production function causes about a one-percent increase in
the investment/GDP ratio. But the fraction of employment volatility explained by the
technology impulse is essentially zero. Further, the use of a more refined version of
the Solow residual would probably eliminate what little role the technology impulse
is found to have.

2.3. Failure of the baseline neoclassical model to explain persistence

Cogley and Nason (1995) observed that the pattern of movements of employment
and output in the baseline neoclassical model is essentially that of its technology
driving force. The point would apply to other driving forces as well. The neoclassical
model cannot mimic the pattern of recession and recovery in response to a single
shock, despite the common-sense impression that recessions often result from discrete
shocks. In particular, after a one-year temporary decline in productivity, employment
and output return to normal immediately in the neoclassical baseline model.

Ch. 17: Labor-MarketFrictions and EmploymentFluctuations

1143

2.4. Absence of unemployment from the baseline neoclassical model

The baseline model considers only two uses of time - employment and leisure.
A strong consensus has emerged in macroeconomic thinking that a realistic model
needs to consider a third use of time - job search or unemployment. Hall (1997)
takes the following approach to demonstrating the need for explicit consideration
of unemployment: He considers a neoclassical model without unemployment, but
one where shifts in household preferences drive fluctuations along with shifts
in technology and changes in government purchases. Because he considers three
aggregate variables - output, consumption, and hours of work - he is able to solve
for the values of the three impulses from the values of the three observed variables,
based on standard values for the parameters of the neoclassical model. Almost all
the explanatory power is assigned to the preference shift. Changes in government
purchases have a small role because the observed changes are small and not generally
associated with booms or recessions. Technology shifts also receive little weight
because they operate solely through the intertemporal investment channel and because
they should cause employment to change much more than consumption.
Hall models the preference shift as a random variable that determines the marginal
rate of substitution contemporaneously between consumption and leisure. Shifts in
the variable cause employment and consumption to move in the same direction. Hall
uses an empirical approach to determine the relative explanatory powers of the driving
forces for employment fluctuations. Almost all the credit goes to the preference shift.
But his conclusion is not that preference shifts are actually a major driving force.
Rather, another use of time - unemployment - is left out of the model. Periods of higher
unemployment are times when employment and consumption are both low. A better
way to explain the positive correlation of employment and consumption at businesscycle frequencies is to bring unemployment explicitly into the model.
Rotemberg and Woodford (1996) demonstrate the failure of the baseline model in
a rather different way. They focus on the joint time-series properties of employment,
output, and consumption. They show that the data contain a business cycle in the
weak sense defined by Beveridge and Nelson (1981) - the data tend to return to a
long-run trend whenever they deviate from that trend in the short run. The forecast
of employment growth is unusually high, for example, if employment is below its
trend because a recession occurred recently. In the baseline model driven by a
technology shock that follows a strict random walk [not the AR(1) process with a serial
correlation of 0.95 1 discussed earlier], employment and other variables lack almost any
tendency to return to normal. They derive measures of that tendency from a 3-variable
vector autoregression. When there is a tendency to return to normal, the VAR forecasts
future values for the variables that are different from the current values. They measure
this forecasting power at various horizons. Their findings are summarized in Table 1.
In the baseline model, the current value of output is close to the best value of the
forecast of future values at any horizon. There is a very slow-moving forecastable
component in the baseline model, associated with capital accumulation, so the standard

1144

R.E. H a H

Table 1
Failure of the baseline modela
Standard deviation of forecastable componentof output (percent)

Baseline model
Actual data with VAR

8 quarters
ahead

12 quarters
ahead

24 quarters
ahead

Infinitely
ahead

0.17
2.95

0.23
3.22

0.36
3.05

0.53
3.06

a Data from Rotembergand Woodford (1996).

deviation o f the forecastable component rises as the horizon lengthens. In the actual
data for the USA, there is a pronounced rebound from abnormal conditions in a year
or two. The standard deviation of the change in output forecasted by the VAR is
about 3 percent at all horizons. In addition to being much larger than the forecastable
component in the baseline model, the time profile of the forecasting power is quite
different in the actual US economy - the forecasted change occurs almost entirely in
the first 8 quarters. In the baseline model, the forecasting power grows quite a bit
after 8 quarters.
Related failures of the baseline model are revealed in the correlations of the
foreeastable components. In the baseline model, the forecasted change in work effort
should have the opposite sign from the forecasted change in output. When a shock has
caused the economy to be at a point below its steady-state capital stock, work effort
will be above its steady state while output will be below. As capital is accumulated,
output rises and work effort falls. In fact, forecasted movements in output and work
effort are in the s a m e direction. After a recession, both hours of work and output rise
more rapidly than normal.
It appears that a reasonable explanation for the failure of the baseline model in
Rotemberg and Woodford's work is the absence o f unemployment in the model. The
forecastable rebound that occurs in the US economy following a recession occurs
during the period when workers displaced during the recession are making their
way back into long-term employment. In the baseline model, there is no burst of
unemployment in the first place and no two-year period of rematching. Both anomalies
reported by Rotemberg and Woodford are resolved by adding unemployment to the
model - the augmented model has much more predictable recovery from bad (or good)
shocks, and output and work effort move in the same direction during recoveries.
Not only does consideration of unemployment provide a more sensible interpretation
of correlations among key macro variables, but modern ideas about both amplification
and persistence often involve job destruction and job search, key ideas in the modern
theory of unemployment.

Ch. 17: Labor-Market Frictions and Employment Fluctuations

1145

3. Amplification
Amplification occurs when the response of employment to a driving force is stronger
than in the baseline neoclassical model. Macro research in the DSGE framework has
recognized the need for amplification mechanisms since Kydland and Prescott's (1982)
paper launched the framework. The mechanisms I discuss in this section all involve
elastic labor supply, either in the conventional sense or in the sense that there is another
activity - j o b search - that is a substitute for work.

3.1. Elastic conventional labor supply

The earliest amplification mechanisms invoked elastic labor supply in the standard
setting where workers choose between work effort and leisure. I f labor supply is
more elastic - for example, if the labor part of the kernel of the utility function is
(~ - n) s instead of log(~ - n) - the response of employment to a technology shock
is almost twice as large; see Campbell (1994, Table 3). Then a favorable impulse to
technology sets off the process that is the signature of the real business cycle model a burst of extra employment and a decline in consumption resulting in vigorous capital
accumulation.
In addition to the simple assertion of elastic labor supply, the literature proposing
fluctuations theories based on that hypothesis has offered three supporting ideas.
First was Kydland and Prescott's (1982) use of non-time-separable utility. Second
was Rogerson's (1988) observation that workers facing a binary choice between not
working and working full time may behave as if they had linear utility and perfectly
elastic labor supply. Third was B enhabib, Rogerson and Wright's (1991) consideration
of substitution between work in the market and work at home. Their paper marked
the beginning of the investigation of margins other than labor-leisure within DSGE
models.
A convenient family of non-time-separable preferences follows suggestions of
Sargent (1979, p. 371) and Kydland and Prescott (1982) [my discussion is taken from
Hall (1991b)]. Let zt be the accumulated stock of current and past work effort, with
persistence factor co:
t

zt = (1 - co) ~

~oSnt_s.

(3.1)

s=0

My derivation will take nt to be weeks of work in period t and will assume

(realistically) that variations in hours of work per week are small. The parameter ~o
controls the memory of past work and leisure. If ~o is 0, there is no memory; only
current work effort matters. I f ~o is large (close to its upper limit of 1), then zt depends
on a long distributed lag of past work effort. As in my earlier discussion of the baseline

1146

R.E. H a l l

model, the worker orders work schedules with a utility function that is separable over
time in the cumulation variable, z:
(3.2)
-

t-O

1~---1

"

Define effective leisure as ~ - zt and actual leisure as B - nt. The parameter o is both the
intertemporal elasticity of substitution in effective leisure and the long-ruff elasticity of
substitution in actual leisure (where the long run is enough time so that the distributed
lag feature does not matter). In the short run, the elasticity of substitution in actual
leisure is greater than a by an amount that is controlled by the memory parameter, ~o.
The parameter ~ is the number of weeks physically available for work.
A worker with a high cr will suffer little from a work schedule involving many
weeks of work per year in one decade and few weeks per year in another decade,
in comparison to putting in the same number of lifetime weeks with no variation
from decade to decade. In a situation with free choice of weeks, such a worker will
concentrate weeks disproportionately during the years of highest wages.
On the other hand, a worker with low intertemporal substitution (low o) but high
memory persistence, o) (that is, close to one), will tolerate short-term fluctuations
in weeks of work but resist decade-to decade movements. Kydland and Prescott use
preferences that are slightly more general - current work can have a role in the utility
function beyond the role implicit in the variable zt.
To illustrate the difference between the short-run and medium-run responses of labor
supply to wage changes, consider the following question: let 2N be the number of
periods considered to define the medium run, which might be 24 months. Suppose a
worker increases weeks of work by 1 percent in periods t - N , . . . , t . . . . . t + N. By what
percent does the supply price of a week of work in period t increase? The elasticity
of labor supply over the 2N + 1-period run is the ratio of the two numbers.
It is convenient to use the ~-constant or Frisch labor supply schedule to answer this
question. Let ,~ be the Lagrangian multiplier associated with the worker's intertemporal
budget constraint. The first-order condition associated with labor supply is
O U (hi . . . . . n t , . . . , lilT)

Ont

= )~wt.

(3.3)

Here wt is the real wage in period t stated in period-0 prices, that is, in prices
discounted to period 0. The Frisch inverse labor supply function is simply the marginal
disamenity of work stated in wage units:
10U(nl

)~

.....

nt,. .. ,nT)

Ont

(3.4)

When U is additively separable in labor, this can be solved to give current labor
supply as a fimction of the current wage. Absent separability, it states the supply price

Ch. 17." Labor-Market Frictions and Employment Fluctuations

1147

of work in one period as a function of the level o f work in that and other periods.
Keeping & constant has two interpretations. First, Equation (3.4) gives the supply price
of labor at different points in time along the same labor-supply trajectory. Under this
interpretation, statements about the response of the supply price to different levels of
work are comparisons of the supply price at different points in time; the change in
the level o f work is fully anticipated. Second, the supply price conditional on ,~ has a
comparative statics interpretation when the change has little or no effect on ,~. Under
this interpretation, Equation (3.4) is very similar to (but not quite the same as) the
compensated labor supply schedule.
The Frisch labor supply function associated with the preferences considered here
is
Wt =

1
~(1

T
(3.5)

__ co) y ' ~ cos t (~__ Zs) 1/(7.

S=t

Let x be the common increment to n t _ N , . . . , n t , . , rtt+N. For simplicity, assume that

the horizon, T, is infinite and that nt and zt have the common value n in all periods.
Then some manipulations show that the slope of the inverse labor supply schedule is
dw _

dx

1 (~_n)_l/o_

~o

2coN+I)

(3.6)

l+co

The elasticity, e(N), of the labor supply schedule is

~-n
e(N) = U

2coN+I)
1

T +~ J "

(3.7)

If there is no memory of past work (co = 0) or if the displacement of the work is

lengthy (N is large), then the elasticity is just the intertemporal elasticity of substitution
in leisure, o, multiplied by the ratio of non-work time to work time:

n-n
/,/

e(oo) = a - -

(3.8)

The elasticity E(cxD) controls labor supply over the life cycle. A worker with an
e(oo) of 1 will work twice as many weeks at age 40 as at age 20 if the wage at age 40
is double its level at age 20 (and this doubling was known to be in the offing at age 20).
Life-cycle variations in weeks of work do not show an elasticity anywhere near 1 - the
evidence appears to favor values of 0.1 to 0.2. If 7-,
is 5/47 = 0.11 and the mediumn
run elasticity of labor supply is 0.15, then ~r is 0.15/0.11 = 1.4. Here I am considering
anticipated life-cycle changes in the wage or changes of short enough duration that
feedback through & can be neglected.

R.E. Hall

1148

By contrast, the elasticity of labor supply in the context of a one-period displacement

(N = 0) is
~ - n 1 +co
e(0) = ~ .
n 1-~o

(3.9)

If memory decays at a rate of 20 percent per period, as might be appropriate in a

quarterly model, the very-short-run elasticity is 1.8/0.2 = 9 times as ,large as the
medium-run elasticity. The specification is successful in delivering a high short-run
elasticity of labor supply without relying on significant decade-to-decade elasticity of
labor supply.

3.2. Empirical research

There is a huge empirical literature on labor supply. Pencavel (1986) and Killingsworth
and Heckman (1986) survey the direct evidence from panel data on individuals.
MaCurdy (1981) is one of the leading studies they consider. The basic approach is
the following: the elasticity of labor supply is the ratio of the change in work effort
to the change change in wage that occurs as the result of a change in one or another
instrumental variable. For example, as a worker moves from age 29 to age 30, the
worker's wage typically rises more than normal because this is a steep part of the
age-wage-rate profile. If hours of work also rise by more than trend from age 29 to
age 30, there is a positive elasticity of intertemporal substitution. Pencavel's (1986)
Table 1.22, p. 85, suggests that the elasticity estimated on this basis is somewhere
between 0 and 0.45 for men. Card (1994) reviews subsequent research and concludes
that Pencavel's earlier conclusion survives unaltered.
Pencavel appropriately devotes considerable attention to the one group of shortrun exogenous events whose labor supply effects are well documented - the negative
income tax experiments. Experimental subjects experienced a three-year reduction of
30, 50, or 70 percent in effective wages. Pencavel's survey reaches the conclusion
that the elasticity of the response of labor supply to these wage reductions was in the
fairly narrow range from 0.06 to 0.19 (Table 1.21, p. 80). This finding is the single
most telling evidence against the view that intertemporal substitution is high in the
short run.
The negative income tax findings are less than definitive for the following reason. For
good reasons relating to asymmetric information, workers delegate to their employers
the determination of weeks of work. Workers shop among employers with different
policies for setting weeks of work, but once the worker accepts a job, the weeks
of work required on that job are largely out of the worker's control. In particular,
if an event occurs that is personal to the worker, but not within the class of events
(such as disability) contemplated by the employment arrangement, it is unlikely that
the employer will agree to a reduction in weeks ad hoe. Employment arrangements
with given, understood rules help control opportunistic behavior by both employers

Ch. 17:

1149

Labor-Market Frictions and Employment Fluctuations

Table 2
Seasonal averageddeviations from trenda
Quarter
Number of workers employed
Weekly hours
Total hours

-1.45
-0.87
-2.32

0.07
-0.14
-0.07

0.30
0.81
1.11

1.08
0.20
1.28

a Data from Barsky and Miron (1989, Table 2).

and workers. Workers could take extra weeks off by quitting one job and delaying
taking another job, but that step dissipates the value o f job-specific capital. The finding
of small reductions in weeks of work in the negative income tax experiments is
not inconsistent with the hypothesis that much larger reductions can occur when the
marginal revenue product o f labor declines in a downturn. One is unprecedented and
unfamiliar, completely new to the environment under which employment arrangements
have evolved; the other is exactly within the historical experience that shaped those
arrangements.
Another reason that panel studies, both survey and experimental, are not good
evidence against elastic short-run supply is the amount of variability they reveal in
annual work effort. According to MaCurdy (1981), the standard deviation of annual
hours of work around the predictions of his labor supply function is several hundred
hours, a significant fraction of the normal level of around 2000 hours. Most of this
noise is variation over time around a worker's own normal level of work. I f the
intertemporal elasticity of labor supply is as low as the numbers in Pencavel's survey,
with respect to substitution between one year and the next, then the deadweight burden
of the unexplained variability of work is extremely high. A more reasonable conclusion
is that the low elasticities apply to life-cycle influences but that much higher elasticities
operate at year-to-year frequencies.
A low intertemporal elasticity of substitution in the short run should also make
workers averse to predictable seasonal variations in their volume of work. Table 2,
taken from Barsky and Miron (1989, Table 2), presents the seasonal averages in percent
deviations from trend by quarter found for the private non-agricultural sector of the
US economy. The United States has a recession every winter comparable to businesscycle recessions. There is a boom in the summer and fall. Although one might suppose
that part of the seasonal movements in hours of work reflects seasonal variations in
preferences for work and leisure, it is hard to see how that would result in more
work in the summer, during the vacation season, and less work in the winter. If
workers had a strong aversion to uneven work schedules, institutions would develop to
smooth employment over the season. The seasonal data suggest reasonable amounts
of intertemporat substitution among the quarters of the year.

1150

R.~HaH

Mulligan (1995) surveys many studies of intertemporal substitution in labor supply,

including some not considered in earlier surveys. He stresses novel tests, such as
those occurring during exceptional events including wars, the construction of the
Alaskan pipeline, and the Exxon Valdez cleanup. Unfortunately, he does not consider
the negative income tax experiments explicitly but appears to believe that their results
should be lumped with panel studies where there are no large exogenous changes in
wages (the experiments are mentioned only in footnote 2 and in the summary of his
paper). Evidence from the premiums needed to induce brief periods of 'extraordinary
effort or acceptance of irregular work schedules yields higher values of the IES.
Mulligan presents evidence on wage premiums in Alaska from the periods of high
activity associated with the building of the Alaska pipeline and the Valdez cleanup;
these range from 0.5 to 2.8. This type of evidence is not fully convincing, however,
because if there is a distribution of the IES across workers, only those with the highest
values will contribute observations. Mulligan makes an attempt to infer the elasticity
of substitution from the experience of World War II, but, as he points out, this is a
questionable exercise because, by most measures, real wages were lower during the
war than at other times.
Recall that the intertemporal elasticity of labor supply in the baseline neoclassical
model is around 4, well above even most of Mulligan's findings. Much higher values
than 4 are needed to achieve the degree of magnification required in a realistic
macroeconomic model. Intertemporal substitution in labor supply can only be part
of the story. Models that do not consider unemployment as a use of time alternative
to work appear to be incapable of explaining observed employment volatility along
neoclassical lines. Even with an infinite intertemporal elasticity of substitution, as
Campbell (1994) shows, the elasticity of employment with respect to the technology
shock is still below 1 unless the shock is highly transitory.
3.3. Unemployment

As I noted earlier, the most conspicuous shortcoming of the baseline model is its failure
to understand unemployment. The mechanism by which workers lose jobs in response
to adverse shocks is a promising area to find amplification, and the slow process of
re-employment is surely part of the story of persistent periods of slack.
The baseline neoclassical model fails to deal with unemployment in two ways. First,
it assumes that the labor market clears instantaneously. Even if workers are leaving
some jobs and taking others, the process takes no resources and no time. Second,
the model recognizes no heterogeneity in workers or jobs. The model contains no
ingredients that would suggest that workers should change jobs - that a worker is more
productive in a new job than in the current one. Unemployment cannot be grafted on
to the baseline model. A new model, unfortunately much more complicated, is needed
to deal effectively with unemployment. New work on job destruction, job creation, and
job search has made important advances in this area. Only recently have these ideas
been incorporated in DSGE models. Newly developed models achieve employment

Ch. 17:

1151

Labor-Market Frictions and Employment Fluctuations

Table 3
Alternative measures of quarterly rates of job loss a
Source
Permanent separations, UI system data
CPS tenure survey, 1981
All separations, Current Population Survey
Gross employment reductions, LRD
Permanent layoffs, PSID, 1985
Displaced workers survey, all workers, 1991 1993
Displaced workers survey, workers on the job for at least 3 years, 1991-1993

Quarterly rate of
job loss (%)
t7.23
10.04
8.29
5.66
1.81
0.61
0.59

a For sources, see Hall (1995).

amplification by operating on the employment - unemployment margin rather than on

the employment - leisure margin. In a sense, they consider labor supply to be elastic
because events can cause significant movements o f workers between work and job
search, even if they cause little movement along the market-nonmarket margin.
Even in normal times, rates of job loss are astonishingly high in the US economy
and in other economies like it. Hall (1995) presents data on a number of measures
o f separation rates. First, the most comprehensive measure o f job separations comes
from the unemployment insurance system, which includes even the briefest jobs lasting
a day or two. Over a quarter, the ratio o f total separations to employment is about
17 percent. The same worker can contribute many separations in the same quarter, if
engaged in day work, construction, or other high-turnover activities. Second, the tenure
survey in the Current Population Survey asks workers how long ago they began their
current jobs. Because the shortest category considered is 6 months, this measure does
not include multiple separations within a 6-month period, and so, when stated as a
quarterly rate, tenure is lower but still a substantial 10 percent per quarter. Third, the
Current Population Survey measures separations implicitly, when the same person is
reported as working in one month and working at a different job or not working the
following month. The rate shown in Table 3 is adjusted for an upward bias that results
from random errors in reporting labor-market status in the survey.
The fourth line in Table 3 reports the rate o f gross employment reduction, from
Davis, Haltiwanger and Schuh (1996). This rate is based on quarterly reductions in
employment at the plant level. Because firms sometimes hire during a quarter when
total employment falls, the change in employment understates the total separation rate.
Their measure is properly called the job destruction rate rather than the separation
rate.
The remaining three lines in the table consider separations initiated by employers
where the workers had held long-term jobs. These rates are much lower - around one

1152

R.E. Hall

percent per quarter. A large fraction of total job separations arise from temporary or
short-term work.
Rates of job loss rise dramatically at the onset of a recession. Davis and
Haltiwanger's rate of job destruction in manufacturing reached peaks of 11 percent
and 9 percent per quarter in the recessions of 1975 and 1982, from an average level
of 5.7 percent [Davis, Haltiwanger and Schuh (1996)].
The magnitude of job loss when an adverse shock hits the economy is puzzling in
some respects. The great majority of workers have been on the job for 5 years or more
and expect to remain in the same job for many more years [Hall (1982)]. Higher-tenure
workers may have accumulated substantial amounts of job-specific capital, measured as
the difference in the expected present discounted value of earnings at their current jobs
and the values conditional on departing. Evidence in Ruhm (1991) discussed in Hall
(1995) suggests that the typical layoff of a high-tenure worker costs the victim about
1.2 years of earnings, in the form of multiple spells of unemployment and reduced
hourly wages. I f the anticipated value of job-specific capital is divided evenly between
worker and employer, then the typical level of the capital is 2.4 years of earnings, or
around $100 000.
It should take a substantial adverse shock to merit the dissipation of $100 000 of
specific capital. Labor-market institutions should evolve to protect specific capital
against shocks of all kinds, including aggregate ones. Of course, not every job has
the typical amount of match capital. Workers with low tenure or in failing businesses
may be close to the point where separation would be efficient - it would not lower the
joint value of employers and worker. But the evidence at least creates the suspicion that
many of the workers who lose their jobs in a recession do not fall into this category.
As a general matter, it appears that firms tend to lay workers off despite opportunities
to preserve still-valuable job-specific capital. A number of authors have taken this
hypothesis as a point of departure for theories of amplification. In addition, recent work
has considered the role of heterogeneity in the values of job matches - separations are
most likely in the matches whose values are in the lower tail of the distribution, thanks
to idiosyncratic factors.
The basics of the theory of job termination are well developed in labor economics 2.
A core question is the efficiency of terminations - efficiency, as usual, means the
maximization of joint value. Figure 1 displays the analysis of efficient terminations.
The horizontal axis shows earnings available from the next best job in the open
market, net of search costs. The vertical axis shows the worker's marginal product
at this employer. Separation should occur below the 45 line. Whether the separation
is initiated by the worker as a quit or by the employer as a layoff depends on the details
of the employment arrangement 3.

2 For example, Hashimoto and Yu (1980), Hall and Lazear (1984), and McLaughlin (1991).
3 See McLaughlin (1991).

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

1153

Marginalproduct
at firm

45 line

Workerstays,
efficientlY~worke r
departs, "Y

Wageat bestalternativejob

Fig. 1. Efficientseparation.

Efficient separations would be likely if the variables in Figure 1 were observed by

the employer and the worker. For example, if the worker can locate the best possible
outside wage offer costlessly, and the employer can verify the offer, then the employer
will match the offer and retain the worker if the offer is below the worker's marginal
product, and let the worker accept the offer otherwise. This arrangement does not
require the marginal product to be observable 4.
When neither party to the employment contract can verify the other's data,
efficiency is more of a challenge. Any provision granting the employer the right to
lower compensation after a worker has accepted employment and made job-specific
investments will invite opportunistic wage cuts. Even when demand has truly fallen,
and renegotiation of the terms of employment is appropriate to retain the worker
efficiently, the worker will not be able to verify that the employer is not trying to
deprive the worker of job-specific rents. Suppression of renegotiation may be an
important feature of employment arrangements.
Absent government prohibition of certain types of governance, one would expect the
form of the employment relationship to evolve to maximize the joint value achieved
by employers and workers. In principle, this proposition should apply even if either the
employer or the employee, or both, have market power. Maximization of joint value will
occur subject to the constraints of limited abilities to observe or verify key measures
and the likelihood that many workers are unable to borrow as much as they would
otherwise against future earnings.
Most jobs have specific capital. Workers develop skills related to the employer's
particular way of doing business. They develop personal relationships with their
co-workers. They may choose places to live and particular houses based on their

4 Hall and Lilien (1979) discussed efficient employment arrangements with unilateral information private
to employers.

1154

R.E. Hall

employer's location. Firms accumulate valuable knowledge about their workers' skills.
More subtle employment practices may be needed to protect investments in specific
capital.
When the efficiency of the continuation of the match is a live issue, protection of
specific investments becomes a serious challenge. In that case, some kind of joint or
unilateral procedure is needed to determine if a match should continue or end. I f either
party has the power to end the job (the worker to quit or the employer to terminate),
the party can use that power to deprive the other party of the expected 'return to the
investment. For example, an employer might attract a worker to make an expensive
move by offering a high salary. A year later, the employer might approach the worker
and say that the worker would be terminated unless the worker accepted a much lower
salary. The worker would accept the salary reduction as long as the salary remained
above the value of the next best job, which might involve another expensive move. An
employment arrangement can include severance pay to limit this type of opportunistic
behavior by employers.
3.3.1. Mechanism design and labor contracts"

The discussion of the design of the labor contract has been strongly influenced by the
literature on mechanism design derived from Mirrlees's (1971) famous paper. A key
idea in this literature is that contracts can only be contingent on measures that are
verifiable - it is not enough that the measures be observable. Hart (1983) discusses
the first round of thinking along these lines, where separation or other employment
decisions are made unilaterally by worker or firm, subject to a contract determined in
advance. A more recent elaboration of the theory of the employment relationship in
the mechanism design framework is in the work of Charles Kahn and Gur Huberman
(1988). In their model, the worker's productivity is observed only by the employer,
but the productivity depends on an investment in specific capital observed only by
the worker. Absent both of these information limitations, simple contracts would
give the first-best outcome. If productivity were verifiable, then the wage would be
contingent on actual productivity, and the worker would have the right incentive to
make the investment. If the investment were itself observable, the employer would
reward the worker for making the investment. With both unobservable, the following
more complicated contract delivers the efficient outcome: The parties agree in advance
on a wage to be paid after the investment is made. Upon observing the worker's
productivity later, the employer can either keep the worker and pay the wage, or
discharge the worker. The worker does in fact make the investment and is retained,
which is the efficient outcome.
Gilson and Mnookin (1990) argue that the up or out rule common in law firms is
the result of suppression of renegotiation. In order to induce associates to make firmspecific investments, the firm promises not to offer the associate a salary just above
the best outside salary. Instead, at a predetermined time, the firm chooses between
offering partnership or terminating the associate.

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

1155

Although Kahn and Huberman do not stress the point, suppression of renegotiation
is central to the success of their contract. After the worker has made the firm-specific
investment, the employer could say, "If I have to pay you the wage we agreed upon,
I won't keep you. But if you agree to a lower wage, I will keep you." There is no
violation of the contract in this offer. But if the worker anticipates that the employer is
free to make this offer, the worker will not make the investment and the scheme will
fail.
Considered as a game played only once, the Kahn-Huberman contract fails the test
of credibility - it is not subgame perfect. Suppression of renegotiation requires the
employer to commit not to take a step later that would be rational and permitted under
the terms of the contract. The problem is the same as the one studied extensively
by monetary economists (a central bank needs some way to commit not to create a
monetary surprise later, when such a surprise would be rational later) and in public
finance (the tax authorities need some way to commit not to levy a capital tax later,
when such a tax is the ideal, neutral lump-sum tax later)5.
Although in both the monetary and fiscal settings, there are no formal institutions to
enforce commitments, experience - especially recently - suggests that something like
the favorable equilibrium with commitment can be achieved anyway. Reputations of
policymakers and institutions seem to be an important part of the story - see Barro and
Gordon (1983) in the analogous context of monetary policy. Reputation may explain
the credibility of the suppression of renegotiation as well. If an employer is expected to
remain in business permanently, it will pay for it to develop a reputation for adhering
to policies of not renegotiating. The concept of reputation can be explained in models
of games of repeated play, or in other frameworks 6.
Suppression of renegotiation seems to be an important part of the cultural norms of
the labor market as well. The offer to retain an employee by departing from previously
announced standards of compensation is seen as morally wrong. Standards of ethical
conduct support up-or-out rules in universities and professional practices. It is wrong
to extend a non-tenured faculty member's appointment after denial of tenure, even
though both sides favor it.
Truman Bewley's extensive field study of employment relationships in a depressed
local labor market documents the absence of renegotiation 7. By far the most
common reason given by employers and their advisers for not rewriting employment
arrangements in order to preserve jobs is that lowering wages would destroy morale.
In other words, workers see a departure from the established compensation patterns
as a violation of the rules of the workplace. They think it is wrong to depart from
the principle that employers unwilling to pay promised levels of compensation should
discharge their workers.
5 See Fischer (1980). On the general issue of the value of commitment in games, see Fudenberg and
Tirole (1991, pp. 74-77).
6 See Carmichael (1984).
7 Bewley (1994).

1156

R.E. Hall

Value at firm
Inefficient
45 line
i: qult /
i
i /
Efficient

Efficient
retention
W

............. i ............................................

Inefficient
layoff
/
/

/
/

i
!
i

Efficient layoffquit

Effiaent i
layoff

Contract value,
w
Value at best alternative job

Fig. 2. Wage contract with suppression of

renegofiafion.

Suppression of renegotiation has some of the implications o f the types o f wage

rigidity considered in macroeconomics. But it does not explain any failure of the
labor market to clear. It puts no restriction on the terms under which new workers
are hired; it is completely consistent with market clearing in the market for new
hires. Figure 2 shows that suppression of renegotiation results in excess, inefficient
separations. Suppose that the worker was hired with the understanding that the wage
would be w. The firm has the right to terminate the worker if the wage falls below w
and the worker has the right to quit if there is an alternative job paying more than w.
The standard for efficiency remains as in Figure 1 and does not involve the contract
wage. Figure 2 shows that a separation wilt always occur if the match has become
inefficient. In the inefficient area below the 45 line, either a quit will occur (the triangle
on the right) or a layoff will occur (the triangle at the lower left), or both a quit and a
layoff will occur (the lower right quadrant). The suppression of renegotiation permits
the destruction of efficient matches, however. When conditions are good in the outside
market, relative to the contract wage, but conditions are even better at this employer
(the triangle at the upper right), the worker quits even though the two parties could
renegotiate to mutual advantage - there is a wage that will keep employment profitable
for the employer but also exceed the worker's best alternative wage.
At the left in Figure 2 is the case o f greatest interest in this chapter. An inefficient
layoff occurs when conditions are bad at the firm but even worse in the outside market.
The parties fail to renegotiate a wage reduction, even though a mutually beneficial one
is available.
Finally, the upper left quadrant describes a success for the contract; retention is
efficient and it actually happens.

Ch. 17." Labor-MarketFrictions and Employment Fluctuations

1157

3.3.2. The modern strategic view o f the employment relationship

Modern thinking about the employment relationship, as reflected in Diamond (1982a,
b), Mortensen (1982), Ramey and Watson (1997), Caballero and Harmrlour (1996,
1998), and many other papers, insists that strategic relationships, such as the
employment relationship, satisfy the criterion of subgame perfection. Parties will not
adhere to terms such as fixed wages that they can negotiate around later to their mutual
benefit. An employment contract does not necessarily guide the relationship as stated,
but only establishes the threat points for a subsequent bilateral bargaining problem.
The Nash solution to that bargaining problem - where the parties split the joint surplus
from their relationship - governs the outcome. For further discussion of the relation
between the two branches, see Aghion, Dewatripont and Rey (1990) and Hall (1995,
1997) 8.
3.3.3. Efficiency wages
The theory o f efficiency wages - Shapiro and Stiglitz (1984) and Akerlof and Yellen
(1990) - has had an important role in macroeeonomics for more than a decade.
At a minimum, the theory helps us understand why the natural or chronic level
of unemployment is so high. Employers seek to create idiosyncratic value for their
workers in their jobs, so that the threat to terminate deters misconduct such as shirking.
Absent unemployment, employers wilt pay wage premiums to create the needed
idiosyncratic value. Because it is impossible for every employer to pay a premium,
there is unemployment in equilibrium. Note that unemployment from efficiency-wage
factors is not a socially or privately valuable use of time directly - efficiency-wage
models do not suggest that workers have elastic labor supply in the conventional
sense.
A number of writers have discussed the ways that efficiency wages contribute
to amplification - see, for example, Danthine and Donaldson (1995), Picard (1993,
Chapter 7), Phelps (1994) and D. Romer (1996, p. 220). Woodford's (1994b) discussion
of Phelps reveals the benefits of a full DSGE treatment, as some of Phelps's proposed
mechanisms may not work as he describes, once all feedbacks are considered.
Woodford (1994a) shows that technology shocks have no more effect in a DSGE
model with efficiency wages than in an otherwise similar one with a neoclassical
labor market. MacLeod, Malcomson and Gomme (1994) develop a DSGE model where
unemployment arises only because of efficiency wages. The model is able to match
the volatility of output but falls short of matching the volatility of employment. The
authors suggest that adding elastic labor supply as a second amplification mechanism
would overcome this problem.

8 The recent literature on contracts in general has gone through a similar transformation see, for
example, Segal and Whinston (1996, 1997).

1158

R.E. Hall

3.3.4. Job destruction

Models with dynamic labor markets that incorporate job destruction, job search, and
job creation have made important progress in explaining amplification. Job loss after
an adverse shock seems a natural way to model employment reductions. As Mortensen
and Pissarides (1994) point out, it is natural to assume the absence of adjustment costs
for job destruction. As a result, there is an important asymmetry in the adjustment of
employment. The level of employment can decline immediately when an ~idverse shock
strikes, whereas the rate of increase is limited by the costs of hiring, which are convex
in the hiring rate. Heterogeneity is essential to the story - if workers and jobs are
homogeneous, there is no reason for matches to break up and no time required to put
workers back in jobs.
Wright (1986) appears the first to build a modern general equilibrium model where
unemployment arises from heterogeneity and time-consuming matching. In Wright's
model, as in a number of successors, separation is an exogenous event. Workers are
thoughtful about selecting a new job from the heterogeneous set that is available.
Search is time-consuming because workers find out about only one new job per period
of search. Aggregate unemployment can jump upward because of an information
limitation that can cause all searchers to make the inference that it is a good idea
to wait for a better job to come along [the information setup is similar to the one in
Lucas (1972)].
Mortensen and Pissarides (1994) is a leading example of current thought about job
destruction and unemployment, although theirs is not a full DSGE model - product
prices are taken as exogenous. The authors avoid dealing with a full model of the
heterogeneity of job-worker matches through the assumption that the productivity of
an existing match is drawn from the same distribution for all matches, not from a
distribution that depends on the history of the match. Both job destruction and job
creation are the result of rational economic behavior by employers and workers. Job
destruction occurs at the moment that the joint surplus from the match passes through
zero. A key concept in the theory is the option value of the employment relationship,
which is an element of joint value.
Merz (1995) and Andolfatto (1996) developed DSGE models with job search. To
remain within the representative agent general-equilibrium framework - with huge
resulting simplification - they presume that families or broader institutions insure
individual workers against job loss. In these papers, jobs end at random, not in response
to economic forces. But the levels of unemployment and employment fluctuate because
of changes in the rate of job creation driven by aggregate conditions. These models
achieve amplification, as discussed earlier, by opening up the employment-search
margin. Because they do not permit jumps in job destruction along the lines suggested
by Mortensen and Pissarides, the amount of amplification is limited.
Caballero and Hammour (1996, 1998) have developed a model of endogenous
job destruction. Caballero, Engel and Haltiwanger (1997) apply the ideas of that
work empirically. A job is destroyed the moment that its match value crosses zero,

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

Valueat f i r m

1159

X
45 line

Valueat best alternativejob

Fig. 3. Separations in the Ramey Watson

model.

in accord with the efficiency condition discussed earlier. The value of each match
begins at a positive level, reflecting match capital created by the worker's search
effort and the employer's recruiting effort. Thereafter, it evolves as idiosyncratic and
aggregate shocks perturb product demand, productivity, and the worker's alternative
opportunities. In their general form, this type of model is hard to handle because the
state of the economy at each moment includes the distribution of matches by current
value, which has a dimension equal to the number o f matches.
Gomes, Greenwood and Rebelo (1997) tackle the hard problem of studying a DSGE
model without the simplifying assumptions of earlier authors. Their workers do not
enjoy the perfect unemployment insurance assumed in earlier models. The value of
a match evolves according to a stochastic process with memory, where every match
is also influenced by an aggregate variable, so the distribution of workers by current
match productivity cannot be simplified.
Efficiency wages have been brought back into the picture in the DSGE framework by
G. Ramey and Watson (1997). Figure 3 strips their model down to its bare essentials.
Workers can enjoy a benefit, X, if they misbehave - for example, X might be the
amount they could steal. Misbehavior is detected with certainty by the employer, but
cannot be proven in court, so it cannot be a contingency in a contract. Unless workers
have a personal value from continuing in the job of at least X, they will take X and
then find another job.
The zone of inefficient separations in the Ramey-Watson model is the area between
the 45 line and the line that is X above the 45 line. A job could have substantial
joint value, say at J in the figure. But a small shock could move that job below the
upper line, causing a separation. The employment relationship is unnecessarily fragile
(compared to its full-information version) because it breaks up whenever the joint value
achieved by the match falls below X,, rather than surviving unless it falls to zero.
In what sense is there amplification in the Ramey-Watson model? Jobs are at
risk to small shocks even though they have positive amounts of joint job-specific

1160

R.E. Hall

value. In a world of homogeneous worker-employer matches, their model explains

job destruction without requiring that all matches have little match value. On the
other hand, with heterogeneous match values, as in Caballero and Hammour (1996)
and related research, the contribution of efficiency wages to amplification is less
clear. In those models, job destruction occurs when match values drift down to
zero, under the influence of random idiosyncratic and aggregate influences. The
Ramey-Watson setup changes the boundary point where job destruction occurs, but
does not change the magnitude of the response to adverse aggregate' shocks in an
obvious way.
3.3.5. Reorganization and reallocation
Lilien (1982) began the literature suggesting that reorganization or reallocation could
create aggregate effects on employment and unemployment. Impulses that have no
net effect on aggregate productivity, for example, nonetheless raise unemployment
during the period when they cause workers to move from one sector to another.
Reorganization is an activity that is a close substitute for production [Hall (1991a)].
The most conspicuous form of reorganization is the movement of workers from
unsuccessful productive units to new or growing units. Other forms of reorganization
include relocation and re-employment of capital and the rearrangement of contractual
relations among units. One can think of these activities as investment flows that form
organizational capital. As in the case of the use of output either for consumption
or capital formation, production and organizational capital formation are perfect
substitutes. Perfect substitution is a natural source of amplification, just as is the perfect
substitution between market work and time spent in other activities.
Flows into reorganization occur out of jobs where the match value has just reached
zero, possibly as the result of an aggregate impulse. Match value will fall either if
workers' marginal contributions fall at their current jobs or if the likely value of
employment elsewhere rises, net o f search costs. Thus three types of impulses are
amplified in the reorganizational view:
(1) Impulses that raise workers' contributions in some sectors and lower them
in others, without affecting the efficiency of search, such as changes in the
composition of product demand.
(2) Impulses that lower productivity in all sectors but do not affect the efficiency of
search, such as reductions in productivity in all sectors.
(3) Impulses that do not affect productivity but raise the effciency of search, such as
streamlining the labor market.
Data on cyclical flows of labor are helpful in understanding reorganization. Flows
out of various industries - measured either as gross job destruction [Davis, Haltiwanger
and Schuh (1996)] or as net employment change - are highly correlated across
industries. In particular, the abrupt shedding of workers during a recession occurs in
most industries. Impulses that stimulate movements of workers from one sector to
another cannot explain the most important facts about recessions.

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

1161

An exogenous improvement in the efficiency of job search relative to the productivity

of employment would explain the burst of job separation and high volume of jobseeking in recessions. This explanation is a close relative to the one based on
productivity at home rising relative to productivity in the market - workers are sucked
out of employment because of the rising attractiveness of an alternative use of time.
It shares the defects of that view discussed earlier. It does have the advantage of
explaining - however implausibly - the sharp increase in unemployment in recessions,
a phenomenon not considered in the existing home production models.
Endogenous changes in job search costs are a more promising way to make
reorganization a believable element in fluctuations theory. They arise in models of
complementarity. Peter Diamond (1982b) began modern rigorous thinking on this
topic. In his model, producer-consumers search for each other. Upon making a match,
each can consume and then produce again. The presence of one search agent confers
an external benefit on others by raising the probability of encountering a partner.
This is a thick-market externality. In Diamond's model, two or more equilibria are
possible. In one there are relatively few searchers ready to trade. Because it is difficult
to trade, less production takes place. It is a decentralized equilibrium. In the superior
equilibrium, more traders are in the market, so more production takes place. Again,
this is a decentralized equilibrium.
Diamond's model - like many successors based on complementarities - contains the
ultimate form of amplification, indeterminacy. The tiniest impulse, including sunspots,
could trigger a move from one equilibrium to another, with very different levels of
output and employment.
As stressed in a number o f places in this chapter, realistic fluctuations models need to
consider unemployment seriously and explicitly. Most research on complementarities
has concentrated on output rather than unemployment. Hall (1991a) makes an attempt
to apply the logic of Diamond's model of search complementarities to unemployment
over the business cycle. The paper offers a crude measure of endogenous increases in
search efficiency when unemployment is higher.
At one level, it must be true that it is better for one worker to search when
many others are searching as well. Like most other economic activities, job search
is concentrated during the daylight hours Monday through Friday. It is efficient
to concentrate job-worker matching during a limited set of hours of the week.
Many job markets - including the one for economists - are highly seasonal. Again,
temporal concentration of matching activities is efficient. It is a leap from these
observations, however, to the conclusion that recessions are good times to look for
work in the same way that Tuesday at 3 pm and the first week in January are good
times.
Before rejecting the view that there are increasing returns to aggregate search,
one should consider carefully the evidence developed by Davis, Haltiwanger and
Schuh (1996) that the hiring rate (measured by gross job creation) reaches a startling
peak immediately after the spike of job destruction that occurs during the initial
contraction phase of a recession. The extended period o f high unemployment following

1162

R.E. HaH

a contraction is a period of matching frenzy, with both job destruction and job creation
at abnormally high levels.
Evidence cited by Hall (1991a) on the cyclical behavior of job-finding rates is mixed.
Blanchard and Diamond (1990) report that a recession that raises unemployment
by two percentage points reduces the job-finding rate from a normal level of
24.0 percent per month to 21.8 percent per month. On the other hand, Hall reports
a regression relating the Davis-Haltiwanger measure of the volume of job-worker
matching to the level of unemployment. He finds an increasing margimll benefit from
the stock of unemployment on the flow of new matches.
Although the amplification mechanism based on endogenous improvements in
search efficiency during recessions is on uncertain ground, the evidence just reviewed
raises serious doubts about the opposite (and conventional) view that recessions are
times when jobs become much harder to find. A reasonable intermediate view is that
search efficiency is about the same at high and low unemployment. This disposes of
a potential attenuation mechanism - job matches would be more stable in recessions
than normal times if job search became more costly in recessions.

4. Persistence
The time-series properties of the principal macro variables are reasonably well
understood. Unemployment is stationary - it returns about one third of the way to
its normal level each year after a shock displaces it 9. Output and employment have
both cyclical and highly persistent - possibly integrated - components. The persistence
mechanisms in a fluctuations model need to be able to explain the stationary but serially
correlated movements of unemployment and the corresponding cyclical movements of
output and employment. The highly persistent components of employment and output
derive from slow-moving changes in preferences and technology and are not in the
domain of the persistence mechanism of the fluctuations model.
Although a number of authors have identified sources of persistence other than the
mechanics of job search [such as Burnside and Eichenbaum (1996) and Saint-Paul
(1996)], I will focus mainly on this single topic, which dominates current thinking
about persistence.
4.1. Time-consuming matching in the labor market
One of the most interesting and successful recent developments in the labor side
of macroeconomics has been the development of modern models of job search.
Diamond (1982b) and Mortensen (1982) are the starting points. Good summaries are

9 In the USA. In many other countries, unemploymentis close to a random walk.

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

1163

in Mortensen (1986), Pissarides (1990), and Romer (1996, chapter 10). My discussion
will be brief because Mortensen's chapter in this volume covers this area in detail.
In the standard matching model, a random meeting occurs between a job seeker and
an employer. A match occurs if it increases the joint value of the two parties, in which
case they divide the joint surplus. The simplest model has a constant probability that a
job-seeker will be matched. The persistence parameter for aggregate unemployment the serial correlation coefficient - is controlled by the job-finding probability. The
matching model provides a simple and elegant persistence mechanism for a general
equilibrium macro model.
From the start, it has been clear that it is an uphill battle to use the matching model
to explain the actual persistence of unemployment in the USA. To see the relation
between the job-matching rate and the serial correlation of unemployment, consider the
following elementary model. Let dt be job destruction, nt be employment, ~ be the fixed
supply of labor, ut = ~ - nt be unemployment, and f the per-period job-finding rate.
Then employment this period consists of employment last period plus those among
the unemployed who found new jobs less the number of jobs destroyed:
nt =nt 1 + f u r - d r

(4.1)

ut = (1 - f ) u t

(4.2)

or

1 +dt.

Thus, if job destruction is white noise, unemployment follows an AR(1) process with
serial correlation 1 - f .
As I noted earlier, the average job-finding rate is about 24 percent per month. The
monthly serial correlation of unemployment is 0.988, which would imply a job-finding
rate of only 1.2 percent per month. There is a discrepancy of a factor of 20 between
the time-series properties of unemployment and the job-finding rates experienced by
individuals. Cole and Rogerson (1996) have studied this discrepancy and concluded,
"Our main finding is that the [matching] model can account for the business cycle facts,
but only if the average duration of a non-employment spell is relatively high - about
nine months or longer." With an average job-finding rate of 24 percent per month, the
average duration is actually much less. Something is missing from the simple model.
4.2. The importance o f secondary j o b loss f o r persistence

Hall (1995) suggests that the missing element is induced secondary job loss. The first
job that a recently discharged worker finds may be an explicitly temporary job, or it
may turn out to be a bad match once the worker joins the firm, or the match may break
soon because, in its early stages, it has little job-specific capital. There is evidence of
large amounts of secondary spells of unemployment following an initial impulse.

R.E. Hall

1164
12
10
8
6
o

4
2
0
72

73

74

75

76

77

78

79

80 81
Quarters

82

83

84

85

86

87

88

Fig. 4. Gross employment reduction rate in manufacturing.

Figure 4 shows quarterly data on gross employment reductions in manufacturing,

taken from the work of Davis, Haltiwanger and Schuh. Gross employment reductions
are measured at the level of individual plants. The series shows the total reduction
in employment at plants where employment fell from one quarter to the next, as
a percent of total employment. Gross employment reductions appear to be the best
available measure of the immediate effect of adverse macroeconomic events on the
labor market. In particular, as Figure 4 shows, recessions start off with large bursts
of employment reductions. The flow of gross employment reductions is not persistent;
during the extended slump after a sharp contraction, gross employment reductions are
at normal levels 10. Persistence in unemployment and employment appear to come from
other sources.
Data on the flow of workers into unemployment provide another, quite different
view of the dynamics of job loss. The best data for this purpose show the flow from
permanent layoffs alone, separately from temporary layoffs, quits, new entrants, and
re-entrants. Figure 5 shows these data since they became available in 197611. New
permanent layoffs are much more persistent than gross job reductions. A burst of job
reductions, as in 1982, is followed by several years of higher new permanent layoffs.
The data have a strong distributed lag relationship - see Hall (1995).
A number of factors enter the explanation of the lag from employment reductions to
new unemployment. First, employment reductions are measured only in manufacturing,

10 As Davis, Haltiwanger and Schuh note, plant level employment is highly persistent; it is essentially
a random walk. Hence the flow of reductions is close to white noise.
tl The data come from the Current Population Survey and are published in Employment and Earnings.
They refer to workers who became unemployed as a result o f permanent layoff, whose unemployment
began within five weeks of the survey.

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

1165

3.5

2.5
2

0.5 l
0

~llll 1111 II 1IN II I'~ 1111',~'111111 fill llllll Ill ll'~Ill',II~ll lllllIlllllll~

Quarters

Fig. 5. New permanent layoff unemployment. Source: Bureau of Labor

Statistics, Current Population Survey, permanent layoff unemployed
less than 5 weeks.

whereas new unemployment is measured economy-wide 12. A systematic lag of nonmanufacturing behind manufacturing would explain some part of the lag. Second,
many workers who lose their jobs do not become unemployed- they move immediately
to other jobs or leave the labor force. During the period of slack labor markets
following a burst of employment reductions, a larger fraction of job-losers become
unemployed. Third, permanent job loss has important delayed effects. Many of the
workers who move quickly to other jobs have taken temporary work, either jobs with
predetermined short terms, or those with naturally high turnover. Those who left the
labor force upon loss of a long-term job often re-enter the labor force.
The micro and macro evidence suggests strongly that terminations beget later
terminations. When an event breaks a set of long-term employment relationships, the
workers released into the labor market will form new relationships. Many o f the new
jobs will prove to be short-lived.. First, it.may make sense for an individual totake a
temporary job while looking for a new permanent job. Second, a worker long out of
the market may experiment with alternative types of work before finding a good longterm match. Third, employers may have explicit policies of hiring many candidates
and keeping only the fraction who prove to be well matched. Fourth, immediately after
being hired, the typical worker will be close to the margin for discharge, either by the
standards o f the efficient separation model or the models of suppressed renegotiation
or efficiency wages. Both the systematic accumulation of match-specific capital and
the random accumulation o f rent will have had little time to occur. Low-tenure workers

t2 In principle, data on new permanent-layoffunemployment among workers previously employed in

manufacturing could be tabulated from the Current Population Survey,but it would require processing
all of the monthly CPS tapes. I do not believe this has yet been done.

1166

R.E. Hall

are the logical candidates for separation - last hired, first fired is the rational separation
rule under broad conditions.
A specific adverse event will create an immediate burst of terminations, followed
by the second, third, and subsequent rounds of terminations. Induced subsequent job
losses seem to be a promising explanation of persistence. Following a single adverse
shock, employment will be depressed and unemployment elevated by subsequent
rounds of adjustment in the labor market.
A glance at the data show that a simple model of transitions between jobs and search
cannot be faithful to even the most conspicuous features of the market's dynamics.
Rates of separation from jobs decline sharply with tenure on the job, and job-finding
rates fall with the duration of unemployment. Part of the duration dependence is
genuine and part reflects the sorting of heterogeneous workers 13. Moreover, previous
history appears to influence transition rates. For example, workers terminated from
long-term jobs have lower job-finding rates than do other searchers, are more likely to
lose subsequent jobs than are other short-tenure workers, and have lower job-finding
rates in subsequent spells of unemployment.
Some basic properties of job loss have emerged in this review of the evidence.
Microeconomic studies of serious job loss show significant downstream effects on
the subsequent experiences of individuals in the labor market. Loss of a long-term
job leads to a period of episodic employment, periods of job search or time out of
the labor market, and lower earnings when working. The effects extend for at least
four years. In the macroeconomic evidence, bursts of gross employment reductions
coincide with abnormal levels of serious job loss. The downstream effects visible in
time series data for unemployment are similar to the effects found in micro data for
individuals.
The macro data show occasional sharp disruptions of employment followed
by long periods of rebuilding of employment relationships. This rebuilding may
be an important part of the propagation mechanism of the business cycle. The
length of time that the economy takes to recover from an adverse shock has
perplexed macroeconomists for many years. Rebuilding may help solve this puzzle
of persistence.
Den Haan, Ramey and Watson (1997) have developed a DSGE model with realistic
persistence in which efficient job destruction interacts with capital formation. They
provide an alternative explanation of induced secondary job loss. A key property
of their model is that the idiosyncratic shock at the level of the plant or individual
job match is unpredictable white noise. An aggregate shock results in a first rotmd
of job destruction. There follows a period of high interest rates during which the
threshold value for the idiosyncratic shock changes so as to increase the probability
of job destruction. Until the aggregate shock wears off, job destruction continues
at abnormally high levels. The model is successful in explaining the persistence of

13 See Heckmanand Singer (1985) and Devine and Kiefer (1991).

Ch. 17:

Labor-Market Frictions and Employment Fluctuations

1167

job destruction and unemployment, without invoking unrealistically low rates o f job
finding. On the other hand, it relies on highly persistent technology shocks (with a
quarterly serial correlation of 0.95) in order to generate persistent changes in interest
rates. The model's assumption that the idiosyncratic component of job match value is
white noise is also intrinsic to the model's success in explaining persistence. Under the
more realistic assumption o f a random walk for the idiosyncratic component, all of the
job destruction triggered by an aggregate shift in technology would occur immediately
and there would be no persistent subsequent job destruction.

5. Conclusion
In the economies of the USA and other modem countries, large responses, especially
recessions, seem to result from small impulses. Their effects on the economy
must operate through an amplification mechanism. The fragility of the employment
relationship seems to underlie that sensitivity. Despite substantial job-specific capital
in the majority of jobs, millions of workers are released into the labor market during
each contraction. The resulting unemployment is persistent. Not only does it take time
for workers displaced by a recession to find new jobs, but the average one has to find
several new jobs, a process that stretches over about four years.
DSGE models have come a long way since Kydland and Prescott (1982) in incorporating labor-market frictions and giving correspondingly more realistic portrayals of
the economy. Recognition of the heterogeneity of workers and jobs has been central
to this improvement in macro modeling.

Acknowledgments
This research was supported by the National Science Foundation under grant SBR9410039 and is part of the NBER's research program in Economic Fluctuations and
Growth. I am grateful to the editors for helpful comments.

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Chapter 18

JOB REALLOCATION, EMPLOYMENT FLUCTUATIONS AND

UNEMPLOYMENT *
DALE T. MORTENSEN
Northwestern University
CHRISTOPHER A. PISSARIDES
London School of Economics

Contents
Abstract
Keywords
Introduction
1. O E C D facts
2. The equilibrium rate o f unemployment
2.1. Job destruction and job creation conditions
2.2. Generalized Nash bargaining
2.3. Fundamental determinants of unemployment
3. Employment fluctuations
3.1. Stochastic equilibrium
3.2. The Beveridge curve
3.3. Job creation and job destruction flows
3.4. Quits and worker flows
4. Explaining the data
4.1. Explaining job flows data
4.2. Capital accumulation and shock propagation
5. Technological progress and job reallocation
5.1. Disembodied technology
5.2. Adoption through "creative destruction"
6. O E C D unemployment differences
6.1. 'Skill-biased' technology shocks
6.2. Mean-preserving shocks to idiosyncratic productivity

1172
1172
1173

1174
1183
1185
1188

1192
1194
1194
1196
1197
1198
1200
1201
1203
1207
1208
1210
1213
1215
1218

* Presented at the Federal Reserve Conference on "Recent Developments in Macroeconomics I",

February 27-28, 1997, New York, NY. The authors acknowledge financial support from the US National
Science Foundation, Northwestern University, and the Centre for Economic Performance at the London
School of Economics.
Handbook of Macroeconomics, Volume 1, Edited by J.B. Taylor and M. Woodford
1999 Elsevier Science B.V. All rights reserved
1171

1172
6.3. Other influences
7. Concluding remarks
Appendix A. Mathematical appendix
A.1. Mean-preservingshifts in productivity
A.2. Labor's bargaining strength
References

D.T. Mortensen and C.A. Pissarides

1220
1223
1223
1223
1224
1225

Abstract
The purpose of this chapter is twofold. First, it reviews the model of search and
matching equilibrium and derives the properties of employment and unemployment
equilibrium. Second, it applies the model to the study of employment fluctuations and
to the explanation of differences in unemployment rates in industrialized countries.
The search and matching model is built on the assumptions of a time-consuming
matching technology that determines the rate of job creation given the unmatched
number of workers and jobs; and on a stochastic arrival of idiosyncratic shocks that
determines the rate of job destruction given the wage contract between matched firms
and workers. The outcome is a model for the flow of new jobs and unemployed workers
from inactivity to production (the 'job creation' flow) and one for the flow of workers
from employment to unemployment and of jobs out of the market (the 'job destruction'
flow). Steady-state equilibrium is at the point where the two flows are equal.
The model is shown to explain well the employment fluctuations observed in the
US economy, within the context of a real business cycle model. It is also shown that
the large differences in unemployment rates observed in industrialized countries can
be attributed to a large extent to differences in policy towards employment protection
legislation (which increases the duration of unemployment and reduces the flow into
unemployment) and the generosity of the welfare state (which reduces job creation).
It is argued that on the whole European countries have been more generous in their
unemployment support policies and in their employment protection legislation than the
USA. The chapter also surveys other reasons given in the literature for the observed
levels in unemployment, including mismatch and real interest rates.

Keywords
J E L classification: J63, J64, J65, J68, E24, E32, J41

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1173

Introduction

Market economies experience large employment fluctuations and average unemployment rates that are often different from those experienced by apparently similar
economies. The search and matching framework provides a convenient lens through
which to view explanations of such differences. Our purpose in this chapter is twofold:
first, to present the essential concepts that underlie the framework and, second, to use
the framework to suggest answers to the questions posed by the data.
Existing employment relationships command monopoly rents because of search
and recruiting investments, hiring and firing costs, and other forms of match-specific
human capital formation. The surplus that accrues is allocated between the parties
to the employment relationship by a wage contract. Given a particular wage rule,
employers provide jobs and recruit workers while workers search for employment. At
the same time, an existing employer-worker match ends when sufficiently bad news
arrives about their expected future. These job creation and job destruction decisions
generate worker flows into and out of employment which depend on the current value
of the employed stock. When the two flows differ, employment dynamics are set in
motion which, under a reasonable set of conditions, lead to a unique steady-state
employment level. These properties characterize the equilibrium model of job creation
and job destruction applied in the chapter.
The search and matching approach owes its origins to the pioneering works of
Stigler (1962), Phelps (1968) and Friedman (1968) and was already at an advanced
state when the Phelps et al. (1970) volume was published. The equilibrium analysis
of the current vintage of models, however, did not start until the early 1980s, when
models by Diamond (1982a,b), Mortensen (1982a,b) and Pissarides (1984a,b) explored
the properties of two-sided search and characterized the nature and welfare properties
of market equilibrium. Despite a flurry of activity since then, there are still many
important questions that are unexplored. One such question is the dynamics of worker
movement in and out of the labor force, of which, despite its empirical importance
[Clark and Summers (1979), Blanchard and Diamond (1989)] and some attempts to
model it by Burdett et al. (1984), Pissarides (1990, Chapter 6) and Andolfatto and
Gomme (1996), our knowledge is still scant.
Virtually all search equilibrium models assume an exogenous labor force, which
is used to normalize all aggregate quantities, and model either the equilibrium
employment or unemployment rate. It is simple enough to superimpose on this
structure a neoclassical labor-supply decision, as is done, for example, by Andolfatto
(1996) and Merz (1995), but still the worker flow from the labor force to out
of the labor force is ignored. Given this restriction, we can interchangeably talk
either about employment equilibrium or about unemployment equilibrium. In the
latter case, the equilibrium is often referred to as a "natural rate" equilibrium,
following Friedman's introduction of the term in 1968. Indeed, the equilibrium that
we shall describe corresponds closely to the one advocated by Friedman (1968) and
Phelps (1967, t968).

1174

19.T. Mortensen and C.A. Pissarides

We attribute the observed fluctuations in employment (or unemployment) to

fluctuations in the natural rate, i.e., we ignore inflation and expectation errors. The
driving force in the search and matching models that we describe is virtually without
exception a real productivity or reatlocation shock [but see Howitt (1988) for an
exception]. The reason for this is partly that models with real shocks calibrate the
data fairly well but also, more importantly, that the search and matching approach is
about the transmission and propagation mechanisms of shocks, not about their origins.
It is then more convenient to take the simplest possible shock in this framework, which
is a proportional productivity shock, as driving force and concentrate on the dynamics
and steady states implied by the model - than dwell on debates of whether employment
cycles are due to real or monetary shocks.
Section 1 summarizes the aggregate data for OECD countries. Section 2 contains
the core equilibrium matching model with a surplus sharing wage contract. The
fundamental determinants of the natural rate o f unemployment are reviewed in this
section. In Section 3 the model is embedded into a real business cycle model and its
consistency with some recent facts on job flows is reviewed. In section 4 we review
calibrations of the model and introduce capital accumulation. In section 5 we consider
technological innovation and its employment effects. Finally, in Section 6, we return
to OECD data and examine the model's implications for the facts noted in Section 1.
How far can the model explain those facts and what remains to be done? We find that
although a lot can be explained and the framework of search and matching models is
a convenient device for studying those facts, a lot remains for future work.

1. O E C D facts

What are the main facts about employment and unemployment that the search and
matching approach can help explain? In Figures 1 and 2, labor force and unemployment
time series from 1960 to 1995 are illustrated for the USA, Japan and a weighted
average of the four largest European economies, Germany, France, Italy and the United
Kingdom.
The four European countries are grouped together because their unemployment
and labor force experiences have been sufficiently similar to each other. Comparable
data can also be found for most of the other members of the European Union, in
particular Spain, the Benelux, and Scandinavian countries. The experience of Spain
and the Scandinavian countries, however, has been different from that of the big
four, essentially for labor-market policy reasons. In Spain, excessive safeguarding of
the rights of workers through the legal system created a sharp distinction between
insiders and outsiders and led to low aggregate job creation. In the Scandinavian
countries large-scale active labor market policies held unemployment artificially low
until recently. Since we shall not address issues of labor market policy in any detail, we
decided not to aggregate those countries with the four large economies. The experience

1175

Ch. 18." Job Reallocation, Employment Fluctuations and Unemployment

68-,

66\\\ \ \ / / f - ~ - ~ \

. /"

.-"'USA

64
\\~

'

62

.g

Japan

/"

60

Europe

58 -t~
56
54
60

//

65

70

75

80

85

90

95

Year
Fig. 1. Labor force p~ticipation rates, 1960-1995.

of the Benelux countries is sufficiently close to that of France and Germany, to the
extent that data from them will not add to the information given here.
Figure 1 shows the sharply contrasting participation experience of the USA on
the one hand and Europe and Japan on the other. Whereas in the early 1960s the
participation rates in Europe and the USA were essentially the same, since then
participation in the USA has been on an upward trend and in Europe on a downward
trend. The upward trend in the USA was driven largely by the female participation
rate, whereas in Europe, where female participation rates have also increased, the
downward trend was driven by early retirements among men and by later school
leaving. In Japan the participation rate is uniformly above the European rate but its
dynamic behavior since 1960 has been very similar to the European rate. The figure
also shows some evidence of cyclical variations in the participation rate: it is these
cyclical movements that the search and matching approach could in principle handle,
but has so far ignored.
The trend changes, in the USA in particular, are more likely the outcome of lifetime
labor supply decisions that are independent of the labor market frictions that underlie
the search and matching approach. In Europe, however, much of the decline in laborforce participation has been the result of policy incentives or of private responses to the
rise in unemployment ("discouragement"). The policy to encourage early retirement
was also largely in response to the rising unemployment, so the fall in participation
can be partly attributed to the same factors that increased unemployment during this
period. But exogenous labor supply changes have also played an important role, as
comparison of Figures 1 and 2 shows. The trend decline in labor force participation

1176

D.T. Mortensen and C.A. Pissarides

10
/- ~ J Europe
I \
/

/
\

]II
/I /
\\ //
?~/1~\1

l
[

//\\

I \j\ \\\

\\\
'\

IilI\ \\\1 I/

\~

\\

1/

\X

\\ ~ / / U S A /

Japan
t

60

65

70

75

i - Y - F q ~ - i

80

85

90

95

Year
Fig. 2. Standardizedunemploymentrates, 1960-1995.
began before the unemployment rise and it was accompanied by a fall in annual hours
of work for those that remained in the labor force.
We shall briefly return to the question of participation changes in the final section. In
the remainder of this section we look at the behavior of unemployment and at gross job
creation and job destruction flows normalized by the labor force. The aim is to point
out key features of the data ("stylized facts") that will guide the model presentation
in the rest of the chapter.
Figure 2 plots the unemployment rates for the three country groups, as far as possible
adjusted to the same (US) definition. Table 1 gives data for more countries for two
periods that were approximately in the same cyclical phase. The contrast is clear.
Whereas in the USA and Japan unemployment is a cyclical variable without trend,
in Europe the biggest changes in unemployment over the last thirty years were due
to changes in the average level of unemployment across cycles. This latter feature
of the European time series led most who analyzed this problem to conclude that the
changes in European unemployment are changes in the "natural rate", not changes in its
cyclical component [Layard et al. (1991), Phelps (1994), Blanchard and Katz (1997)].
The approach that we describe in this chapter is motivated by this observation and is
especially suitable for the analysis of changes in the natural rate. Inflation, expectations
errors and other nominal influences are ignored.
The net changes in employment over the cycle conceal large movements in gross job
creation and job destruction, as well as worker turnover for other reasons. Information
on this feature of labor markets sheds light on the appropriate flow models that should
be used to analyze aggregate labor market changes. This feature of labor markets has
been emphasized by Davis and Haltiwanger (1992) in particular, but also by others

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1177

Table 1
OECD unemployment,1974-79 to 1986~90a,b
Country

Unemploymentrate 1974-1979

Percent change, 1974-79 to 1986-90

1.5

81.8

Europe
Austria
Belgium

6.3

41.1

Denmark

5.5

44.7

Finland

4.4

-2.3

France

4.5

77.8

Germany

3.2

61.2

Ireland

7.6

75.7

Italy

4.6

51.5

Netherlands

5.1

54.5

Norway

1.8

66.5

Spain

5.3

126.1

Sweden

1.5

12.5

Switzerland

1.0

64.2

United Kingdom

5.1

54.5

6.7

-14.4

Others
USA
Cmlada

7.2

14.2

Australia

5.0

36.4

Japan

1.9

27.4

a Source: Layard et al. (1991), p. 398.

b The table shows the average of annual unemploymentin 1974-1979 and the change in the log of this
average from 1974-79 to 1986-90.

since then. Recently Contini et al. (1995) have assembled data on job reallocation for
several countries. Their summary Table is shown in Table 2 and the results are also
summarized in Figure 3.
For most countries the job flow data are calculated from establishment level flows,
though for some only firm-level data were available. Annual gross job creation reflects
employment change only in the establishments or firms that are new entrants or that
have experienced an increase in employment over the period. The job creation rate
is defined as the sum o f the gross increase in employment expressed as a percentage
of the total labor force. Similarly, gross job destruction includes only units that have
experienced a decrease in employment and the j o b destruction rate is equal to the
gross decrease in employment as a percentage of the employment level. By definition

1178

D.T. Mortensen and C.A. Pissarides

Table 2
Net and gross job flows, OECD, late 1980sa
Country

Period

Japan
UK
Germany
Finland
Italy
USA
Canada
France
Sweden
Denmark
New Zealand

1985-1992
1985-1991
1983-1990
1986-1990
1984-1993
1984-1991
1983-1991
1984-1992
1985-1992
1983-1989
1987-1992

Job creation
8.64
8.70
9.00
10.40
11.90
13.00
14.50
13.90
14.50
16.00
15.70

Job destruction Net job creation

5.26
6.60
7.50
12.00
11.09
10.40
11.90
13.20
14.60
13.80
19.80

3.39
2.10
1.50
- 1.60
0.81
2.60
2.60
0.70
-0.10
2.20
-4.10

Gross
reallocation
13.89
15.30
16.50
22.40
22.99
23.40
26.40
27.10
29.10
29.80
35.50

a Source: Contini et al. (1995), Table 3.1 [derived mainly from OECD Employment Outlook (1987,
1994)].

then, the net growth rate in employment is the difference between the job creation rate
and the job destruction rate. International comparisons of data of this kind are fraught
with difficulties and Contini et al. (1995, p. 18) warn that the numbers for Japan and
the United Kingdom are probably understated and for France and New Zealand are
overstated. So if anything, the small differences shown in Table 2 are likely to be
overstated.
Notwithstanding the statistical problems, the results show that Japan has low gross
job creation and job destruction rates, despite high net job creation. The United
Kingdom and Germany, also with positive net job creation, have low gross flows. But
the rest of the countries have high gross job flows, comparable to those of the USA.
There does not seem to be any relation between the volume of gross reallocation and
the net employment change, and the USA does not appear unusually turbulent when
compared to other countries. These findings are also illustrated in Figure 3.
Some regularities emerge from the international comparison of job creation and job
destruction rates. These findings apply to comparisons of economy-wide job creation
and job destruction flows but are also consistent with the more detailed analysis of
Davis et al. (1996) for US manufacturing flows.
First, the flow data always exclude the public sector, where job reallocation is small.
In some European countries the public sector employs a large fraction of the labor force
(8% in Japan, 8.5% in the USA, 7.9% in Germany, 11% in the UK, 22.5% in Italy;
the highest share in the European Union is in Denmark, 31%).

1179

Ch. 18. Job Reallocation, Employment Fluctuations and Unemployment

25

20

15

CA
USA

i<

10 UK +GE//~ +FI
/
5

1~0

15
'
20,
Job destruction rate (%)

25

Fig. 3. Job creation and job destructionrates, late 1980s, 11 countries.

Second, gross job reallocation is inversely correlated with capital intensity: service
jobs create and destroy more jobs than manufacturing does.
Third, smaller and younger establishments create and destroy more jobs than larger
and older plants; about one-third of job creation and job destruction is due to plant
entry and exit. So in international comparisons countries with a larger fraction of
smaller firms (e.g. Italy) are likely to have a larger job reallocation rate than countries
with larger firms (e.g. the USA).
Fourth, at the individual level, the main cause of job turnover is idiosyncratic shocks,
i.e. shocks that do not appear correlated with common economy-wide or sector-specific
shocks, or with other common characteristics across firms. The implication of this
fact is that the regularities listed above, as well as the business cycle, explain less
than half the variance of gross job creation and job destruction across production
units. Aggregate and cyclical shocks explain a small fraction of the variance, about
10 percent. Measurable firm characteristics, such as size and age, explain more, but
still less than half.
Fifth, although younger plants are more likely to create and destroy jobs, there is
large persistence in job creation and job destruction. The idiosyncratic shocks that
cause job reallocation do not reverse shortly after they occur. In both the USA and
Italy (the only two countries with comparable data on this issue), about 70 percent of

1180

D.T. Mortensen and C.A. Pissarides

jobs created in one year are still active the next year and about 55 percent are active
two years later. Persistence rates for job destruction are slightly higher.
The cyclical properties of job flows, which is of primary concern in the analysis
of employment fluctuations, are not clear-cut in the empirical data so far assembled.
A fact that seems to be universal is that job creation and job destruction flows are
negatively correlated with each other. Thus, recessions are times when job destruction
rates rise and job creation rates fall, and vice versa for expansions. More controversial,
but potentially more interesting, is the finding that job destruction is more "volatile",
in the sense that even when abstracting from growth, the length of time when job
destruction is the dominant flow is shorter than the length of time when job creation
is the dominant flow. Since on average over the cycle job destruction and job creation
rates must be equal, it follows that job destruction rates must peak at higher values
than job creation rates, which are more flat. This asymmetry is consistent with the
observation that recessions are on average of shorter duration than booms and has
attracted a lot of attention in the empirical literature, where, following Davis and
Haltiwanger (1990), it is often reported as a negative correlation between gross job
reallocation and net job reallocation. However, the negative correlation, although a
strong feature of the US manufacturing data, is not universal. The "asymmetry" of
job creation and job destruction rates here is simply taken to mean that the difference
between job destruction and job creation when positive is larger and of shorter duration
than when it is negative.
One final observation on the international comparison of job flows is of interest.
There does not appear to be a significant correlation across countries either between
the level of unemployment on the one hand and the gross job reallocation rate on the
other or between labor productivity growth and the job reallocation rate. There does
seem, however, to be a correlation between the gross job reallocation rate and the rate
of long-term unemployment: countries with lower job reallocation rates seem to have,
on average, longer unemployment durations [Garibaldi et al. 1997)].
Comparative data on worker flows are even less reliable than comparative data on
job flows, even though the definition of worker flows can be a lot less ambiguous
than the definition of job flows. The gross flow of workers in and out of employment,
defined analogously to the gross flow of jobs, is necessarily larger than the job flow. The
difference is, however, large. Contini et al. (1995, p. 108) report that in both the USA
and the major European economies, the worker flow is about three times as big as the
job flow. There is some evidence that worker flows are bigger for the USA than for the
European countries or Japan, and also that in the USA there is more movement in and
out o f unemployment and the labor force. The latter claim, however, may be based
on the different kind of question that is often asked about participation in national
surveys. Two interesting aggregate facts that have emerged from the study of worker
flows, bearing in mind the paucity of the data, are that gross unemployment flows rise
in recession and fall in the boom, whereas flows into employment are strongly procyclical and separations mildly pro-cyclical or neutral. Of course, because the stock
of unemployment rises in recession as well, the average rate at which workers leave

1181

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

2.5

CA
+

USA

2.0
H+

DE+

1.5

Austria

NO
+

AU+ +NZ

1.0

UK +

PO +

SW +

~D

GE +
SP+ IT+

0.5

IR+~

GR +

SWI
BE+ +

+JA

NE
0.0

I-

10
20
30
40
Outflow rate (outflows/unemployment)

50

Fig. 4. Unemploymentinflowand outflowrates, 1992.

unemployment goes down, even though the gross number of exits goes up. The finding
about employment flows is explained by the fact that in the boom job creation is up and
voluntary job-to-job quits are also up, leading to more inflows; whereas in recession
quits are sufficiently down but job destruction up giving rise to conflicting influences
on separations.
Still, substantial systematic cross-country differences between unemployment inflow
and outflow rates do exist, reflecting underlying differences in unemployment incidence
and duration between Europe and the USA. In Figure 4, borrowed from Martin (1994),
inflow-outflow rate combinations in 1992 are plotted for the OECD countries. These
plots show that although the average length of unemployment spells (the inverse of
the outflow rate) is much longer in the typical EU country than in the USA, the
probability of job loss (to the extent reflected by the inflow rate) is much smaller.
Hence, long spells of unemployment rather than more frequent spells is the reason for
higher unemployment in the EU relative to the USA.
The contrasting experience of unemployment in the USA and Europe is reflected
in contrasting experience in wage growth. The fall in US real earnings at the bottom
end of the wage distribution, in contrast to growth in Europe, has been documented
by many writers and by the OECD in its official publications [see, e.g. OECD (1994),
Chapter 5]. We show in our Figure 5 a feature of wage and unemployment behavior

1182

D.T. Mortensen and C.A. Pissarides

100
/-x

80

~ F R

NO

60
+

IT
40

UK

~ .
AU +

.=~

JA

20

\--~ CA
SW+
\
USA

-20
-20

-10

10

20

30

Increase in inequality (%)

Fig. 5. Rise in unemploymentand wage inequality (late 1970s to late 1980s).

that should be explainable within the search and matching framework, though to our
knowledge there are as yet no models that claim to explain it fully. We make an attempt
to explain it in Section 5.1 [see also Mortensen and Pissarides [1999)]. Thus, for twelve
OECD countries with comparable data on wage inequality, there appears to be a close
correlation between the percentage change in wage inequality during the 1980s and
the percentage rise in unemployment. Wage inequality is measured by the ratio of the
earnings of the most educated group in the population to the least educated [usually,
university graduates versus early school leavers; see OECD (1994), p. 160-1). Other
measures of inequality, however, give similar results [e.g. OECD (1994), p. 3; the
results in Galbraith (1996), are also consistent with our claim, despite his claim to the
contrary, if one measures the change in inequality by the change in the Gini coefficient
of the wage distribution].
Figure 5 shows that the USA, Canada and Sweden experienced the biggest rises
in inequality and the smaller rises in unemployment (fall in the USA). Japan and
Australia come next, with moderate rises in both, and the European countries follow,
with small rises or falls in inequality but big rises in unemployment. The only country
that does not conform to this rule is the United Kingdom, which experienced NorthAmerican style increase in inequality and European-style increase in unemployment
over the sample of the chart. Recently, however, unemployment in the UK has fallen
substantially, giving support to the view that the reforms of the 1980s moved the United

Ch. 18: Job Reallocation, EmploymentFluctuations and Unemployment

1183

Kingdom closer to a US style economy but had their impact first on inequality and
only more recently on unemployment.

2. The equilibrium rate of unemployment

Here we introduce the formalities of the search and matching approach and derive the
equations that express the dynamics of the stock o f unemployment (or employment).
This analysis will point to the variables that need to be explained in order to arrive
at an equilibrium characterization of employment flows and unemployment levels. We
shall talk explicitly about unemployment, with the solution for employment implied
by the assumption of an exogenous labor force.
The search and matching approach to aggregate labor market analysis is based on
Pissarides' (1990) model of equilibrium unemployment as extended by Mortensen and
Pissarides (1994) to allow for job destruction. The approach interprets unemployment
as the consequence of the need to reallocate workers across activities and the fact that
the process takes time. The model is founded on two constructs, a matching function
that characterizes the search and recruiting process by which new job-worker matches
are created and an idiosyncratic productivity shock that captures the reason for resource
reallocation across alternative activities. Given these concepts, decisions about the
creation of new jobs, about recruiting and search effort, and about the conditions that
induce job-worker separations can be formalized 1.
The job-worker matching process is similar to a production process, in which
"employment" is produced as an intermediary production input. The output, the flow
of new matches, is produced with search and recruiting efforts supplied by workers and
employers respectively. As a simple description, the existence of a market matching
function is invoked, an aggregate relation between matching output and the inputs.
Under the simplifying assumption that all employers with a vacancy recruit with equal
intensity and that only unemployed workers search, also at a given intensity, aggregate
matching inputs can be represented simply by the numbers of job vacancies v and of
unemployed workers u.
Let the function m(v, u) represent the matching rate associated with every possible
vacancy and unemployment pair. As in production theory, it is reasonable to suppose

t Of course, that at least some unemploymentis due to "frictional" factors has alwaysbeen recognized.
Lilien (1982) was among the first to claim that even "cyclical"unemploymentwas of this kind. Although
his results have been criticized, e.g. by Abraham and Katz (1986) and Blanchard and Diamond (1989),
the modern approach to unemploymentgroups all kinds of unemploymentinto one, as we do here.

D.T. Mortensen and C.A. Pissarides

1184

that this function is increasing in both arguments but exhibits decreasing marginal
products to each input. Constant returns, in the sense that

m(v,u)=m

(u)
1,-~ v = q(O) v

where

0-

O
U

(2.1)

is a convenient additional assumption, one that is consistent with available evidence 2.

The ratio of vacancies to unemployment, 0, market tightness, is an endogenous variable
to be determined.
On average, a job is filled by a worker at the rate re(o, u)/v = q(O) and workers
find jobs at rate m(v, u)/u = Oq(O). By the assumption of a constant returns
matching function, q(O) is decreasing and Oq(O) increasing in 0. Oq(O) represents
what labor economists call the unemployment spell duration hazard 3. The duration of
unemployment spells is a random exponential variable with expectation equal to the
inverse o f the hazard, 1/Oq (0), a decreasing function of market tightness. Analogously,
q(O) is the vacancy duration hazard and its inverse, 1/q(O) is the mean duration of
vacancies.
As noted above, the most important source of job-worker separations is job
destruction attributable to an idiosyncratic shock to match productivity. Because initial
decisions regarding location, technology, and/or product line choices embodied in a
particular match are irreversible, subsequent innovations and taste changes, not known
with certainty at the time of match formation, shock the market value of the product or
service provided. For example, the initial decision might involve the choice o f locating
a productive activity on one of many "islands". In future, island-specific conditions that
affect total match productivity, say the weather, may change. If the news about future
profitability implicit in the shock is bad enough, then continuation of the activity on
that particular island is no longer profitable. In this case, the worker loses the job.
To model this idea, we assume that the productivity of each job is the mathematical
product of two components, p, which is common to all jobs, and x, which is
idiosyncratic. The idiosyncratic component takes values in the range [0, 1], it is
distributed according to the c.d.f. F(x) and new shocks arrive at the Poisson
rate Z. Note that these assumptions satisfy the empirical properties of idiosyncratic
job destruction, i.e. the shocks have persistence and they appear to hit the job
independently of the aggregate state of the economy (here represented by p).
Entrepreneurs are unconstrained with respect to initial location, technology and
product choice and also have the same information about market conditions. Under
the assumption that they know the product that commands the highest productivity, all
will create jobs at the highest idiosyncratic productivity, x = 1. Given this property

2 See Pissarides (1986) and Blanchard and Diamond (1989).

3 As workers are generally happy when an unemployment spell ends, the unemploymenthazard seems
an ironic label. This unfortunate term is borrowed from statistical duration analysis where the typical
spell is that of a "life" that ends as a consequence of some "hazard", e.g. a heart attack or a failure.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1185

of the model and the assumption that future match product evolves according to a
Markov process with persistence, all matches are equally productive initially, until a
shock arrives 4.
Under these assumptions, an existing match starts life with x = 1 but is eventually
destroyed when a new value of x arrives below some reservation threshold, another
endogenous variable denoted as R. Unemployment incidence 3.F(R), the average
rate of transition from employment to unemployment, increases with the reservation
threshold.
As all workers are assumed to participate, the unemployed fraction evolves over time
in response to the difference between the flow of workers who transit from employment
to unemployment and the flow that transits in the opposite direction, i.e.,
/t = AF(R)(1 - u) - Oq(O) u,

(2.2)

where 1 - u represents both employment and the employment rate. The steady-state
equilibrium unemployment rate is
u=

)tF(R)
)~F(R) + Oq(O)"

(2.3)

Equivalently, individual unemployment histories are described by a simple two-state

Markov chain where the steady-state unemployment rate is also the fraction of
time over the long run that the representative participant spends unemployed. It
decreases with market tightness and increases with the reservation product, because
the unemployment hazard Oq(O) and the employment hazard )~F(R) are both increasing
functions.
2.1. Job destruction and j o b creation conditions

A formal equilibrium model of unemployment requires specification of preferences,

expectations, and a wage determination mechanism. We assume that both workers and
employers maximize wealth, defined as the expected present value o f future net income
streams conditional on current information. Forward looking rational expectations are
imposed. Several wage determination mechanisms are consistent with the matching
approach. Following much of the literature, we shall assume bilateral bargaining as
the baseline model.
Given this specification, equilibrium market tightness satisfies the following job
creation condition: the expected present value of the future return to hiring a worker
equals the expected cost. The hiring decision is implicit in the act of posting a

4 Generalizing the model to realistically allow for productivity heterogeneity across vacancies and for
the fact that a random sample of new job-worker matches initially improve in average productivity are
still problems at the research frontier.

1186

D. 17 Mortensen and C.A. Pissarides

job vacancy and is taken by an employer. In contrast, the equilibrium reservation

product, R, reflects the decisions o f both parties to continue an existing employment
relationship. Individual rationality implies that separation occurs when the forwardlooking capital value o f continuing the match to either party is less than the capital
value o f separation. For joint rationality, the sum o f the values o f continuing the match
must be less than the sum o f the values o f separating, otherwise a redistribution o f
the pair's future incomes can make both better off. Whether these job destruction
conditions also satisfy the requirements o f joint optimality depends' on the wage
mechanism assumed. For a given wage determination mechanism, a search equilibrium
is a pair (R, 0) that simultaneously solves these job creation and job destruction
conditions.
For expositional purposes, we invoke the existence o f a wage mechanism general
enough to accommodate the special cases o f interest. A wage contract, formally a
pair (w0, w(x)), is composed o f a starting wage w0 E Re and a continuing wage function
w : X --+ Re that obtains after any future shock to match specific productivity. Implicit
in this specification is the idea that a worker and an employer negotiate an initial wage
when they meet and then subsequently renegotiate in response to new information
about the future value o f their match 5.
A continuing match has specific productivity x and the worker is paid a wage w(x).
Given that the match ends in the future if a new match specific shock z arrives which
is less than some reservation threshold R, its capital value to an employer, J ( x ) , solves
the following asset pricing equation
r J ( x ) = p x - w(x) + ~

JR 1[J(z) -

J(x)] dF(z) + )~F(R)[ V - p T - d(x)],

(2.4)

where r represents the risk free interest rate, V is the value of a vacancy, a n d p T denotes
a firing cost borne by the employer, represented as forgone output. We multiply the
termination cost by p to show that it is generally more expensive to fire a more skilled
worker than a less skilled one. The termination cost is assumed to be a pure tax and
not a transfer payment to the worker and to be policy-determined. For example, it may
represent the administrative cost o f applying for permission to fire, as is the case in
many European countries. O f course, T ~> 0 and none o f the fundamental results are
due to a strictly positive T.
Condition (2.4), that the return on the capital value of an existing job-worker
match to the employer is equal to current profit plus the expected capital gain or
loss associated with the possible arrival of a productivity shock, is a continuous-time

5 Note that contracts of this form are instantly "renegotiated" on the arrival of a new idiosyncratic
shock. MacLeod and Malcomson (1993) persuasively argue that the initial wage need not be adjusted
until an event occurs that would otherwise yield an inefficient separation. Contracts of this form may
well generate more realistic wage dynamics but job creation and job destruction decisions are the same
under theirs and our specification. Hence, for the purpose at hand, there is no relevant difference.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1187

Bellman equation. A n analogous relationship implicitly defines the asset value o f the
same match to the worker involved, W ( x ) . Namely,
r W ( x ) = w ( x ) + ;~

fR [W(z) -

W(x)] dF(z) + , ~ F ( R ) [ U - W(x)],

(2.5)

where U is the capital value of unemployment.

Given a match product shock z, the employer prefers separation if and only if its
value V exceeds the value of continuation J (z). Similarly, the worker will opt for
maemployment if and only if its value, U, exceeds W (z). Given that both J (z) and
W (z) are increasing, separation occurs when a new value o f the shock arrives that
falls below the reservation threshold
R = max {Re, R w } ,

(2.6)

where J(Re) = V - p T and W ( R w ) = U. Because in the bilateral bargain wealth is

transferable between worker and employer, the separation rule should be jointly optimal
in the sense that it maximizes their total wealth. The necessary and sufficient condition
for joint optimization is that R = Re = Rw where J ( R ) + W ( R ) = V - p T + U, a
condition that holds only for an appropriately designed wage contract 6.
Although the idiosyncratic component of a new job match is x = 1, the expected
profit from a new match will generally be different from J(1), as defined in
Equation (2.4), because o f the existence of a job creation cost. We therefore introduce
the notation J0 for the expected profit o f a new match to the employer and write the
asset pricing equation for the present value o f an unfilled vacancy, V, as
r V = - p c + q( O)[Jo - V - p C ] ,

(2.7)

where p c is the recruiting cost flow per vacancy held, and p C is a fixed cost of hiring
and training a new worker plus any other match-specific investment required. Here
these costs are indexed by the aggregate productivity parameter to reflect the fact that
the forgone output that these costs represent is larger when labor is more productive.
The value of unemployment solves
r U = b + Oq(O)[Wo - U],

(2.8)

where b represents unemployment-contingent income. Crucially for many o f the results

that hold in matching equilibrium, unemployment-contingent income is independent
o f employment income or o f the aggregate state o f the economy.

6 See Mortensen (1978) for an early analysis of this issue within the search equilibrium framework. For
alternative approaches to the modeling of the job destruction flow, see Bertola and Caballero (1994), who
model a firm with many employees moving between a high-employment and a low-employment state,
and Caballero and Hammour (1994), who analyze the implications of sunk costs and appropriation.

1188

D.T. Mortensen and C.A. Pissarides

Given an initial wage equal to wo, the by now familiar asset pricing relations imply
that the initial value o f a match to employer and worker respectively satisfy

//
//

rJo = p - Wo + )~

and
rWo = w0+,~

[J(z) - J0] d F ( z ) + )dZ(R)[ V - p T - J0l

[ W ( z ) - W0] d F ( z ) + ) ~ F ( R ) [ U - W0],

(2.9)

(2.10)

where J ( x ) and W(x) represent the values o f m a t c h continuation defined above.

The j o b creation condition that we defined earlier is equivalent to a free entry
condition for new vacancies. The exploitation o f all profitable opportunities from j o b
creation requires that new vacancies are created until the capital value o f holding one
open is driven to zero, i.e.,
V=0

:~ ~ + C qtv)

Jo

(2.11)

As the expected number o f periods required to fill a vacancy is 1/q(O), the condition
equates the cost o f recruiting and hiring a worker to the anticipated discounted
future profit stream. The fact that vacancy duration is increasing in market tightness
guarantees that free entry will act to equate the two.
2.2. Generalized Nash bargaining

The generalized axiomatic Nash bilateral bargaining outcome with "threat point"
equal to the option o f looking for an alternative match partner is the baseline wage
specification assumption found in the literature on search equilibrium 7. Given that
the existence o f market friction creates quasi-rents for any matched pair, bilateral
bargaining after worker and employer meet is the natural starting point for an
analysis 8.

7 See Diamond (1982b), Mortensen (1978, 1982a,b), and Pissarides (1985, 1990).
s Binmore, Rubinstein and Wotinsky (1986), Rubinstein and Wolinsky (1985) and Wolinsky (1987)
applied Rubinstein's strategic model in the search equilibrium framework. The analyses in these papers
imply the following: If the worker searches and the employer recruits at the same intensities and if
/3 is interpreted as the probability that the worker makes the wage demand (1 -/3 is the probability that
the employer makes an offer) in each round of the bargaining, then the unique Markov perfect solution
to the strategic wage bargaining is the assumed generalized Nash solution. If neither searches but there
is a positive probability of an exogenous job destruction shock during negotiations, the solution is again
the one assumed but with/3 = . However, if neither seeks an alternative partner while bargaining
and there is zero probability of job destruction, the strategic solution divides the joint product of the
match Jo - p C + Wo subject to the constraint that both receive at least the option value of searching
and recruiting, U and V, rather than the net surplus, as we assumed. As these bargaining outcomes
generate the same job creation and job destruction decisions, we consider only the former case with a
/3 between 0 and 1.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1189

Given the notation introduced above, the starting wage determined by the generalized Nash bargain over the future joint income stream foreseen by worker and employer
supports the outcome
wo = arg max {[Wo - U]/3 [So -(Wo - U)] l-is }
subject to the following definition of initial match surplus,
So =- J o - p C -

(2.12)

V + Wo- U

In the language of axiomatic bargaining theory the parameter/3 represents the worker's
relative "bargaining power." Analogously, the continuing wage contract supports the
outcome
w(x) = arg max { [ W ( x ) - U] t~ [S(x) - (W(x) - U)] l-Is},

where continuing match surplus is defined by

S(x) = W ( x ) - U + J ( x ) -

(2.13)

V +pT.

The difference between the initial wage bargain and subsequent renegotiation arises
for two reasons. First, hiring costs are "sunk" in the latter case but "on-the-table" in
the former. Second, termination costs are not incurred if no match is formed initially
but must be paid if an existing match is destroyed.
The solution to these two different optimization problems satisfy the following firstorder conditions
/3(Jo - V - p C )

= (1 - / 3 ) (w0 - u ) ~

w0 - u =/3SO

(2.14)

and
/3(J(x) - V + p T ) = (1 - / 3 ) ( W ( x ) - U) ~ W ( x ) -

U =/3S(x).

(2.15)

As an immediate consequence of Equation (2.15), it follows that the reservation

threshold R, defined by Equation (2.6) is jointly rational, i.e., it solves
S ( R ) = J ( R ) - V + p T + W ( R ) - U = O.

As a preliminary step in solving for the match surplus function and the continuing wage contract that supports the bargaining solution, first rewrite Equations
(2.4) and (2.5) as follows:
(r + )0 (J(x) - V + p T ) = p x - w(x) - r ( V - p T )
1

+ 2, ~ [J(z) - V + p T ] dE(z)

(2.16)

1190

D.T. Mortensen and C.A. Pissarides

and
i" 1

(r + )0 (W(x) - U) = w(x) - r U + )~ JR [W(z) - U] dF(z).

(2. 17)

By summing these equations, one obtains the following functional equation which the
surplus function must solve
S(x)

p x - r ( U + V - p T ) + 3. f l S(z) dF(z)

(2.18)

r+J,

Because S(R) = 0 implies f~ S ( z ) d F ( z ) = f max(S(z), 0)dF(z), the right-hand side

satisfies the Blackwell sufficient conditions for a contraction. Furthermore, the solution
is linear in x. Hence, the solution can be written as S(x) = (x - R)/(r + )0 where R is
the unique solution to
pR+

(2.19)

(z-R)dF(z)=r(U+V-pT).

The reservation product, pR, plus the option value of continuing the match attributable
to the possibility that match product will increase in the future, the left-hand side,
equals the flow value of continuation to the pair, the right-hand side of the equation.
As the left- and right-hand sides of Equation (2.16) multiplied by 1 -/3 respectively
equal the left- and right-hand sides of Equation (2.17) when multiplied by /3
given (2.15), the continuing match product specific wage that supports the bargaining
outcome is
(2.20)

w(x) = rU +/3 [px - r(V - p T ) - rU].

Note that this result is the generalized Nash outcome in a continuous bargain over
match output px given a "threat point" equal to the flow values of continuing the
match, namely (r(V - p T ) , rU).
Analogously, by summing equations (2.9) and (2.10), one obtains
(r + )OSo = (r + X ) ( J o - V - p C +
= p-r(U

Wo - U)

+ V)-(r + X)pC-lpT

+ ,~

S(z)dF(z)

(2.21)

= p(1 - R) - (r + )Op(C + T) = (r + X) (S(x) - p C - p T )

by virtue of Equations (2.12) and (2.19). Hence, the free entry conditions (2.11) and the
initial surplus division rule (2.14) yield the following equilibrium relationship between
market tightness and the reservation product:
p c _ Jo - p C = (1 -/3) So
q(O)
= (1-[3)p(lrm+R-c-T).

(2.22)

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1191

The logic of the derivation of the initial wage is similar to that used to obtain the
continuing wage function. First, rewrite Equations (2.9) and (2.10) as
(r + ~) (Jo - V - p C )

= p - wo - r V - (r + ) t ) p C - )tpT

+ 3,

[J(z) - V + p T ] dE(z)

and
( r + ) O ( W o - U) = wo - r U + ) ~

JR1[W(z)-

U] dF(z).

Second, multiply both sides of the first equation by 1 -/3, both sides of the second by
/3, and then apply Equations (2.14) and (2.15) to obtain
wo = r U +/3 [p - r ( V + U) - (r + ) O p C - )~pT].

(2.23)

Note that the initial wage equals the worker's share of the initial match flow surplus
p - r ( V + U + p C ) less the sum of hiring and firing costs amortized over the initial
period prior to the arrival of a subsequent match specific shock ){p(C + T). In short,

the worker share of both the quasi-rents and match specific investments required to
both create and end the match is the market power parameter/3.
To complete the derivation of the equilibrium conditions, we use the fact that the free
entry condition (2.22), the surplus sharing rule (2.14), and the value of unemployment
equation (2.8) imply that the flow value of unemployment is linear and increasing in
market tightness.
rU=b+/3Oq(O)So=b+(P--~/3)O.

By direct substitution into Equations (2.23) and (2.20), the equilibrium wage contract
can be written as
w0 =/3p [1 + cO - (r + )0 C - )~T] + (1 -/3) b

(2.24)

w(x) =/3p (x + cO + r T ) + (1 -/3) b.

(2.25)

and

Finally, the reservation threshold equation (2.19) becomes

p

+ ~

(x-R)dF(x)

= r(g-pT)

(2.26)
=b-rpT+(lfi~fi)pcO.

As the left-hand side is increasing in R, the equation implicitly defines a positive

equilibrium relationship between the reservation product and market tightness, one
that reflects the pressure on wages induced by greater market tightness.

1192
R

R*

D.T Mortensen and C.A. Pissarides

>
C

D
O*

Fig. 6. Equilibrium reservation product and market tightness

(R*, 0").

An equilibrium solution is any pair (R*, 0") that solves the job creation condition
(2.22) and the job destruction condition (2.26). The associated starting wage w0,
continuing wage function w(x), and steady-state unemployment rate u are those
specified in Equations (2.24), (2.25), and (2.3). Because the relation defined by the job
creation condition (2.22) is downward sloping, as illustrated by the line CC in Figure 6,
while the job destruction condition (2.26) can be represented as the upward sloping
line DD, there is a single equilibrium solution to the two equations 9. The equilibrium
pair is strictly positive if the product of a new match, p, less the opportunity cost of
employment, b, is sufficient to cover recruiting, hiring, and anticipated firing costs.
2.3. Fundamental determinants o f unemployment

Figure 6 provides insight into how the various parameters of the model affect the
steady-state unemployment rate. For this purpose, it is useful to remember that the
job creation line CC reflects the standard dynamic demand requirement that the cost
of hiring and training a worker is equal to the expected present value of the future profit
attributable to that worker over the life of the job. It is downward sloping because a
higher reservation threshold implies a shorter expected life for any new match. The
upward slope of the job destruction line DD reflects the sensitivity of the reservation
product threshold to general wage pressure as reflected by market tightness.
Now it is clear from Equation (2.22) that given R neither p nor b influence
equilibrium 0. Thus, general productivity and the supply price of labor do not shift CC.
By dividing Equation (2.26) byp, we find that b andp enter the equilibrium conditions
as a ratio b/p. Hence, the influence of general productivity and the opportunity cost of
employment is due entirely to the fact that the latter is independent of the former. If
for whatever reason the opportunity cost of employment b was proportional to general
productivity [as in the long-run equilibrium model of Phelps (1994), through wealth

9 Note in passing that the equilibrium pair is stationary even out of steady state because there is no
feedback from currentemploymentto expectationsabout future match output. This fact is an implication
of the linear specificationof both agent preferences and productiontechnologyand of the absence of
memory in the idiosyncraticshock process. A change in any one of these specificationassumptions
substantially complicatesbut enriches the model.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1193

accumulation], general productivity changes would not influence the equilibrium rate
of unemployment.
Given our specification and the interpretation of the two lines in Figure 6, an
increase in the supply price of labor, b, or a fall in general productivity p, shifts
the D D line up but has no direct effect on CC. As a consequence, the equilibrium
value of the reservation threshold increases and the equilibrium value of market
tightness falls with b/p. Hence, steady-state unemployment increases because both
unemployment duration and incidence increase in response.
The other parameters of the model have more complicated effects on equilibrium
unemployment and at the analytical level we can only derive unambiguous results
for unemployment duration and incidence, but not for the stock of unemployment.
Inspection of equations (2.22) and (2.26) shows that the only other parameter that
shifts only one of the lines is the job creation cost C. An increase in C shifts C C to
the left and so implies lower R and 0: unemployment duration rises but incidence
falls. The intuition behind the result is that higher job creation costs reduce job
creation, increasing the duration of unemployment, but also reduce job destruction,
to economize on the job creation costs that are incurred if the firm is to re-enter the
market. The effect on unemployment is ambiguous.
A similar ambiguity arises from changes in job termination costs. Higher T shifts
the CC line to the left and the D D line to the right. Although the effect on 0 appears
ambiguous, a formal differentiation of the equilibrium conditions yields a negative
net effect on both R and 0. Once again, job destruction falls, because it is now more
expensive to fire workers, implying less unemployment incidence. Job creation falls
because over its lifetime the job will pay the termination cost with probability 1,
implying a longer duration of unemployment.
Other parameters of the model have even more complicated effects on unemployment duration and incidence. The rate of discount, r, and the rate of arrival of
shocks, )~, both shift the job creation line down, because, in the case of r, future
product is discounted more heavily and in the case of ;~, the expected life of the job
falls. But the job destruction line also shifts. Differentiation of the two equilibrium
conditions shows that both r and X reduce market tightness, and so increase the
duration o f unemployment. The arrival rate of idiosyncratic shocks also reduces the
reservation threshold, reducing the incidence of unemployment but the rate of discount
has ambiguous effects on the threshold.
Finally, an increase in the worker's share of match surplus as reflected in an increase
in the "market power" parameter/3 shift CC downward but D D upward in Figure 6.
The result is a negative effect on equilibrium market tightness but the sign of the
resultant change in the reservation product is indeterminate. Differentiation of the
equilibrium conditions shows that the effect of/3 on R has the sign of/3 - t/, where
t/is the elasticity of the matching function with respect to unemployment. Interestingly,
if/3 = t/ the search externalities are internalized by the wage bargain, and it is a
useful benchmark case in simulations with search equilibrium models [Hosios (1990),
Pissarides (1990)].

1194

D.T. Mortensen and C.A. Pissarides

3. Employment fluctuations
The negative co-movement between aggregate measures of vacancies and unemployment, known as the Beveridge curve, has long been an empirical regularity of interest in
the literature on labor market dynamics 10. Generally, high vacancies and low levels of
unemployment characterize a "tight" labor market in which workers find jobs quickly
and higher wage rates prevail. Time-series observations suggest that job vacancy
movements lead unemployment changes both in the sense that drops ~n job vacancy
rates herald downturns in employment and that employment recoveries follow jumps
in vacancies. These observations also suggest that fluctuations in derived demand for
labor, as reflected in vacancy movements, rather than labor supply shocks are the
principal driving force behind cyclical unemployment dynamics.
The empirical work of Davis and Haltiwanger (1990, 1992) and Davis, Haltiwanger
and Schuh (1996) has stimulated general interest in the components & n e t employment
change, which they call job creation and job destruction flows. As we saw in Section 1,
the job creation and job destruction rates move in opposite directions over the business
cycle but are always both large and positive at every level of industry and regional
disaggregation. These facts suggest that employment reallocation across economic
activities is a significant and continual process that accounts for a large measure of
unemployment.
Mortensen and Pissarides (1994), Mortensen (1994b), Cole and Rogerson (1996),
and den Haan, Ramey and Watson (1997) claim that an extended version of the
equilibriurn unemployment model, one that allows for an aggregate shock to labor
productivity, can explain the stylized facts of the job creation and job destruction
flows that we listed in Section 1. To recall, apart from the negative correlation between
them just noted, job destruction is more volatile than job creation (which, at least for
US manufacturing, shows up as negative correlation between the sum and difference
of the job creation and job destruction flows) and quit rates are procyclical, i.e. there
is a positive correlation between quit rates and the difference between job creation and
job destruction. The purpose of this section is to present a version of the model that
allows for employment fluctuations which can be used to illustrate these claims.
3.1. Stochastic equilibrium

The source of the underlying job reallocation process in the Mortensen-Pissarides

model is an idiosyncratic shock which acts as match-specific "news" in the sense that
it changes the profit prospect for an individual job on arrival. A general aggregate
productivity shock which affects the output of every job by the same proportion is
added here. Specifically, we let exogenous jumps in the common component of job

l0 For an interesting early treatment, see Hansen (1970). For more recent search-based analyses, see
Pissarides (1986) and Blanchard and Diamond (1989).

Ch. 18: Job Reallocation, EmploymentFluctuations and Unemployment

1195

productivity p induce the cycle. On the argument that recruiting and hiring costs
represent forgone output, we continue assuming as well that these costs are indexed
by the productivity parameter p.
According to real business cycle theory, economic fluctuations are induced by
exogenous persistent shocks to aggregate labor productivity 11. Whether exogenous
technical change is the cause or not, labor productivity is procyclical in fact and our
model's implications for wage and employment responses are an implication of that
fact whatever its cause. Given sufficient persistence, one would expect these shocks
to induce cyclical effects on the market tightness and the reservation idiosyncratic
product which are similar to those associated with a permanent change in the level of
aggregate productivity.
For the sake of a simple presentation, assume that aggregate productivity fluctuates
between a high value Ph and a low value Pl, where the continuous time transition rate
or frequency is t/. For this specification, the autocorrelation coefficient of the p-process
given a short time interval of length A is 2e -r/a - 1. Indeed,

E{p(t + A) [p(t) =Pi} = e-~APi + (1 - e -hA) pj

= (2e -~a - 1)pi + 2 (1 - e -*/a) E{p},
where 1 - e ,a is the probability of a change in state during the interval (t, t + A),
and E { p } = (Ph +pt)/2 is the ergodic mean of this symmetric Markov chain. In the
case of permanent aggregate productivity, i.e., ~/= 0, the equilibrium pair in state i,
(Ri, Oi), solves Equations (2.22) and (2.26) given p = Pi. Consequently, Ph > Pt implies
Oh > 0l and Rt < Rh in this case. This fact generalizes but only if the aggregate shock
frequency t/is not too large.
For ~ > 0, the equilibrium relationships are more complicated because forward
looking agents knowing themselves to be in state i anticipate the effects and likelihood
of transiting to statej in the future. Indeed, under generalized Nash bargaining in which
the initial wage is set contingent on the aggregate state and the continuing wage is
renegotiated in the event of either an aggregate or a match specific shock, the surplus
value of a continuing match with idiosyncratic productivity x in aggregate state i, Si(x),
and the surplus value of a new match in state i, SOi, satisfy the following generalization
of Equations (2.18) and (2.21):

rSi(x) = p i x - r ( g ; + g i - p i T ) + ,1

['

[Si(z)-Si(x)] dF(x) + t/[Sj(x)- S/(x)],

d Ri

rSo; = p ; x o - r(U~ + Vi - p i T ) - (r + ,l + ~ ) p ; ( C + T )

+,1

[S;(z) - so;] dF(~) + n [SOj - So;],

i

(3.1)
11 For example, see Kydland and Prescott (1982) and Lucas (1987).

D.T. Mortensen and C.A. Pissarides

1196

where the aggregate state contingent values o f a vacancy and unemployment solve
rVi = q ( O i ) ( l -[~)Soi q- ~ (Vj - Vi) - p i c ,
rUi = b + Oiq ( Oi) flSoi + 71 ( Uj - Ui) .

(3.2)

An equilibrium now is a state contingent reservation threshold and market tightness

pair (Ri, Oi), one for i = 1 and another for i = h, that satisfy the free entry job creation
condition and job destruction condition in both states, i.e.,
V~=0

and

S~(R~)=0,

i E {I,h}.

Market tightness is procyclical and market tightness and the reservation product
threshold move in opposite directions in response to aggregate shocks if the shock
is sufficiently persistent. Formally, a unique equilibrium exists with the property that
Ph > Pl

Rh < Rt f o r all ~ while a critical value cc > ~ > 0 exists such that

Oh > (<) 0t a s ~ < ( > ) ~ 12

Aggregate state contingent equilibrium market tightness is actually lower in the
higher aggregate product state for sufficiently large values of the shock frequency
because investment in job creation is relatively cheaper when productivity is low and
because the present value of the retvxns to job creation investments are independent
of the current aggregate state in the limit as ~ becomes large. In other words, job
creation investment is larger when aggregate productivity is higher only if expected
return given high current productivity offsets the cost advantage of investment in the
low productivity state, a condition that requires sufficient persistence in the productivity
shock.
3.2. The Beveridge curve

As just demonstrated, "boom" and "bust" in this simple model are synonymous with
the prevalence of the "high" and "low" average labor productivity when the aggregate
shock is persistent. Unemployment dynamics in each aggregate state are determined
by the law of motion
/t = )~F(R,)(1 - u) - Oiq(Oi) u.

(3.3)

Hence, the unemployment rate tends toward the lower of the two aggregate state
contingent values, represented by
.
)tF(Ri)
ui = )~F(Ri) + Oiq(Oi)'

i E {I, h},

(3.4)

during a boom and tends toward the higher value in a bust.

12 Formalderivationsof the value equations, those of(3.1) and (3.2), and proofscan be found in Burdett,
Mortensen and Wright (1996).

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

uh Uz

1197

Oh

Oh

Ot

v;

- -

.2

.7

Fig. 7. The Beveridge curve.

The observation that actual vacancies and unemployment time series are negatively
correlated is consistent with this model under appropriate conditions, a fact illustrated
in Figure 7. In the figure, the two rays from the origin, labeled 0l and Oh, represent the
vacancy-unemployment ratios in the two aggregate states when Oh > 0l. The negatively
sloped curves represent the locus of points along which there is no change over time in
the unemployment rate, one for each of the two states. Because the curve for aggregate
state i is defined by
vq(v/ui)
- - tlF(Ri),
1 - ui
Rh < Rl implies that uh < uz for every v as drawn in Figure 7. Finally, the two steadystate vacancy-unemployment pairs lie at the respective intersections of the appropriate
curves, labeled L and H in the figure. Provided that the curve along which/l = 0 doesn't
shift in too much when aggregate productivity increases, v~ > v~ as well as u~ < u~.
However, sufficient persistence, in the form of a low transition frequency, is necessary
here. Indeed, the points L and H lie on a common ray when persistence is at the critical
value tl = ~ since 0l = Oh by definition.
3.3. Job creation and j o b destruction flows

In our simple model, the notion of a job is equivalent to that of an establishment, plant,
or firm given the linear technology assumption. Consequently, the job creation flow,
the employment changes summed across all new and expanding plants over a given
period of observation, can be associated with the flow of new matches in the model.
Analogously, job destruction, the absolute sum o f employment reductions across
contracting and dying establishments, is equal to all matches that either experience
an idiosyncratic shock that falls below the reservation threshold or were above the

D.T. Mortensen and C.A. Pissarides

1198

threshold last period but are below it this period. The fact that market tightness
and the reservation product move in opposite directions in response to an aggregate
productivity shock implies negative co-movements in the two series, as observed.
Furthermore, a negative productivity shock induces immediate job destruction while a
positive shock results in new job creation only with a lag. This property of the model is
consistent with the fact that job destruction "spikes" are observed in the job destruction
series for US manufacturing which are not matched by job creation "spurts" 13. As in
the OECD data, cyclical job destruction at the onset of recession is completed faster
than cyclical job creation at the onset of a boom.

3.4. Quits and worker flows

As the model is constructed so far, aggregate hires are equivalent to job creation
and separations equal job destruction. These identities no longer hold when some
employed workers quit to take other jobs without intervening unemployment spells.
As these so-called j o b to job flows constitute a significant component of both hires
and separations, are procyclical, and represent a worker reallocation process across
jobs, their incorporation in the model represents an important extension.
Job to job worker flows can be viewed as the outcome of a decision by some workers
to search for vacancies while employed, as in Mortensen (1994b). Given that Oq(O)
represents the rate at which employed as well as unemployed workers find a vacant
job, the quit flow representing job to job movement in aggregate state i E {l, h} is
Qi = Oiq(Oi)(1 - ui)si,
where s i is the fraction of the employed who search and Oi is now the ratio of vacancies
to searching workers, i.e.
0i =

1)i

ui +si(1 - ui)"
Once employed, workers have an incentive to move from lower to higher paying jobs.
Suppose that employed workers can search only at an extra cost, ~, interpreted as
foregone leisure, a reduction in b. As search is jointly optimal for the pair if and only
if the expected return, equal to the product of the job-finding rate and the gain in

13 These points are discussed in more detail in Mortensen and Pissarides (1994) and Mortensen
(1994b).

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1199

match surplus realized, exceeds the cost, all workers employed at x equal to or less
than some critical value, denoted as Qi, will search where 14
Oiq(Oi) [S/(1) - Si (Qi)] = a,

i c {l, h}.

(3.5)

Because idiosyncratic productivity is distributed F ( x ) - F ( R ) across jobs, it follows

that the fraction of the employed workers who search in aggregate state i is given by
(3.6)

si = F ( Q i ) - F(Ri).

Because a quit represents an employment transition for the worker and the loss of a
filled job for the employer, the surplus value equation under joint wealth maximization
is
rSi(x) = p i x - o - r(Ui + Vi - T) + ~

[Si(z) - Si(x)] dF(x)

+ t/[Sj(x) - S i ( x ) ] + Oiq(Oi)(Si(1)-Si(x))

(3.7)

V x < Qi.

Because the worker does not search when x >7 Qi and this condition always holds when
x = 1, Equations (3.1) continue to hold in this range. To the extent that market tightness
is procyclical, Equation (3.5) implies Qh > Ql. Hence, the quit flow is procyclical for
two separate reasons. First, because Q is higher and R is lower in the high aggregate
productivity state, the fraction of employed workers who search is procyclical, i.e.,
sh > sl. Second, because Oh > 01 when the aggregate shock is sufficiently persistent,
the rate at which searching workers meet vacancies Oq(O) is also larger in the high
aggregate product state.
Worker reallocation across different activities is represented by both the direct
movement from one job to another via quits and by movements through unemployment
induced by job destruction and subsequent new job creation. Davis, Haltiwanger
and Schuh (1996) estimate that between 30% and 50% o f worker reallocation is
attributable to the job destruction and creation process. Given the procyclicality of
the quit flow and the flow of hires, the sum o f job creation and quits is highly
procyclical, while the separation flow, the sum of job destruction and quits, is acyclical.
Hence, the reallocation o f workers across activities is procyclical relative to the more
countercyclical reallocation of jobs across activities both in fact and according to the
model.
The quit process also interacts with job creation and job destruction in more
complicated ways that are not explicitly modeled here. For example, when a worker

14 Although the decision to maximize the sum of the pair's expected future discounted income by the
appropriate choice of the worker's search effort is individually rational under an appropriate contract,
both costless monitoring and enforcement of the contract is generally necessary to overcome problems
of dynamic inconsistency. Indeed, otherwise the worker will search if and only if the personal gain
exceeds cost, i.e., iff W/(1)- W/(x) =/~[Si(1)- Si(x)] > o" which would imply too few quits.

1200

D.T. Mortensen and C.A. Pissarides

quits an existing job to take a new one, the employer can c h o o s e to search for a
replacement. If the decision is not to replace the worker, the quit has induced the
destruction of a job with no net change in either the number o f jobs or unemployment.
I f the decision is to declare the job vacant, a new job was created by the original
match but there will be no net reduction.in unemployment unless the old job vacated
is filled by an unemployed worker. O f course, if filled by an employed worker, the
employer left by that worker must decide whether o r n o t to seek a replacement. This
sequential replacement process by which a new vacancy leads to an ever/tual hire from
the unemployment pool, known in the literature as a vacancy chain, propagates the
effects o f job creation shocks on unemployment [see Contini and Revelli (1997) and
Akerlof, Rose and Yellen (1998)].
Also, quit rates are high in the first several months after the formation of new
matches and then decline significantly with match tenure, presumably as a consequence
o f learning about the initially unknown "quality" o f the fit between worker and
job 15. This source o f quits is o f significant magnitude and it represents the primary
form o f quits to unemployment. Because this "job shopping" process implies that an
unemployed worker typically tries out a sequence o f jobs before finding satisfaction,
a job destruction shock is likely to be followed by a drawn-out period o f higher
than normal flow into and out o f unemployment 16. Were the job shopping process
incorporated in the model, job reallocation shock effects on worker flows would be
prolonged and amplified, features that should also improve the model's fit to the data.

4. Explaining the data

Besides the attempts to use the models that we have described to match the stylized
facts o f job and worker flows 17, there have recently been some attempts to calibrate
stochastic versions o f the models to explain the cyclical behavior o f the US economy.
These attempts are partly motivated by the emergence o f the new data on job flows that
need to be explained and partly by the apparent failure of competitive labor market
models to match the business cycle facts in the data. In order to explain the business
cycle facts the models need to be extended to include capital, an exercise that has
attracted some attention recently 18

15 There is an extensive labor economics literature on this point initiated by the seminal theoretical
development by Jovanovic (1979). See Farber (1994) for a recent analysis of the micro-data evidence on
tenure effects on quit rates and the extent to which these are explained by the job shopping hypothesis.
Pissarides (1994) explains these facts within a search model with learning on the job.
J6 Hall (1995) argues that this effect is apparent in the lag relatioships between the time series
aggregates.
17 For attempts to estimate structural forms of the matching model see Pissarides (1986) and Yashiv
(1997).
18 When used to calibrate the business cycle facts the models are often offered as alternatives and
compared with Hansen's (1985) indivisible labor model.

Ch. 18:

J o b Reallocation, E m p l o y m e n t Fluctuations and U n e m p l o y m e n t

1201

4.1. Explaining j o b f l o w s data

Cole and Rogerson (1996) conduct an analysis of the extent to which the rudimentary
Mortensen-Pissarides model can explain characteristics of the time series observations
on employment and job flows in US manufacturing. For this purpose, they construct the
following stylized approximation to the continuous time formulation sketched above:
Job creation in period t, ct, is equal to the matches that form during the observation
period and survive to its end. As one can ignore the possibility that a job is both
created and destroyed when the observation period is sufficiently short, approximate
job creation in period t is
ct = as, ~(1 - nt 1),

1-

(4.1)

a s t = e -O~tq(O~),

where nt-1 = 1 - ut-1 is employment at the beginning of the period, 1 - ai is the

probability that the representative worker who is unemployed at the beginning o f the
period is not matched with a job during the period given that aggregate state i prevails,
Oiq(Oi) is the aggregate state contingent unemployment hazard rate, and st E {l, h} is
the aggregate state that prevails during period t.
Job destruction in period t has two components as already noted. First, the fraction of
filled jobs that experience a shock less than the prevailing reservation threshold, which
equals 1 - e -;~F(RI)given aggregate state i prevails, are destroyed. Second, the fraction of
existing jobs that do not experience a shock but have match productivity less than the
current reservation threshold are also destroyed. The latter is Gt I(Rt) where Gt-1 (x) is
the fraction of jobs at the beginning of the period that have match productivity less than
or equal to x. Although this distribution of jobs over productivity is not stationary but
instead evolves in response to the history of aggregate shocks, between shock arrivals
it converges toward an aggregate state contingent distribution equal to 0 for all x <~ R i
obviously and F ( x ) - F ( R i ) / ( 1 - F ( R i ) ) for all values of Ri < x < 1. Given sufficient
persistence in the aggregate shock (i.e., t/ small enough), Cole and Rogerson argue
that these steady-state distributions can be used to approximate Gt-1. Because Rh < Rt
implies that job destruction attributable to a change in the aggregate state only occurs
when the transition is from high to low productivity, the following characterization of
the job destruction flow holds as an approximation:
dt = (b,, + Ot6o) nt-i

Ot =

where

1 ifst_l = h and st =l,

0 otherwise,

6i = 1 - e-zF(Ri),
6o =
~ (F(Rl) -

(4.2)
F
(Rh))

where
2"glh = 3"ghl = 375 =

1 - e -rl

is the probability of an aggregate state transition. Finally, the aggregate employment

process {nt} is generated by the following stochastic difference equation defined by
the employment adjustment identity
r/t+1 ~-~ n t + t+l -

dt+l = as, + (1 - as, - 6s,+, -

~t+160) nt

1202

D.T. Mortensen and C.A. Pissarides

given the Markov forcing process {st} defined on the state space {l,h} and
characterized by the symmetric probability of transition Jr.
Obviously, the employment, job creation, and job destruction processes are interrelated and fully characterized by the set of reduced form parameters {al, ah, 6t, 6h, 60, Jr}.
The question asked by Cole and Rogerson (1996) is whether an appropriate choice of
these parameters will replicate the salient features of the Davis-Haltiwanger-Schuh
observations, which they summarize in the following useful way:
(1) Volatility: Job creation is roughly four times as volatile as employment, and job
destruction is more than six times as volatile.
(2) Persistence: The series for job creation, job destruction and employment display
strong positive autocorrelation, but the autocorrelation for employment, which is
0.9, is nearly twice that for the other two series.
(3) Contemporaneous Correlations: Creation and destruction have a fairly large negative correlation. Destruction is (weakly) negatively correlated with employment,
whereas creation is virtually uncorrelated with employment.
(4) Dynamics: Creation is negatively correlated with lagged employment, and positively correlated with fuWxe employment. The opposite pattern holds for destruction.
To answer their question, Cole and Rogerson simulate the model above for trial
parameter values, compute the associated simulation statistics, and then adjust the
parameter values to obtain a better match. They conclude that the model can replicate
observations in their sense when the probability of finding a job is not too large.
Specifically, the model simulation for the parameter set
{al, ah, 6l, 6h, 6o, zc} = {0.21, 0.30, 0.069, 0.044, 0.01,0.2}
generates their preferred results which are not only consistent with their qualitative
characterization of the data but are quite close in quantitative terms as well. Given that
the two job destruction rates 6l and 6h are set to match the average of 0.055 reported in
the Davis-Haltiwanger-Schuh data, one potential problem which Cole and Rogerson
emphasize and discuss are the low values of the probabilities of finding employment.
To see the significance of the point, simply note that the two state contingent steadystate unemployment rates associated with this parameter set are

ul

6l+al-0"25'

uh

6h + ah

0 . 1 3 ,

two numbers that yield an average unemployment rate of 19%. Nonetheless, the authors
argue that these numbers are reasonable given the following observations reported
by Blanchard and Diamond (1990): First, although the simple model ignores nonparticipants, in fact the flow to employment from this stock is roughly equal to the
flow from those officially categorized as unemployed. Second, the number of workers
classified as out-of-the-labor-force who report they want jobs is also roughly equal to

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1203

the number classified as unemployed. Including these individuals in the pool of the
unemployed would rationalize the low average value of a, especially if these workers
search at lower intensities.
4.2. Capital accumulation and shock propagation

Merz (1995) and Andolfatto (1996) each construct different but related syntheses
of the neoclassical stochastic growth model and the Pissarides (1990) model of
frictional unemployment. The contributions of these authors include a demonstration
that the "technology shocks" responsible for business cycles in the real business
cycle (RBC) model will also induce negative correlation between vacancies and
unemployment, the Beveridge curve, and a positive correlation between flows into
and out of unemployment in a version of the model with a labor market characterized
by a matching process. However, like the earlier simpler RBC models, the amended
models fail to propagate productivity shocks in the manner suggested by the observed
persistence in actual output growth rates.
Recently, den Haan, Ramey and Watson (1997) have constructed, calibrated,
and simulated a synthesis of the Mortensen and Pissarides (1994) model of job
creation and job destruction with the neoclassical stochastic capital accumulation
model. As in the Merz and Andolfatto models, job creation is governed by a
matching function whose inputs include vacancies and unemployed workers. In
addition, a job destruction margin is introduced by supposing that existing job
matches experience idiosyncratic productivity shocks orthogonal to the aggregate
shock to match productivity as described above. They find that interaction between
the household saving decision and the job destruction decision play a key role in
propagating aggregate productivity shocks. As a consequence, their synthesis provides
an explanation for the observed autocorrelation in output growth rates as well as the
correlation patterns observed in job flows with themselves and employment, those
matched by Cole and Rogerson (1996).
Den Haan et al. (1997) explicitly formulated the model in discrete time with
each period equal to one quarter. Following Merz (1995) and Andolfatto (1996),
idiosyncratic variation in labor income attributable to unemployment spells is fully
insured through income pooling. Hence, the existence of a representative household
can be invoked; one assumed to have additively separable preferences over future
consumption streams represented by ~ t ytu(Ct) where t is the time period index,
y is the time discount factor, and u(C) is one period utility expressed as a concave
function of consumption. A single consumable and durable asset, capital, exists which
also serves as a productive input. The sequence of future market returns for holding
the asset, denoted {rt}, is an endogenous stochastic process. Hence, the optimal
consumption plan must satisfy the usual Euler equation
u'(Ct) = gEt{u'(Ct+l)(1 - 6 + rt+l)},

(4.3)

where the expectation is taken with respect to information available in period t and
6 is the rate of physical capital depreciation.

D.T. Mortensen and C.A. Pissarides

1204

The surplus value of a new match is another endogenous stochastic process, denoted
{S+1}. When an unemployed worker and job vacancy meet at the beginning of
period t + 1, Nash bargaining takes place. The outcome allocates the share fiStl
to the worker and the remainder (1 -fl)Sl to the employer, where as above fi
represents worker market power. The anticipated bargaining outcome motivates search
and recruiting effort by unemployed workers and employers with vacancies during
period t. The flow return to unemployed search is the sum of home production while
unemployed, b, and the expected gain attributable to finding a match: '

b+Otq(Ot)[3Et{

u ( t+l
~
)S?+1) .

(4.4)

The expected capital gain, the second term, is the product of the probability of finding
a job and the expected value of the worker's share of match surplus given information
available in period t appropriately discounted back to the present by a factor which
accounts for any difference in the marginal utility of consumption in the next and
the current period. Similarly, free entry of vacancies requires zero profit in the sense
that recruiting cost per vacancy posted, ptc, equals expected return, the product of the
probability that the employer finds a match and the employer's share of its expected
discounted surplus value:

ptc = q(Ot)(1 -[3)Et{ Yu'(Ct~+~) t+l ]"

S"

(4.5)

The aggregate productivity shock, the process {pt}, is Markov with the transition
probability kemel assumed to be common knowledge. For simplicity, den Haan et
al. (1997) assume that the match-specific process, represented by {xt}, is i.i.d, with
c.d.f. F(x) 19. Still, the idiosyncratic shock is expected to persist for the duration of the
current period. The output of an existing match in period t is ptxtf(kt) where kt is the
amount of capital per worker rented during the period at rate rt, andf(k), normalized
output per worker, is an increasing concave function. Because the option value of
continuing the match is zero for the employer and equal to the flow value of search for
the worker, b + [3ptcO/(1 -[3) from Equations (4.4) and (4.5), the joint match surplus
conditional on idiosyncratic productivity xt is

St(xt) = mlax ~ t x t f (k) - rtk - b - ~lP~CflOt)

+ Et

{ yut(Ct+l)

u'(Ct~ max {St(Xt+l), O}

(4.6)

}
,

where the last term reflects appropriate discounting of next-period surplus and the
option to destroy the match next period if need be.
19 Otherwise,the distributionof idiosyncraticproductivityacross existingmatchesis a decisionrelevant
state variable.Theyclaimthatthe modelloses no essentialpropertyas a consequenceof this abstraction.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1205

By implication of the optimal capital choice, the current period demand for rented
capital by an existing match characterized by idiosyncratic productivity xt = x is

k[(x)= { d ~p,
0

if

(4.7)

otherwise,

where d = (ft)-i is a decreasing function and Rt is the reservation value of the

idiosyncratic shock. Obviously, the representation reflects the fact that an existing jobworker match is destroyed and no capital is rented if an idiosyncratic shock is realized
below the reservation value. The capital rental rate rt is determined by the capital
market clearing condition which can be written as

Kt=[fRid(~pt) dF(x)lNt,

(4.8)

where (Kt,Nt) is the given aggregate capital stock and employment pair as of the
beginning of period t.
As the current reservation value Rt solves St(R) = 0, Equation (4.6) implies

t~c (4.9)
max{ptRtf(k)-rdQ+lZttr ]lbll(Ct+l)
~
max {St(xt+l), 0}} = b+ ~_fiw./3pt
Given that xt ~ F(x), it follows that expected ex ante match surplus conditional on
knowledge of (Pt,Rt) is
--',

--

f max{St(x),O}dF(x)= fR~ {m~x {Ptf(k)-rtk}-mkax {ptRtf(k)-rtk} } dF(x)

(4.10)
by Equation (4.6). The fact that xt+1~ F(x) as well together with Equation (4.9) and
(4.10) imply
max {ptRf(k)
k

- rtk}

/3ptc tl
=b+~_flvt

- Et

ut(Ct)

t+l

(4.11)

(mU {p,+,xf(k) - max {Pt+,Rt+f(k)

k

- rt+lk})dg(x) [ .
J

Finally, because x = 1 for a new match, So = St(l). Hence, Equations (4.6) and (4.10)
imply that Equation (4.5) can be written as

ptc = q(Ot)(1 -/3)

}.
x E f gU'(Ct+l)[n~x{pt+,f(k)-rt+,k}-m~x{pt+lRt+,f(k)-rt+lk}l
(4.12)

D.T. Mortensenand C.A. Pissarides

1206

Note that Equations (4.11) and (4.12) are generalizations of the job destruction and job
creation conditions. Indeed, in the non-stochastic case with linear utility and no capital,
these equations are equivalent to Equations (2.26) and (2.22) since Equation (4.3)
implies 7 = 1/(1 + rt) for all t and the discrete time specification and the assumption
that the idiosyncratic shock persists for one period imply that the duration of any shock
is unity, i.e., tt = 1. However, a complete characterization of general equilibrium also
requires that the equilibrium conditions of the neoclassical stochastic growth model,
Equations (4.3) and (4.8), and the laws of motion hold.
The laws of motion for capital and employment are

gt+ 1 (1 - 6)Kt +Pt [~RRl

t xf ( (g ~
=

dF(x) l Nt

(4.13)

- cptOtq(Ot)(1 - Art) - Ct
and

Nt+1 Otq(Ot)(1 -- Aft) -- F(R) Nt

=

(4.14)

respectively 2. The first equation reflects the effects of job destruction and capital
demand decisions made at the beginning of the period on output and the consumption
decision while the second reflect the outcomes of current period job creation and
destruction decisions. As the information relevant state of the economy is a triple
composed of the capital stock, the employment level, and the aggregate shock, a
dynamic stationary general equilibrium is a vector function that maps the state
variable triple (N, K,p) to the four endogenous variables (C, r, R, 0); one that solves
the Euler equation (4.3), the capital market clearing condition (4.8), the job destruction
condition (4.11), and the job creation condition (4.12) under the laws of motion (4.13)
and (4.14).
Den Haan et al. (1997) derive the properties of the equilibrium by solving and
simulating a particular parameterization of the model numerically. The qualitative
properties they report are intuitively suggested by the known implications of the
two models married in this synthesis. For example, a positive aggregate shock
stimulates current investment in both job creation and physical capital which augment
employment and productive capacity in the next period. In the short run, these
investments must be financed with an output increase induced by a lower than
normal reservation productivity choice and by a reduction in consumption. However,
because of the consumption smoothing motive, the limited ability to increase output by
increasing utilization through reductions in job destruction, and the complementarity
of physical capital and labor, more investment of both types is made in subsequent
periods as well, i.e., the shock is propagated.
20 Followingthe literature, home production b cannot be used to create capital by assumption. It is
simply consumed.

Ch. 18." Job Reallocation, Employment Fluctuations and Unemployment

1207

A negative shock has an immediate and sharp negative effect on output along the
job destruction margin. Although the effect is cushioned by the reallocation of existing
capital to those jobs that continue, rental rates fall on impact in response to the decrease
in demand for capital induced by job destruction and will be expected to fall further
in the future as a consequence of the persistence in the shock. The result is a reduction
in capital formation and job creation which has the effect of reducing output further in
the future. Again the consumption smoothing motive interacting with the job creation
and destruction process propagates the shock into the future.
As a consequence of the adjustment mechanisms described above, the simulated
model implies strong first- and second-order autocorrelation in output growth rates,
substantial persistence in the response of physical capital to negative productivity
shocks, and a substantial magnification of the effects of productivity shocks on
aggregate output. Neither the RBC model nor the augmented model featuring job
matching but exogenous job destruction, like those of Merz (1995) and Andolfatto
(1996), explain these features of the aggregate time-series data. As in Cole and
Rogerson's (1996) reduced form analysis of the Mortensen and Pissarides job creation
and destruction model, the calibrated version of the extended model studied by den
Haan et al. (1997) also reproduces all the job flow time series stylized facts.

5. Technological progress and job reallocation

Search and matching models have been used to address the old "luddite" question
of the influence of technological progress on job flows and unemployment levels.
The common view is that new technology destroys jobs. Of course, innovations also
generate new job creation. But, the resulting reallocation of workers from the old to
new jobs may require an intervening unemployment spell. In this section, we explore
the relation between the exogenous rate of technological progress and steady-state
employment.
The analysis that follows suggests that the extent to which technical progress is
"embodied" is critical. The distinction between embodied and disembodied technology
is Solow's. In his original growth model [Solow (1956)], any improvement in
technology instantaneously affected the productivity of all factors of production
currently employed. But later he introduced the vintage model of embodied technical
change in which productive improvements is a property of new capital investment only
[Solow (1959)]. In the latter case, to capture the productivity benefits of technical
change, older capital vintages must be replaced with the most recent equipment.
Our analysis begins by making the original assumption of disembodied technology.
We show that if the rate of interest is independent of the rate of technological progress,
faster technological progress leads to more job creation in the steady state. The
dominant effect in this case is one of"capitalization". Because the costs of job creation
are paid initially, faster technological progress implies a lower effective discount rate
on future profits, leading to a higher present discounted value for profits [see Pissarides

D.T. Mortensen and C.A. Pissarides

1208

(1990), Chapter 2]. The effect o f faster growth on j o b destruction is, however, o f
indeterminate sign. We then consider the vintage model in the sense that "new capital"
is assumed to be embodied only in newly created jobs. We show that under the
assumption that the same worker cannot be m o v e d from an old j o b to a new one
without intervening unemployment, steady-state unemployment is higher at faster rates
o f technological progress [as in A g h i o n and Howitt (1994)] 21.

5.1. Disembodied technology

L e t p ( t ) represent the aggregate productivity parameter but now expressed as a function

o f time t. We assume that the rate o f technological progress g is constant, exogenous,
and less than the rate o f time discount, i.e.,

-g

<r.

(5.1)

P
We treat r as a constant independent o f g 22. The other restrictions made are the same as
in the basic model o f Section 2.1, with the additional assumption that unemployment
income is also a function o f time. We assume for simplicity that b(t) = bp(t). This
assumption is needed to ensure the existence o f a steady-state growth equilibrium
and is plausible in a long-run equilibrium when p(t) is an aggregate productivity
parameter 23.
The j o b creation and j o b destruction conditions o f Section 2.1 change in an obvious
way. Because all parameters in the value expressions (2.4), (2.5), (2.7) and (2.8) are
multiplied by p(t), and the wage equation still satisfies either (2.20) or (2.23), there
is an equilibrium where all value expressions grow at constant rate g. Intuitively, the
firm that has a j o b with value J(x, t) at time t, expects to make a capital gain o f
dJ(x, t)/dt ==-J(x) = gJ(x) on it. The same holds true for the value o f a j o b to the
worker, W(x, t), and the value o f unemployment, U(x, t), where the capital gain is,
respectively, gW(x) and gU(x). But the value o f a vacant job, V(t), because it is zero

21 Mortensen and Pissarides (1998) consider a more general case of adoption of the new technology at
a cost and show that the two cases that we consider here are two limiting cases, the first case approached
when the adoption cost tends to zero and the second when the adoption cost tends to infinity. The main
result of the paper is that there is a critical level of the adoption cost below which the dominant influences
on job creation and job destruction are those described here under disembodied technology and above
which the dominant influences are those described under embodied technology. See also Aghion and
Howitt (1998, chapter 4) for more analysis of this issue.
22 Eriksson (1997) embeds the model in an optimizing (Ramsey) growth model and shows that the
restriction that the effective discount rate decline with the rate of growth can be violated by feasible
parameter values. He also considers the effects of growth on unemployment in an endogenous growth
framework.
23 Making b(t) a proportional function of the equilibrium wage rate would not change the results.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1209

by the free entry condition, does not change. It is this asymmetry between V(t) on the
one hand and the other asset values on the other that creates the capitalization effect
of faster growth.
We do not reproduce all the value expressions with growth but show instead the
value of a continuing job to the firm, (2.4):

rJ(x, t) = p(t) x - w(x, t) + 3.

fR [J(z, t) - J(x, t)] dF(z)

(5.2)

+ Z F ( R ) [ V ( t ) - p ( t ) T - J(x, t)] + J(x, t).

The capital gain to the firm is shown as an addition to revenues from continuing the
job. Replacing the capital gain by its steady-state value, we get
1

(r - g) J(x, t) = p(t) x - w(x, t) + )~ fR [J(z, t) - J(x, t)] dF(z)

(5.3)

+ ~ F ( R ) [ V ( t ) - p ( t ) T - J ( x , t)].

The main result of the introduction of growth can be seen from Equation (5.3).
Because all value expressions grow at the constant rate g, wages will also grow at the
constant rate g, and so all time-dependent variables in Equation (5.3) can be written
as proportional functions of p(t). Letting then J ( x , t) = p(t) J ( x ) and using similar
notation for the other time-dependent variables, we can re-write Equation (5.3) in the
same form as Equation (2.4), except that the discount rate r is replaced by r - g .
It is straightforward to work through the model of Section 2 with the assumption
that all time-dependent variables are proportional functions of aggregate productivity
and show that there is a solution for the job creation and job destruction flows that
replicate the solution shown in Figure 6 but with r replaced by r - g . Hence, under
the assumption that r - g falls monotonically in g, we find that faster disembodied
technological progress increases market tightness 0 but has ambiguous effects on the
reservation productivity R. Therefore, faster growth increases job creation, decreases
the duration of unemployment but has ambiguous effects on job destruction and
the incidence of unemployment in general. However, much of the literature on the
effects of growth on unemployment concentrates on the obsolescence effects of new
technology on job destruction (see the next section) and ignores the idiosyncratic
reasons for job destruction. This assumption, also adopted in Pissarides (1990,
Chapter 2), is justified in the long-rma context by the fact that most variations in
the job destruction rate in the data are high-frequency, with, at least in the European
context where there have been substantial changes in the unemployment rate, virtually a
constant job destruction flow across business cycles. This fact justifies a 0, 1 restriction
on the support of the distribution of idiosyncratic shocks. In this case, variations in R
do not influence the job destruction rate, which is equal to 2~, and so the effect of faster
growth is to increase job creation and reduce unemployment.

1210

D.T. Mortensen and C.A. Pissarides

5.2. Adoption through "'creative destruction '"

New technology cannot always be adopted by existing jobs. Much of public discussion
and a large body of literature deals with the situation where the adoption of new
technology requires the creation of new jobs with new capital equipment. This process
of implementation is referred to in the literature as "creative destruction", because old
jobs have to be destroyed to release the resources for the creation of new jobs [see
Aghion and Howitt (1992, 1994), Grossman and Helpman (1991), and Caballero and
Hammour (1994)]. In this section we assume that the process of creative destruction
induces a transition of the worker to unemployment and search for a new job. We
demonstrate that more rapid technological progress under these assumptions induces
more labor reallocation and so higher unemployment because of both lower job
creation rate and higher job destruction rate.
In order to emphasize the new element of the model we abstract from idiosyncratic
productivity shocks. Instead, heterogeneity in productivity arises because older jobs
embody less productive technology and a job is destroyed when the technology
embodied becomes obsolete.
Given that current technological improvements affect only productivity in newly
created jobs, we need to distinguish between the date at which a job is created, its
vintage v, and the current date, denoted as t. The expected present value of both
future profit J and wage income W for a given job-worker match depends on the
job's vintage and the current date. These value functions solve the following asset
pricing equations:
rY(v, t) = p ( v ) x - w(v, t) - 6Y (v, t) + J (v, t),

(5.4)

r W ( v , t) = w(v, t) - 6[W(v, t) - U(t)] + W(o, t),

where x represents job match productivity, w(v, t) is the wage paid on a job of vintage v
at date t, 6 > 0 represents an exogenous job separation rate, and U(t) is the value of
unemployed search at t.
The fixed cost of investment in a new job, denoted as p(t)C, is incurred when the
match forms. The investment is specific to a job, i.e., it is "irreversible" with no outside
option value once the match forms. The recruiting costs, p(t) c, are modelled as a cost
per vacancy posted. New vacancies enter at every date until market tightness is such
that the value of creating a vacancy, V(t), is zero, i.e.
r V ( t ) = q(O)[J(t, t) - p ( t ) C ] - cp(t) = 0,

(5.5)

where q(O) is the rate at which vacancies are filled. Similarly, the value of
unemployment solves the asset pricing equation
r U ( t ) = p(t) b + Oq(O)[W(t, t) - U(t)] + U(t),

(5.6)

where p ( t ) b represents the opportunity cost of employment and where Oq(O) is the rate
at which workers find vacancies. As before, recruiting costs, the investment required to

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1211

create a match, and the opportunity cost of employment grow at rate g by assumption
to assure the existence o f a balanced growth path equilibrium solution to the model.
We assume that the wage bargain divides the surplus value o f a continuing match
in fixed proportion, i.e.,

/3J(v, t) = (1 -/3)[W(v, t) - U(t)],

(5.7)

where/3 represents the worker's share 24. Because Equations (5.4) and (5.6) imply

(r + 6)J(v, t) =p(v)x - w(v, t) + J(v, t),

(r + ~)[W(v, v) - U(t)] = w(v, t) - rU(t) + W(v, t),
the wage contract that supports the assumed bargaining outcome (5.7) is

w(v, t) =/3p(v)x +p(t) ((1 -/3) b +/3 (cO + Oq(O) C))

by virtue of the free entry condition (5.5). The first term on the
worker's productivity while the second captures the worker's option
firm. Because the latter grows at the rate of technological progress
stationary, every job becomes obsolete eventually.
By substituting from the wage equation into the first of Equations

(5.8)
right reflects the
value outside the
but the former is
(5.4), we obtain

(r+6)J(v,t) = (1-/3)p(v)x-p(t)((1 -/3)b+/3(c0+ Oq(O)C))+J(v,t).

(5.9)

Indeed, Equation (5.9) holds only for t - v ~< r where r is the optimal economic lifespan of a job. The employer's choice of a job's economic life maximizes its value,
i.e.,

J(v't)=max~r ~JtF+~[(1-/3)P(V)x-p(s)[(1-/3)b+/3(cO+Oq(O)C)]]

(5.10)

e-(r+6)(s-t) ds}.
The maximal value o f a new job at time t is the special solution to this equation
satisfying the balance growth equation J(t,t)
= J(O)p(t) where, given the
normalization p(0) = 1,

J(O) =- J(O, O)
= m a x { f 0 T [ ( 1 - / 3 ) x - e gs [(1 -/3) b + / 3 ( c 0 + Oq(O)C)]]e -(r+~)s ds}.
(5.11)
24 Here workers do not share the cost of initial investment by accepting a lower starting wage for an
initial period of employment as assumed in Section 2. Instead, the initial wage is equal to the continuing
wage at initial productivity. Although equilibrium market tightness will be too low relative to a social
optimum initially, the qualitative behavior of a model under a jointly efficient wage bargain would be
much the same. See Caballero and Hammour (1994, 1996) for more discussion of this issue.

D.T. Mortensen and C.A. Pissarides

1212

The first-order condition for a positive optimal choice of the economic life of a
job equates stationary match product with the rising opportunity cost of continuing an
existing match, i.e.
(1 -/3) x - [(1 -/3) b +/3(c0 + Oq(O) C)] egr = 0.

(5.12)

Since J(t, t) = J(O)p(t), the free entry condition (5.5) can be written as

c = q(O)[J(O)- C].
(5.13)
A search equilibrium is characterized by any market tightness and age at job
destruction pair (0", r*) that solves Equations (5.12) and (5.13).
Because the right-hand side of Equation (5.13) is strictly decreasing in 0, equilibrium market tightness is unique. Of course, given 0", the associated equilibrium value
of the optimal job age at destruction, r*, is the unique solution to Equation (5.12).
Since Equations (5.12), (5.13) and (5.11) imply
c + C = J(O*) = (1 -/3)x for* [1 - eg(s_r.)] e_(r+~)xds '
q(O*)

(5.14)

a necessary but hardly sufficient condition for the existence of a positive equilibrium
pair (0", *) is that match productivity x exceed the opportunity cost of employment b.
Indeed, given this condition, an economically meaningful equilibrium exists only if
both recruiting and creation costs, c and C, are sufficiently small.
Because the surplus value of a match decreases with the rate of technological
progress, g, for every value of market tightness by virtue of Equation (5.1 l) and the
envelope theorem, namely

OJ o

Og

~r* [segS (( 1 -/3)b+/3(c0" + O*q(O*)C))] e (r+~)"ds < 0,

and because both the value of a job and the rate at which vacancies are filled decrease
with market tightness, the free entry condition (5.13) implies that market tightness
falls with the growth rate, i.e.,

00" _ (
q(0*) 2
OJ
Og
~,cq'(O*)+q(~O*)2oJ--~ ~ g

<0.

Because the left-hand side of (5.14) is decreasing in g and the right-hand side is
increasing in both g and z*, it follows that the economic life of a new job also falls
with the rate of growth, i.e.,
Or* _

Og

_ cq'(0*/ o0* _ ( 1 -/3) xeg r* for* (r * - s)e -(r+d-g) s ds

q(o*) ~g

<0.

(1 -/3)xge gr* for* e (r+~-g)s ds

To derive the implications of these facts for unemployment and job flows, first note
that job creation at time t is

I~(t) = O*q(O*) u(t).

(5.15)
Job destruction is equal to the flow of jobs that attain the age of optimal obsolescence
plus the flow of all jobs that experience exogenous destruction. As the fraction of jobs

Ch. 18: Job Reallocation, EmploymentFluctuations and Unemployment

1213

of each cohort that survive to age ~ is e -~r given the exogenous destruction hazard is
6, the job destruction flow at time t is

D(t) = e-ar*K(t - z'*) + 611 - u(t)].

(5.16)

Hence, the steady-state unemployment rate that equates job creation and job destruction flows through time is
u* =

6
di + (1 - e-~*)O*q(O*)"

(5.17)

It increases with the rate o f embodied technical progress because both market tightness
and the economic life of an existing job decline with g and because the unemployment
duration hazard Oq(O) is increasing in 0.
Technological progress in this model adversely effects worker flows into and out of
employment for two reasons. The first is a restriction that we have imposed on the
model, namely, that when a machine is replaced because of obsolescence the worker
that was employed on that machine is also replaced. This assumption also underlies
the work of Aghion and Howitt (1994) and Caballero and Hammour (1996) and is
derived from Schumpeter's notion of "creative destruction". The idea is that when a
job is destroyed it is replaced by a technologically more advanced one, with positive
effects on factor productivity. The second is a particular assumption about the timing
of job creation costs.
The implication of the first restriction for the job destruction flow is straightforward
enough: faster technological progress necessitates more job destruction. Job creation
also fails in our model when there is faster technological progress because as the life of
a job becomes shorter, the expected present value o f future profit attributable to a job
falls. It may turn out to be surprising that even when the interest rate is independent of
growth faster growth does not have a countervailing effect on the present discounted
value of profits. Since in the expressions that we have derived for the surplus from a
job the effective discount rate is r - g, profits are discounted at lower rate. So faster
growth has a "capitalization" effect on the profits stream. Our results, however, show
that this capitalization effect is dominated by the negative influence on the present
value calculation implied by the shorter life of a job.
Aghion and Howitt's (1994) model of the adoption of new technology is essentially
the same as the one in this section, yet it has a bigger capitalization effect that is not
always dominated by the shorter life of the job. This effect is implied by the assumption
that there are job set-up costs that have to be paid before the firm begins the recruiting
process. In this case the profit stream is discounted more heavily, since the zero profit
restriction requires that the present discounted value of profits at the date the vacant
job is created must equal to the set-up costs.

6. OECD unemployment differences

We saw in Section 1 that the unemployment experiences of OECD countries over the
last thirty years have been different from each other. This is all the more surprising

1214

1). T. Mortensen and C.A. Pissarides

because with increasing openness and trade, and with the global oil and material shocks
of the 1970s, the shocks affecting OECD countries cannot have been very different
in different countries. The different experience of OECD countries is most likely due
to a different response of each country to common shocks, due to different market
structures, or to differences in policy.
The most frequently discussed contrast in OECD experience is that between the
USA and "Europe". Although the contrast is often exaggerated, especially in the more
popular discussions, there is some truth in the basic argument, that whereas wages at
the lower end of the wage distribution fell in the USA with unemployment remaining
the same on average, in most of Europe wages increased but unemployment increased
too. We saw in Section 1 that there appears to be a trade off between the increase in
wage inequality and the increase in unemployment experienced by OECD countries.
Figure 4 shows that over the 1980s the USA experienced a bigger increase in inequality
and a smaller increase in unemployment (in fact, a decrease) than the major European
countries.
The experience documented in Figure 4 is most likely a response to a heterogeneous
aggregate productivity shock that can be decomposed into two parts, one that shifted
the productivity distribution to the right and one that widened the range of the
distribution for given mean. There has been a long debate in the literature as to whether
the second component of the shock, the one that worsened prospects for unskilled
workers but improved them for skilled ones, was due to a technology shock, associated
for example with computerization, or to a trade shock, associated with the expansion
of trade with newly industrialized nations in South East Asia and Latin America. Our
analysis, and more generally the search and matching framework, is one that can be
used to analyze the consequences of the shocks, whatever their source.
In this section we survey the key influences that have been identified in the literature
as the causes of the experience of OECD countries summarized in Section 1. In a
discussion of this kind, it is difficult to avoid a discussion of labor market policy,
especially if one were to discuss the unemployment experiences of countries like Spain
and Sweden and why they have been different from the median European experience 25.
The detailed modelling and discussion of labor market policies, however, will take us
beyond the scope of our chapter. We mention instead policy influences in passing, using
parameters that we already have in our analysis to represent the effects of policy. Two
parameters in particular are relevant to our discussion, unemployment income b, which
we take also to represent the generosity of the unemployment insurance system, and
the firing cost T , which we take to stand for employment protection legislation. The
active labor market policies pursued by Sweden, and to a lesser degree by some other

2s There has been a large literature on the unemployment experience of each of these cotmtries. For
Spain, see for example, Blanchard et al. (1995), Dolado and Jimeno (1997) and Marimon and Zilibotti
(1998). For Sweden, see Calmfors (1995) and Ljungqvist and Sargent (1995). See also Scarpetta (1996)
for a cross-countryOECD study.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1215

countries, can be shown in the model by reductions in the job creation cost C, though
this does not do justice to the complexity and sophistication of some of the targeted
policies in operation.
6.1. 'Skill-biased' technology shocks

As noted above, changes in technology that raise the productivity of skilled workers
relative to that of unskilled is one of the explanations given for the recent increase in
US wage dispersion. It has been argued that these same shocks may have generated
the observed increases in European unemployment [see the OECD Jobs Study
(1994), Krugman (1994) and others] 26. The reason for the different response is a
different labor market policy regime. In Europe, where higher level of unemployment
compensation, minimum wages, and employment protection restrict accommodation
through downward wage adjustment, the response is likely to be higher unemployment,
particularly among the unskilled. The purpose of this section is to explore this
hypothesis within the equilibrium search and matching framework.
In the Mortensen-Pissarides model, a producing unit is a job-worker match. To
capture skill differences across workers, one can simply reinterpret the parameter p as
an efficiency unit measure of the worker's skill. Given two workers in an identical
match, the relative product per time period of the second worker is equal to the
ratio P2/P~ where pi, i = 1,2, represents the "skill" of each.
Let P, a set of real numbers, represent the set of skill types and G : P --+ [0, 1]
denote the distribution of the labor force population over these types. Given this
formalization, a pure skill-biased shock to technology can be interpreted as a meanpreserving increase in the spread of G. In this section we argue that such a shock will
increase unemployment in the Mortensen-Pissarides framework and that the extent
of the increase is likely to be larger for economies with high level of unemployment
compensation and stringent employment protection laws.
Given the assumption that skill differences are observable, as say they would be
if associated with different levels of education, we can consistently assume that the
labor market is segmented along skill lines. Across markets the reservation levels of
the idiosyncratic shock and market tightness can differ. In the sequel, let R(p) and 0(p)
characterize equilibrium relationships between these two endogenous variables and
worker skill. Obviously, these functions, which satisfy the job creation and job
destruction conditions Equations (2.22) and (2.26), and the steady-state Beveridge
condition (2.3), determine the equilibrium relationship between unemployment and
skill of interest in this section.
The qualitative differences in both market tightness 0 and the reservation value of
the idiosyncratic component of match product R at two different skill levels are readily

26 Acemoglu (1996, 1998) explains changes in unemployment and wage inequality in terms of
endogenoustechnologychanges and changes in labor supply.

1216

D.T. Mortensen and C.A. Pissarides

Table 3
Baseline parameter values
Parameter

Symbol(s)

Value

Discount rate
Matching elasticity
Recruiting cost
Creation cost
Productivity shock frequency
Minimum match product
Value of leisure
Worker's share
Firing Cost

r
tl
m~o)
C
A
y
b
/3
T

0.02 per quarter

0.5
0.3 ,per worker
0.3 per worker
O.1
0.68 per quarter
0.62 per quarter
0.5
0 per worker

predicted by the model. For a more skilled worker, one characterized by a higher
value of general productivity parameter p, the relative opportunity cost of employment,
the ratio b/p, is lower. Given the assumption that hiring and firing costs increase
proportionately with p, the job destruction relation, D D in Figure 6, is lower given
a higher value o f p and the job creation relation C C is unaffected by variation in p.
As a consequence, markets for the more skilled are tighter, unemployment durations
are shorter. Furthermore, the reservation value of idiosyncratic productivity is lower
in markets for the more skilled and, consequently, the incidence of unemployment is
lower. These inferences are consistent with empirical findings to the extent that the
level of education is a good indicator of skill.
As the unemployment rate is a positive number by definition, the fact that it declines
with the skill parameter p implies that the unemployment-skill profile is convex, at
least on average. To the extent that the relationship has this shape, any increase in the
mean-preserving spread of the distribution of relative productivity, defined above as a
'skill-biased' technology shock, will increase unemployment. This effect can explain
the run up in European unemployment rates relative to those in the USA if European
labor policies increase the convexity of the unemployment-skill profile. In short, if
unemployment compensation and employment protection has a larger relative impact
on the unemployment of unskilled workers, then the same 'skill-biased' technology
shock increases unemployment more in countries with these policies.
To ascertain whether this explanation has force, we calibrate a simple version of
the model and then use it to compute the implied unemployment-skill profile for
different policy regimes. A matching function of the Cobb-Douglas form is assumed
with elasticity with respect to unemployment equal to t/, i.e., ln(q(0)) = -t/ln(0). The
distribution of idiosyncratic shocks is assumed to be uniform on the support [7, 1], i.e.,
F ( x ) = (x - y)/(1 - 7)Vx c [7, 1]. The baseline parameters used in the computations are
reported in Table 3. Except for value of income while unemployed b and the minimum

1217

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

.25
0.2
u(0.77, 1.1,p)
u(0.77, 0,p)
u(0.62, 0,p) 0.1

0 0

0.8

0.9

1.1

1.2

1.3

Fig. 8. Unemployment-skillprofiles.

match product },, which are chosen so that the steady-state unemployment rate of a
worker of average skill (p = 1) is 6.5% and the average duration of an unemployment
spell for such a worker is 3 months, values which reflect experience in the USA over
the past twenty years, the parameter values are similar to those assumed and justified
in Mortensen (1994b) and Millard and Mortensen (1997).
To obtain parameters that reflect the European experience, we maintain the same
values of all parameters except for unemployment income b and firing cost T which
are chosen to yield the same average unemployment rate but an average spell duration
of 9 months. The results, b = 0.77 and T = 1.1, are consistent with the fact that
unemployment compensation and the implicit cost of employment protection are both
substantially higher is Europe than in the USA and the fact that unemployment spells
are much longer in Europe.
The computed unemployment-skill profiles for three different policy parameter
combinations are illustrated in Figure 8. Specifically, each curve is a plot of the
equilibrium unemployment function u(b, T , p ) for value of the skill parameter p. The
flattest profile corresponds to low unemployment compensation and no employment
protection policy, the base line case of (b, T) = (0.62, 0). Given a more generous
unemployment compensation but still no employment protection, (b, T) = (0.77, 0),
the profile lies everywhere above the original but is substantially more convex, i.e.,
the steady-state unemployment rate of the less skilled is more responsive to the level
of unemployment compensation. Adding employment protection, as illustrated by the
solid curve representing the case (b, T) = (0.77, 1.1), actually lowers the unemployment
rate of the more skilled but raises that of the unskilled. In short, employment protection
policy induces even more convexity into the unemployment-skill profile.

D.T. Mortensen and C.A. Pissarides

1218

In sum, a given 'skill-biased' technology shock increases unemployment by more

when unemployment compensation and the implicit firing cost associated with
employment protection policy are higher in the Mortensen-Pissarides model. The
magnitudes of the computed differences in unemployment rates across skills suggest
that indeed shocks of this form could well explain the secular rise in European
unemployment rates relative to the USA in the 1980s.
Returning now briefly to the question of participation, recall that alongside the
relative (and absolute) rise in European unemployment there has also been a decline in
participation rates. We saw in this section that once the model is reinterpreted as one
where there are many submarkets, one for each skill, the policy changes that we have
described can be shown to have a bigger impact on the market returns of the lower
skills than those of the higher skills. I f we now require that participation of skill group p
takes place only when the total net r e m m from that group exceeds some fixed cost, any
policy or other change that increases unemployment because of the relative decline in
the returns from a job match will also increase the threshold participation skill, the
one below which no participation takes place. The reasons given here for the rise in
European unemployment are ones that reduce the net returns from the participation
of low skilled workers and so they are ones that can also explain a fall in the overall
participation rate of these groups.

6.2. Mean-preserving shocks to idiosyncratic productivity

A substantial fraction of the increased US wage inequality has also occurred within
identifiable skill and education groups. In the Mortensen and Pissarides model
earnings dispersion of this form could result as a consequence of greater variation
in match specific idiosyncratic productivity. Following Arrow (1965), suppose that the
idiosyncratic component of productivity is written as a function of a multiplicative
parameter h, so

x(h) = x + h(x - 2 ) ,

(6.1)

where h ~> 0 is a parameter and 2 is the mean of the distribution. We shall consider
the effect of a shift in h on the steady-state equilibrium, evaluated in the neighborhood
of the old equilibrium, h = 0. In order to make the analysis more meaningful
for the question in hand, we assume that p2 >~ rU, i.e. that the reservation wage
of the unemployed job seekers is below mean productivity. This ensures that the
multiplicative shock reduces the productivity of at least some active low-productivity
jobs.
Reworking the job creation and job destruction conditions with x(h) replacing x is
straightforward. The job creation condition (2.22) becomes

c -(1-[3)((l+h)(1-R)
q(O)
r + )~

C- T

(6.2)

Ch. 18: Job Reallocation, EmploymentFluctuationsand Unemployment

1219

whereas the job destruction condition (2.26) becomes

P(I +h)R-hp2q P(Ir+;~

+h)J" fR1 (z-R)dF(z) = b - r p T +

cO.

(6.3)

Equilibrium is still shown by the two lines of Figure 6. Higher h shifts the DD line
up, implying higher reservation productivity at all levels of market tightness, because
the productivity of the marginal job is now worse. But higher h also shifts the CC line
to the right, because, for given reservation productivity greater than zero, the benefits
from the higher productivity of jobs above the mean outweigh the costs from the lower
productivity of jobs below the mean, the tail of which is truncated. Thus, job creation
unambiguously goes up at given unemployment stock but the effect of the higher h on
job destruction is ambiguous from the diagram alone. Differentiation of Equations (6.2)
and (6.3) with respect to h, however, shows that at h = 0, the reservation productivity
rises unambiguously (see Appendix A). So both job creation and job destruction rise
at given unemployment when there is a multiplicative productivity shift.
The effect of this shift on unemployment is ambiguous. On impact, unemployment
rises, because job destruction leads job creation, but whether unemployment rises or
falls in steady state depends on whether the direct impact on job destruction or job
creation dominates. The effect on wage inequality is also ambiguous, because, although
the range of productivities falls, the productivity of the marginal job may rise or fall.
The impact on the productivity of the marginal job, when evaluated at h = 0, is given
by

OR(h)
Oh

OR
Oh (2- R).

(6.4)

We note, however, the following. If the impact of the multiplicative shock on

reservation productivity is large, it is more likely that job destruction will dominate
job creation and unemployment will rise in equilibrium, and also that the productivity
of the marginal job will rise (or fall less) than otherwise. If, on the other hand,
the impact of the multiplicative shock is large on market tightness and small on
the reservation productivity, it is more likely that unemployment will eventually
fall and the productivity of the marginal job will also fall. Thus, in countries
where there are conditions that amplify the impact of multiplicative shocks on job
destruction, their consequence is an increase in unemployment associated with a
decrease (or small increase) in inequality. In countries where the reverse happens,
the consequence of multiplicative shocks is to increase inequality but either reduce
or increase unemployment by a smaller amount.
We can identify one factor in our analysis that might play a role in explaining the
difference between the experience of Europe and the USA, though the explanation
cannot be a complete one. This is the parameter representing labor's bargaining
strength,/3. The Appendix shows that higher/3 implies lower impact of h on 0, though
the impact ofh on R is not likely to depend on/3 at plausible values of/3 [more precisely

1220

D.T. Mortensen and C.A. Pissarides

when/3 is in the neighborhood of the elasticity of the matching function with respect to
unemployment, or the elasticity of q(0)]. Therefore, countries with more powerful labor
organization when hit by a shock that increases inequality are likely to experience more
unemployment, through less job creation, than countries with less powerful labor. It is
often asserted that labor is more powerful in Europe than in the USA, either because of
more powerful trade unions or because of legislation that favors labor. So this could be
one factor behind the different unemployment experience of the two continents. With
regard to inequality, however, the model does not have strong predictions 27.
6.3. Other influences

Several other influences on the equilibrium unemployment rate have been investigated
in the empirical literature, in search of the elusive explanation for the rise in European
unemployment. Virtually all the determinants of the equilibrium rate discussed in
Section 3 have been, at one time or another, listed as possible causes of higher
unemployment in Europe. This includes, in addition to unemployment income and
trade union power discussed above, the real rate of interest, taxes on wages, which
reduce the net surplus from a job match, "mismatch", by which is usually meant more
heterogeneity in the labor market and which is represented by a shift of the aggregate
matching function, employment protection legislation, which increases the costs of job
destruction, and on the positive side "active labor market policies", which reduce the
job creation costs and costs of labor to the firm.
As we saw in Section 2.3, higher real rate of interest reduces market tightness but
has ambiguous effects on the reservation productivity. At given unemployment rates
job creation falls. In terms of the Beveridge diagram, real interest rates have ambiguous
impact on the Beveridge curve but rotate the job creation line down. It has been argued,
however, that empirically higher real interest rates have depressed employment in the
OECD, i.e. that the job creation effect dominates over the job destruction effect [Phelps
(1994)].
Taxes on employment reduce the net surplus from the job, so whether they reduce
job creation or not depends on their influence on non-employment income. If nonemployment income is not taxed, their effects on the equilibrium of the model is similar
to a rise of non-employment income, i.e. they reduce job creation and increase job
destruction at given unemployment rate. Taxes, however, may also have distortionary
effects if they are not proportional to incomes, a topic that would take us beyond the
scope of our chapter 28.
27 One prediction is that the lowest wage is almost certain to rise when the multiplicativeshock arrives,
because of the increase in the reservationproductivityand in market tightness. Then, it becomes likely
that the cross effect of h and/3 on the lowest wage is also positive, so countries with less powerful labor
experience more increase in inequality. (These results are not proved here.)
28 Pissarides (1998), Mortensen (1994a), and Millard and Mortensen (1997) all study tax effects using
search equilibrium models. See also Daveri and Tabellini (1997), who explain the slowdown in growth
and rise in unemploymentin Europe by tax increases on labor.

Ch. 18: Job Reallocation, Employment Fluctuations and Unemployment

1221

Mismatch can arise in our framework in the following sense. The aggregate
matching function conceals a lot of heterogeneity in the labor market. It is a convenient
modelling device when our interest is in aggregate changes rather than individual
employment histories. Out of all the interactions between the many heterogeneous
groups in the population, a stable relationship emerges between the job matching rate
and the stocks of aggregate unemployment and vacancies. But if conditions are such
that the type of workers and jobs available change, either in skill requirement or in
location, the aggregate outcome from the interaction between those groups is also
likely to change. An increase in mismatch shifts the aggregate matching function down
at all levels of vacancies and unemployment.
Mismatch bears some relationship to the more commonly discussed, in the
US literature, "sectoral shifts hypothesis", though it is more general [Lilien (1982)].
It also bears some relationship to the older view of "structural" unemployment, which
was thought to be unemployment arising from fast structural change in the economy
as a whole. In Europe, mismatch has been proposed by Jackman et al. (1989), Layard
et al. (1991) and others as a cause of the rise in European unemployment. The
oil, technology and other real shocks of the 1970s and 1980s increased the speed
with which unemployed workers needed to adapt to the changing requirements of
employers. This led to increased mismatch, which increased unemployment at given
vacancies. Although neither the sectoral shifts hypothesis in the USA, nor the mismatch
hypothesis in Europe, has had much success in accounting for a large fraction of
employment fluctuations, we look here at the implications of the mismatch hypothesis
within the search and matching framework.
The argument is that because labor in Europe is less mobile than in the USA, a
problem aggravated by the longer durations of unemployment in Europe, the changing
requirements of jobs lead to bigger and more prolonged shifts of the aggregate
matching function. Mismatch in the formal model is shown as a fall in the productivity
of the aggregate matching process, i.e. a downward shift of the transition rate q(O) at
all values of 0. This shifts the job creation line in Figure 6 down, reducing both
market tightness and the reservation productivity. But in addition, mismatch has the
implication that for given market tightness, the rate of job matching is lower. This
implies, in our model, a shift of the Beveridge curve out, over and above any effects
that there might be through job creation and job destruction. It is this additional shift
in the Beveridge curve that has attracted most attention in the discussions of mismatch
in the search literature 29.
It is clear that the overall effect of increased mismatch on equilibrium unemployment
is uncertain, because of the three interacting effects: less job entry at given

29 See Jackman et al. (1989) for the United Kingdom, Abraham and Katz (1986) and Blanchard and
Diamond (1989) for the USA and Jackman et al. (1990) for an international comparison of Beveridge
ctuve shifts. Andolfatto (1996) incorporates a stochastic shift parameter in the matching fucntion in his
calibrations of the search and matching model.

1222

D.T. Mortensen and C.A. Pissarides

unemployment, less job destruction and less job creation at given vacancies and
unemployment. The empirical literature, however, invariably takes the latter effect,
shown in the diagrams by the outward shift of the Beveridge curve, as the one that
dominates on unemployment. Of course, a sufficient condition for this is that for
given O, the fall in q(O) due to the direct effect of increased mismatch dominate the
fall in )~F(R) due to the indirect effect from the fall in the reservation productivity. But
since the job creation line in the Beveridge curve diagram (Figure 7) rotates down when
mismatch increases, the effect of increased mismatch on equilibrium job vacancies is
thought in the empirical literature to be unimportant. It is this latter property (higher
unemployment at given vacancies), which has been a feature of the 1980s rise in
European unemployment, that has attracted research in this area.
Countries with more restrictions in job separations are ones that have higher values
for the firing cost T. We saw that those countries should experience less job creation
and job destruction at given unemployment rate, through lower R and 0. The effect on
equilibrium unemployment is ambiguous but the effect on job reallocation is negative.
This result might explain why job reallocation rates differ across countries. In an
analysis of the data on job reallocations given in Section 1 and the employment
protection provisions in different countries as constructed by the OECD, Garibaldi et
al. (1997) found a clear relationship between employment protection legislation and
job reallocation. Given, however, the Beveridge curve equation that defines equilibrium
unemployment, there is no reason to expect a correlation between job reallocation and
equilibrium unemployment 30.
Firing costs might also explain, to some extent, the differences between the job
reallocation rates between small and large firms. Usually large firms in Europe are
subject to many more restrictions on firing workers, imposed either by legislation or
by trade unions. In Italy, where there are severe restrictions on job separations in large
firms, many more small firms come into operation and job reallocation rates in those
small firms are comparable to those in the USA [see Contini et al. (1995)].
Finally, lower job creation costs lead to more job creation at given unemployment
and more job destruction. Once again, the effects on equilibrium unemployment
are ambiguous. Many European governments, however, have tried to encourage job
creation by giving incentives which reduce job creation costs. One of the criticisms
levelled against such policies is that they encourage the creation of "unstable" jobs
that do not stay in operation for long periods. This argument is valid in our analysis
but still hiring subsidies may be justified, particularly if the worker's effective share
of match-specific investments in training and information are less than their share of
continuing match surplus [Mortensen (1996)].

30 Bertola and Rogerson(1997) claim that job reallocationrates do not differ as much across countries
as they should be expectedto do, given differencesin firing costs. They explain this by the differences
in wage inequalitythat characterizescountries, and which tends to reducejob reallocationrates.

Ch. 18: Job Reallocation, EmploymentFluctuationsand Unemployment

7. C o n c l u d i n g

1223

remarks

We have demonstrated that the search and matching approach provides a rich
framework for the analysis of aggregate employment fluctuations and of the observed
differences in average unemployment rates across countries. Calibrations o f the
models track the cyclical fluctuations in the job creation and job destruction flows
reasonably well. The framework provides a convenient medium for the analysis
of policy influences on unemployment, which lie at the heart of the explanations
of average unemployment differences across countries. Although there is still no
consensus on the causes of the higher unemployment rates in Europe than in the
USA, we have shown how policy influences, in particular the unemployment insurance
system and employment protection legislation, can contribute to the differences in both
unemployment rates and wage inequality.
Wages in the models that we have examined are determined by a fixed rule that
shares the economic rents that each employer-worker match creates. Other methods
of wage determination are also consistent with our framework and some promising
work is being done in this area of research. We discuss some of this work in our
companion chapter for the Handbook of Labor Economics. Another promising area
of current research is the interaction between technology, capital and labor in markets
with frictions. This area of research provides a natural framework for the analysis of
hold-up problems and problems of obsolescence and growth. We discussed some work
in this area in this chapter but much remains to be done.

Appendix

A. Mathematical

appendix

A. 1. Mean-preserving shifts in productivity

Differentiation of Equation (6.3) with respect to the parameter h and evaluation of the
result at h = 0 gives

I-~[I-F(R)] N=(~-R)-~

(z-R)dF(z)-~cN. (A.1)

Differentiation also of (6.2) with respect to h gives

c~l 0 0 _ 1-[3 [ I _ R _ O R 1
Oq(O) Oh r + )~
~ "

(1.2)

Substitution of OR~Oh from Equation (A.1) into (A.2) reveals that the sign of O0/Oh
is the same as the sign of
1- R -

2 - R - v ~ z f / ( z - R) dF(z)
1- ~

2, [1 - F ( R ) ]

(A.3)

D.T. Mortensen and C.A. Pissarides

1224

Multiplying out the denominator o f Equation (A.3) and collecting terms, we find that
the sign of the terms in (A.3) is the same as the sign of
1 - 2 - -r +- ~ ,

(1 - z) dF(z),

(1.4)

which is unambiguously positive since

1- 2 =

J01

(1 - z) dF(z).

(1.5)

Hence, the effect of higher h is positive on both R and 0.

A.2. Labor's bargaining strength

Differentiation of Equation (6.3) with respect to/3 gives

3~

1-~--~[1-F(R)]

OR_

0/3

1-~

o0]

cO + /3c-~

(A.6)

Differentiation of Equation (6.2) gives

ctl O0
Oq(O)O/3

c
q(0)(1-/3)

1 OR
(1 - / 3 ) r +)~ 0/3'

(A.7)

Substitution of 00/0/3 from Equation (A.7) into (A.6) reveals that the sign of 0R/0/3
is the same as t/-/3. So R reaches a unique maximum at/3 = ~/, which is also the
efficient point, when the search externalities are internalized [see Hosios (1990)].
Although there is no reason why the two parameters should be equal, the usual
restriction on/3 in symmetric bargaining situations is fi = and the empirical evidence
on t/suggests that it is close to 0.5 so the restriction/3 = t/is a convenient simplification
that may be adopted. We shall do so in the derivations in this Appendix. Under the
restriction then that

OR

o/3

- 0,

(A.S)

the effects of labor's bargaining strength on market tightness become

00
0/3-

0
t/(1 -/3)'

(A.9)

Turning now to the question of the cross partials of h and/3 on R and 0, i.e.
on the response of reservation productivity and market tightness to a multiplicative

Ch. 18: Job Reallocation, Employment Fluctuationsand Unemployment

1225

productivity shift in countries with different labor bargaining strength, we immediately

find from Equation (A.9) that
020

OhO/3

00

7/(1 -/3) Oh

< 0.

(A.10)

So in countries with m o r e powerful labor, the positive response o f market tightness to

the productivity shock is smaller. The cross partial o f R is calculated by differentiating
Equation (A. 1) with respect to/3. This shows that the sign o f the cross partial 02R/OhO/3
is the same as the sign o f
1

00

1 - fi oh

020
/3-OhO/3"

(A.11)

Making use o f Equations (A.2) and (A.10), we easily find that the sign o f Equation (A.11) is the same as

/3(1 - r/)
(1 - / 3 ) r/'

(A.12)

i.e., at fl = t/, it is zero.

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AUTHOR INDEX

Amman, H.M. 368, 535

Anderson, E. 564
Anderson, E.W. 368, 369
Ando, A., s e e Modigliani, E 762
Andolfatto, D. 994, 1158, 1173, 1203, 1207,
1221
Andres, J., s e e Blanchard, O.J. 1214
Araujo, A. 323
Arellano, M. 787
Arifovic, J. 455, 465, 472, 521-523, 525-527,
531
Arrow, K. 664, 1033, 1042
Arrow, K.J. 1218
Arthur, W.B. 454, 476, 534
Ascari, G. 1041
Aschauer, D.A. 1656, 1657
Asea, P., s e e Mendoza, E. 1439
Ashenfelter, O. 618, 1038, 1039
Askildsen, J.E. 1074
Atkeson, A. 575, 610, 786, 847, 1298, 1675,
1718, 1720
Atldnson, A.B. 1673, 1676, 1680, 1682, 1718
Attanasio, O.P. 564, 607, 608, 610-613, 752,
753, 756, 759, 769, 777, 779, 781,783, 784,
787, 789-794, 796, 797, 802, 1264, 1655
Auerbach, A.J. 380, 549, 576, 588, 590, 591,
593, 616, 821, 1624, 1634, 1635, 1639,
1652, 1718
Auerbach, A.J., s e e Feldstein, M.S. 904, 906
Auernheimer, L. 1449
Auster, R. 474
Autor, D. 577
Axilrod, S.H. 1493
Azariadis, C. 262, 264, 271, 289, 389, 395,
516, 527, 658, 660, 661, 1035

Abel;A.B: 818,831, 834, 835, 994, 1069,

1237, 1251, 1253, 1265, 1266, 1268, 1271,
1272, 1284, 1285, 1651
Abowd, J. 567, 568, 570, 571,616, 759
Abraham, J. 1039
Abraham, K.G. 1058
Abraham, K.J. 1183, 1221
Abramovitz, M. 208
Abramowitz, M. 865, 887
Acemoglu, D. 852, 1215
Adam, M. 500
Adams, C. 1538
Adelman, EL., s e e Adelman, I. 9
Adelman, I. 9
Ag6nor, RR. 1543, 1572
Aghion, R 264, 665, 672, 715,719, 1157, 1208,
1210, 1213, 1377, 1450, 1454, 1465
Aiyagari, S.R. 442, 547, 552, 566, 567, 983,
1140, 1293, 1631
Aizenman, J. 1497, 1538, 1540
Akaike, H. 217
Akerlof, G. 1344
Akeflof, G.A. 198, 397, 1034, 1035, 1039,
1157, 1200
al Nowaihi, A. 1415, 1422, 1437
Alesina, A. 162, 277-279, 692, 1404, 1416,
..... 1422-1426,...1.430~1432, 1438, 1439, 1446,
1449, 1450, 1454, 1460, 1461, 1464-1466,
1469, 1471, 1518, 1522, 1540
Alesina, A., s e e Tabellini, G. 1456, 1465
Alessie, R. 774, 775
Allais, M. 661, 1309
Alien, D.S. 871
Allen, E 576
Almeida, A. 1432, 1495
Alogoskoufis, G.S. 166, 214, 215
Altonji, J. 615
Altonji, J., s e e Hayashi, E 796
Altonji, J.G. 789
Altug, S. 584, 595, 611,612, 785, 786, 792
Alvarez, E 575, 996
Ambler, S. 944, 1062, 1067
American Psychiatric Association 1325

Bacchetta, P. 1344
Bacchetta, E, s e e Feldstein, M. 1637
Bachelier, L. 1316
Backus, C.K. 549
Backus, D. 1017, 1031, 1270, 1405, 1414,
1415
Backus, D.K. 9, 42, 45, 938, 1316, 1708
I-1

I-2
Bade, R. 1432, 1438
Bagehot, W. 155, 1485, 1515
Bagwell, K. 1125
Bagwell, K., s e e Bernheim, B.D. 1647
Bailey, M.J. 1643
Bairoch, P. 719, 724
Baker, J.B. 1125
Balasko, Y. 427, 506
Balassa, B.A. 705
Balke, N.S. 6, 61, 114, 204, 205, 221
Ball, L. 42, 72, 199, 1023, 1037, 1039, 1041,
1127, 1415, 1499, 1504, 1542, 1632, 1650,
1651
Ball, R. 1321
Ballard, C. 1639
Banerjee, A., s e e Aghion, R 1377
Bange, M.M., s e e De Bondt, W.E 1321
Banks, J. 751, 758, 759, 770, 783, 788,
790-792
Banks, J., s e e Attanasio, O.P. 756, 759, 793,
794
Bannerjee, A.V 1332
Bansal, R. 1255
Barberis, N. 1294, 1322
Barclays de Zoete Wedd Securities 1238
Barkai, H. 1572
Barnett, S. 831
Barnett, W. 538, 540
Barone, E. 702
Burro, R.J. 101, 157, 158, 173, 237, 245, 246,
252, 269, 271,272, 277-281,284, 643, 651,
657, 659, 671, 675, 681, 683-685, 688,
689, 691-694, 696, 943, 974, 1023, 1055,
1155, 1404, 1405, 1411, 1412, 1414, 1415,
1425, 1438, 1439, 1466, 1485-1489, 1637,
1641, 1642, 1645, 1662, 1675, 1702, 1705,
1707
Barsky, R. 43, 558, 564, 565
Barsky, R., s e e Solon, G. 579, 1058, 1102,
1106
Barsky, R., s e e Warner, E.J. 1019
Barsk-y, R.B. 182, 215, 216, 1149, 1237, 1277,
1294-1296, 1653
Barth, J.R. 1657
Bartle, R.G. 76
Barueci, E. 525
Basar, T. 1449
Basu, S. 399, 402, 433, 983, 992, 994, 1069,
1080-1082, 1096, 1097, 1117, 1142
Bates, D.S. 1310, 1324
Baumol, W.J. 252, 269

Author

Index

Baxter, M. 9, 11, 12, 45, 203, 380, 430, 934,

938, 974, 980, 992, 1296, 1404
Bayoumi, T. 161,211,216, 2t7, 219
Bayoumi, T., s e e Mussa, M. 208
Bazaraa, M.S. 331
Bean, C., s e e Blanchard, O.J. 1214
Bean, C.R. 785, 1497
Beaudry, E 99, 395, 413, 592, 1264
Beaulieu, J.J. 801,802, 876 '
Becket, G. 592, 653
Becker, G.S. 317, 1645
Becket, G.S., s e e Ghez, G. 615, 752, 759
Becket, R. 369
Beetsma, R. 1411, 1436, 1438
Bekaert, G. 1281
Bell, D.E. 1313
Bellman, R. 336, 340
Belsley, D. 882, 887, 888, 892
Beltratti, A. 524, 525
Ben-David, D. 265, 278
Ben Porath, Y. 577, 582
Benabou, R. 1017, 1018, 1031, 1128, 1129,
1469, 1472, 1473
B~nabou, R. 268
Benartzi, S. 1290, 1312, 1313
B6nassy, J. 507
Benassy, J.-E 1506
Benhabib, J. 283, 395, 399-405, 408, 412-414,
417, 419, 421,423-427, 431,433-435, 437,
442, 505, 550, 847, 1145, 1449, 1465, 1467,
1472
Benigno, E, s e e Missale, A. i450
Benjamin, D. 161
Bennett, R. 395
Bensaid, B. 1446, 1449
Benveniste, A. 476, 531
Benveniste, L.M. 321
Bergen, M., s e e Dutta, S. 1019, 1020
Bergen, M., s e e Levy, D. 1014, 1015, 1019
Bergen, P.R. 1041
Berger, L.A. 1330
Bergsla'Sm, V. 538
Bernanke, B.S. 68, 72, 76, 83, 89, 91 93, 114,
144, 178, 182-184, 800, 856, 857, 1036,
1343, 1345, 1346, 1352, 1357, 1361, 1363,
1365, 1369, 1371, 1373, 1376-1378, 1495,
1578
Bernard, A.B. 254, 271,287, 288
Bernard, V.L. 1321
Bernheim, B.D. 1646, 1647, 1649, 1654, 1659,
1660

Author

Index

Berry, M., s e e Dreman, D. 1320

Berry, T.S. 1618
Bertocchi, G. 474
Bertola, G. 643, 708, 801, 821,834, 835, 840,
843, 1187, 1222, 1472, 1580
Bertsekas, D.E 326
Besley, T. 856
Betts, C.M. 217
Beveridge, S. 1062, 1143
Bewley, T. 566, 1155
Bhaskar, V. 1037
Bianchi, M. 290, 292
Bikhchandani, S. 1332
Bils, M. 694, 910, 912, 983, 1053, 1059, 1069,
1070, 1072, 1075, 1076, 1078-1081, 1085,
1087, 1102, 1104, 1119, 1120, 1130
Bils, M.J. 579
Binder, M. 271, 1092
Binmore, K. 462
Binmore, K.G. 1188
Bisin, A. 427
Bismut, C., s e e Benabou, R. 1017, 1018,
1031
Bizet, D. 380
Bjorck, A., s e e Dahlquist, G. 337
Black, E 417, 1280, 1310, 1331, 1507
Blackwell, D. 320
Blad, M., s e e B6nassy, J. 507
Blanchard, O.J. 40-42, 211, 216, 217, 391,
416, 471,504, 643,660, 818, 852, 877, 887,
888, 890, 892, 906, 912, 1013, 1030, 1033,
1034, 1036, 1041, 1112, 1130, 1162, 1173,
1176, 1183, 1184, 1194, 1202, 1214, 1221,
1266, 1491, 1634, 1635, 1645, 1650
Blanchard, O.J., s e e Missale, A. 1450
Blank, R. 579
Blinder, A. 587, 750, 1018-1020, 1038
Blinder, A.S. 41,876, 881,887, 893, 903, 904,
907, 908, 910, 1018, 1085, 1118, 1344,
1485, 1499, 1660
Blinder, A.S., s e e Bernanke, B.S. 83, 91, 93
Bliss, C. 1461, 1465
Bliss, R., s e e Fama, E.E 1280
Blomstrom, M. 277, 279, 280
Bloomfield, A. 156
Blume, L.E. 321,322, 474
Blume, L.E., s e e Bray, M. 474
Blundell, R. 572, 602, 611,612, 620, 764, 770,
779, 781,783, 788, 790-792, 797
Bltmdell, R., s e e Banks, J. 758, 759, 770, 783,
788, 790-792

I-3
Boadway, R. 1463
Bodnar, G. 1318
B6hrn, V. 475, 646
Bohn, H. 1465, 1622, 1650, 1691
Boldrin, M. 362, 399, 400, 506, 962, 1062,
1284, 1297, 1465
Bolen, D.W. 1325
Bollerslev, T. 1236, 1280
BoRon, E, s e e Aghion, E 1377, 1450, 1454,
1465
Bona, J.L. 313
Boothe, P.M. 1658
Bordo, M.D. 152, 155-160, 162, 164-167, 182,
184, 185, 194, 202-204, 207-209, 211,215,
217~21, 1404, 1438, 1590
Bordo, M.D., s e e Bayoumi, T. 161
Bordo, M.D., s e e Belts, C.M. 217
Borenstein, S. 1124
Boschan, C., s e e Bry, G. 8
Boschen, J.E 139
Boskin, M.J. 618
Bossaerts, E 454
Bosworth, B., s e e Collins, S. 653
Bourguignon, E, s e e Levy-Leboyer, M. 222
Bovenberg, A.L., s e e Gordon, R.H. 1637
Bovenberg, L., s e e Beetsma, R. 1411
Bowen, W. 619
Bowman, D. 1313
Boyd, W.H., s e e Boleu, D.W. 1325
Boyle, M., s e e Paulin, G. 751
Boyle, E 380
Boyle, P.P., s e e Tan, K.S. 334
Brainard, W.C. 817
Brauch, R., s e e Paulin, G. 751
Braun, R.A. 974
Braun, S.N., s e e K r a n e , S.D. 876, 877
Bray, A. 1290
Bray, M. 454, 463, 465, 466, 473-475, 527
Brayton, E 1043, 1344, 1485
Brayton, E, s e e Hess, G.D. 1485, 1509
Breeden, D. 1246
Breiman, L. 289
Bresnahan, T.E 911,912
Bretton Woods Commission 208
Broadbent, B. 1412
Broadbent, B., s e e Barro, R.J. 1412
Broadie, M., s e e Boyle, P. 380
Brock, W.A. 319, 407, 455, 528, 532, 547, 552,
556, 942, 951, 1507
Brown, C. 585
Brown, E, s e e Ball, R. 1321

1-4
Brown, S. 1242
Browning, E. 1463
Browning, M. 598, 606, 607, 610-612, 750,
752, 771,778, 787, 792, 798, 803
Browning, M., s e e Attanasio, O.P. 607, 608,
610, 611,613, 779, 789, 791, 1655
Browning, M., s e e Blundell, R. 611,612, 779,
781,783, 790, 791
Broze, L. 487, 488
Brugiavini, A. 775
Brugiavini, A., s e e Banks, J. 770, 788
Brumberg, R., s e e Modigliani, E 761
Brumelle, S.L., s e e Puterman, M.L. 336, 338
Brunner, A.D. 104
Brunnel, K. 179, 183, 191, 1025, 1491
Bruno, M. 471, 1090, 1496, 1538, 1539, 1543,
1553
Bry, G. 8
Bryant, R.C. 1043, 1491, 1497, 1516-1518
Bryant, R.R. 1313
Buchanan, J.M. 1631, 1642
Buchholz, T.G. 1643
Buckle, R.A. 1019
Bufinan, G. 1543
Buiter, W. 1030, 1521
Bulirsch, R., s e e Stoer, J. 334
Bull, N. 1675, 1711
Bullard, J. 466, 507, 509, 515, 526
Bullard, J., s e e Arifovie, J. 527
Bulow, J. 1448, 1449
Burdett, K. 1173, 1196
Bureau of the Census 1618, 1619
Burns, A.E 5, 8, 931,934
Burns, A.E, s e e Mitchell, W.C. 8, 44
Burnside, C. 399, 930, 980-985, 994, 1078,
1142, 1162
Burfless, G. 618, 620
Butkiewiez, J.L. 1621

Caballe, J. 578
Caballero, R.J. 399, 749, 771, 794, 801, 802,
821-823, 828, 830, 832, 834-838, 840-842,
844, 846, 847, 852, 855, 856, 994, 1032,
1157, 1158, 1160, 1187, 1210, 1211, 1213,
1472
Caballero, R.J., s e e Bertola, G. 801,821, 834,
840, 843, 1187
Cagan, E 157, 161,203, 1534
Cage, R., s e e Paulin, G. 751
Calmfors, L. 1214

Author

Index

Calomiris, C.W. 169, 181, 183, 187, 191,

1376
Calvo, G.A. 389, 397, 408, 419, 422, 1030,
1032, 1034, 1114, 1346, 1360, 1363, 1389,
1400, 1415, 1428, 1445-1447, 1449, 1450,
1535, 1538, 1539, 1546, 1552, 1554, 1557,
1563, 1564, 1568, 1569, 1571-1573, 1582,
1583, 1587-1589, 1591, 1592, 1596, 1597,
1599-1603, 1605
Cameron, S. 589
Campbell, J. 92
Campbell, J.R. 846, 847, 994
Campbell, J.Y. 763, 764, 769, 784, 930, 961,
1120, 1140, 1141, 1145, 1150, 1235-1238,
1251, 1255, 1257, 1258, 1261, 1264-1266,
1268, 1270, 1272, 1274, 1275, 1280, 1284,
1286, 1290, 1320, 1655
Canavese, AJ. 1543
Canetti, E.D., s e e Blinder, A.S. 1018, 1118
Canjels, E. 55
Canova, F. 283,376, 377, 379
Cantor, R. 1344
Canzoneri, M.B. 159, 160, 1405, 1414, 1415,
1507, 1508
Capie, E 154, 163, 222, 1438
Caplin, A. 849, 850
Caplin, A.S. 801,910, 1031, 1032
Card, D. 580, 1016, 1148
Card, D., s e e Abowd, J. 567, 568, 570, 571,
616, 759
Card, D., s e e Ashenfelter, O. 1038, 1039
Cardia, E. 1655
Cardia, E., s e e Ambler, S. 1062, 1067
Cardoso, E. 1543
Carey, K., s e e Bernanke, B.S. 178, 182
Carlson, J. 473
Carlson, J.A. 904
Carlson, J.A., s e e Buckle, R.A. 1019
Carlson, J.B. 104
Carlstrom, C. 1348, 1357, 1368, 1378, 1379
Carlton, D. 1129
Carlton, D.W. 1018-1020
Carmichael, H.L. 1155
Carpenter, R.E. 876, 881,912, 1344
Carroll, C.D. 567, 572, 573, 593, 759, 762,
769, 771,785, 788;793;'1264, :1344,1653,
1655
Case, K.E. 1323
Casella, A. 1463, 1465
Caselli, E 277-279, 283, 284, 286

Author

Index

Cass, D. 244, 246, 247, 295, 389, 516, 643,

649, 662, 942, 948, 1673
Cass, D., s e e Balasko, Y. 427
Castafieda, A. 380
Cazzavilan, G. 426
Cecchetti, S.G. 182, 217, 876, 1015, 1016,
1018, 1019, 1251, 1265, 1270, 1272, 1294,
1296
Cecchetti, S.G., s e e Ball, L. 1037
Chadha, B. 1031, 1542
Chah, E.Y. 775
Chamberlain, G. 283, 286, 785
Chamberlain, T.W. 1334
Chamley, C. 400, 851, 1439, 1673, 1675, 1693,
1697, 1699
Champsaur, , P. 538, 463
Chan, L. 1321
Chan, L.K.C. 1653
Chandler, L.V. 176
Chang, C.C.Y., s e e Chamberlain, T.W. 1334
Chaff, V.V. 72, 124, 397, 422, 672, 697, 698,
700, 701, 709, 715, 720, 722, 723, 974,
1036, 1037, 1040-1042, 1371, 1448, 1449,
1459, 1488, 1489, 1578, 1673-1676, 1691,
1699, 1708-1710, 1720, 1723
Chari, V.V.,s e e Atkeson, A. 1675, 1718, 1720
Chatterjee, S. 996, 1126
Chatterji, S. 475, 507
Chattopadhyay, S.K., s e e Chatterji, S. 475,
507
Chen, N. 1281
Chen, X. 476, 532
Cheung, C.S., s e e Chamberlain, T.W. 1334
Chevalier, J.A. 1122, 1123
Chiappori, P.A. 391,395, 516
Childs, G.D. 882
Chinn, M., s e e Frankel, J. 1497
Chiffnko, R.S. 815, 817, 1058, 1066, 1086,
1344, 1367
Chiswick, B., s e e Becker, G. 592
Cho, D. 278
Cho, I.-K. 455, 465, 524, 525
Cho, J.O. 974, 976, 1025, 1036
Cho, J.O., s e e Bils, M. 983, 1075, 1079, 1104
Chou, R.Y. 1236, 1280
Chou, R.Y., s e e Bollerslev, T. 1236, 1280
Choudhfi, E.U., s e e Bordo, M.D. 184, 194
Chow, C.-S. 326, 334
Chow, G.C. 1294
Christensen, L.R. 673, 688

1-5
Christiano, L.J. 43, 67-70, 83, 84, 89, 91-94,
99, 108, 109, 114, 115, 124, 137, 143, 144,
314, 329, 330, 339, 347, 349, 350, 355,
362, 364, 367, 369, 370, 376, 377, 379,
426, 504, 547, 764, 881, 888, 909, 952,
962, 974, 1011, 1017, 1018, 1021, 1030,
1038, 1089, 1100, 1296, 1365, 1369, 1708,
1736
Chffstiano, L.J., s e e Aiyagafi, S.R. 1140
Chffstiano, L.J., s e e Boldrin, M. 962, 1284,
1297
Christiano, L.J., s e e Charl, VV 72, 1449, 1673,
1675, 1676, 1691, 1699, 1708 1710, 1720,
1723
Chung, K.L. 299
Clarida, R. 95, 96, 136, 422, 1364, 1368,
1486
Clark, D., s e e Kushner, H. 476
Clark, J.M. 816
Clark, K.B. 602, 1173
Clark, RB., s e e Mussa, M. 208
Clark, T.A. 173
Clark, T.E. 1091, 1485
Cochrane, J. 1120
Cochrane, J.H. 101, 211, 796, 1234, 1246,
1249, 1296
Cochrane, J.H., s e e Campbell, J.Y. 1237, 1251,
1284, 1286
Coe, D.T. 265
Cogley, T. 211,395, 547, 967, 1142, 1503
Cohen, D. 271
Cohen, D., s e e Greenspan, A. 798, 844, 847
Cob_n, R., s e e Modigliani, E 1321
Cole, H.L. 576, 1163, 1194, 1201-1203, 1207,
1446, 1449, 1603
Cole, H.L., s e e Chaff, V.V. 1459
Coleman, T. 601
Coleman, W.J. 367, 380
Coleman II, W.J. 114
Coleman II, W.J., s e e Bansal, R. 1255
Collins, S. 653
Conference Board 43
Congressional Budget Office 1618, 1619, 1621,
1624-1627, 1639, 1640, 1660
Conley, J.M., s e e O'Barr, W.M. 1332
Conlon, J.R. 1032
Constantinides, G.M. 559, 567, 781,803, 1237,
1284, 1291, 1293
Constantinides, G.M., s e e Ferson, W.E. 1284
Contini, B. 1177, 1178, 1180, 1200, 1222
Cook, T. 194, 195, 1493

I-6
Cooley, T.E 42, 69, 97, 101, 115, 124, 137,
376, 380, 408, 411, 549, 847, 954, 962,
974, 1376, 1463, 1736
Cooley, T.E, s e e Cho, J.O. 974, 976, 1025,
1036
Cooper, R. 204, 398, 824
Cooper, R., s e e Azariadis, C. 395
Cooper, R., s e e Chatterjee, S. 996, 1126
Cootner, EH. 1316
Corbo, V. 1543, 1554
Correia, I. 974, 1537, 1675, 1720, 1733
Cossa, R. 584
Council of Economic Advisers 1639
Cox, D. 705
Cox, W.M. 1621
Cox Edwards, A., s e e Edwards, S. 1543, 1554,
1555, 1575
Crawford, V.E 475
Crossley, T., s e e Browning, M. 610, 798
Croushore, D. 1485, 1653
Crucini, M.J. 178, 705
Crucini, M.J., s e e Baxtel, M. 1296
Cukierman, A. 1404, 1414, 1415, 1432, 1437,
1438, 1450, 1456, 1463, 1465
Cukierman, A., s e e Alesina, A. 1424, 1426
Cukierman, A., s e e Brunner, K. 1025
Cummings, D., s e e Christensen, L.R. 673,
688
Cummins, J.G. 822, 856, 1344
Cunliffe Report 161
Currie, D. 454, 504
Cushman, D.O. 95, 96
Cutler, D.M. 797, 1290, 1320, 1321, 1624
Cyrus, T., s e e Frarlkel, J.A. 280
Dahlquist, G. 337
Daniel, B.C. 1647
Daniel, K. 1322
Danthine, J.-P. 329, 370, 952, 962, 1002,
1157
Darby, M.R. 166
Dasgupta, P. 655, 656
d'Autttme, A. 487
DaVanzo, J. 618
Daveri, E 1220
Davidson, J. 750
Davies, J.B. 766
Davis, D. 1033
Davis, P.J. 333
Davis, S.J. 1151, 1152, 1160, 1161, 1176,
1178, 1180, 1194, 1199

Author

Index

Davis, S.J., s e e Attanasio, O.P. 796, 797

Davutyan, N. 156
Dawid, H. 523, 527
De Bondt, W.E 1307, 1320, 1321, 1323
de Fontnouvelle, E, s e e Brock, W.A. 528
De Fraja, G. 1037
De Gregorio, J. 1546, 1551, 1573, 1575, 1577
de Haan, J., s e e Eijffinger, S. 1404, 1438
de la Torre, M. 41
De Melo, J., s e e Corbo, V. 1543
de Melo, J., s e e Hanson, J. 1543
De Melo, M. 1535, 1551
De Pablo, J.C. 1543
de Soto, H. 695
Deaton, A. 752, 756, 764, 771,775, 776, 783,
785, 787, 794, 798, 1344
Deaton, A., s e e Blinder, A. 750
Deaton, A., s e e Browning, M. 611, 612, 752,
787, 792
Deaton, A.S. 1264
Deaton, A.S., s e e Campbell, J.Y. 764
Debelle, G. 1489, 1518, 1522
DeCanio, S. 454, 463
DeCecco, M. 155
Degeorge, E 1321
DeKock, G. 158
DeLong, J.B. 252, 279, 695, 1042, 1290,
1324
DeLong, J.B., s e e Barsky, R.B. 1237, 1277,
1294~1296
den Haau, W.J. 271,347, 354, 369, 994, 1166,
1194, 1203, 1204, 1206, 1207
Denardo, E.V. 320
Denison, E.E 237, 653
Denizer, C., s e e De Melo, M. 1535, 1551
Denson, E.M. 40
Desdoigts, A. 290
DeTray, D.N., s e e DaVanzo, J. 618
Devereux, M. 952, 1466, 1471
Devereux, M., s e e Alessie, R. 775
Devereux, M., s e e Beaudry, P. 395,413
Devereux, M.B. 1126
Devereux, M.B., s e e Beaudry, E 99
Devine, T.J. 1166
Dewatripont, M., s e e Aghion, P. 1157
Dezhbakhsh, H. 1039
Di Tella, G., s e e Canavese, A.J. 1543
Diamond, P. 796
Diamond, P., s e e Shafir, E. 1316
Diamond, EA. 661, 1157, 1161, 1162, 1173,
1188, 1634, 1645, 1684, 1718

Author

Index

Diamond, EA., s e e Blanchard, O.J. 41, 42,

1162, 1173, 1183, 1184, 1194, 1202, 1221
Diaz-Alejandro, C.E 1543
Diaz-Gimenez, J., s e e Castafieda, A. 380
Dickens, W.T., s e e Akerlof, G.A. 198
Dickey, D.A. 53, 54, 212
Dickinson, J. 618
Dicks-Mireaux, L., s e e Feldstein, M. 1633
Diebold, EX. 6, 11
Dielman, T., s e e KaUick, M. 1325
Dixit, A. 824, 829, 844, 1115, 1121, 1126
Dixit, A.K., s e e Abel, A.B. 835
Dixon, H. 537
Dodd, D.L., s e e Graham, B. 1323
Dolado, J. 1437
Dolado, J.J. 1214
Dolde, W. 1318
Dolde, W..C., s e e Tobin, J. 773
Domar, E. 640
Domberger, S. 1019
Dominguez, K. 164, 182
Domowitz, I. 1020, 1083, 1093
Doms, M. 823, 838
Donaldson, J.B., s e e Constantinides, G.M.
1293
Donaldson, J.B., s e e Danthine, J.-P. 329, 370,
952, 962, 1002, 1157
Doob, J.L. 299
Dornbusch, R. 198, 1043, 1543, 1562, 1563,
1565, 1568, 1582, 1590, 1637
Dotsey, M. 370, 952, 974, 1032, 1043, 1522,
1652
Drazen, A. 1463, 1465, 1541, 1580
Drazen, A., s e e Alesina, A. 162, 1450, 1461,
1465, 1540
Drazen, A., s e e Azariadis, C. 262, 264, 271,
289, 527, 658, 660
Drazen, A., s e e Bertola, G. 1580
Drazen, A., s e e Calvo, G.A. 1571
Dreman, D. 1320, 1323
Dreze, J. 770
Drifflll, J., s e e Backus, D. 1405, 1414, 1415
Driskill, R.A. 1042
Drudi, F. 1450
Drugeon, J.E 426
Dueker, M.J. 1485
Duffle, D. 380
Duffle, D., s e e Constantinides, G.M. 567, 781,
1237, 1291
Duffy, J. 257, 439, 473, 500
Duffy, J., s e e Arifovic, J. 527

I-7
Duffy, J., s e e Bullard, J. 526
Duguay, E 215
Dumas, B. 561, 564
Dunlop, J.T. 939, 1059
Dunn, K.B. 800, 1284
Dunne, T., s e e Doms, M. 823, 838
Dupor, B. 994
Durkheim, 1~. 1331
Durlauf, S.N. 254, 262-264, 268, 270, 271,
287, 289, 303, 550, 905 907
Dm-lauf, S.N., s e e Bernard, A.B. 254, 271,287,
288
Dutta, EK. 380
Dutta, S. 1019, 1020
Dutta, S., s e e Levy, D. 1014, 1015, 1019
Dutton, J. 156
Dyl, E.A. 1334
Dynan, K.E. 770

Easley, D., s e e Blume, L.E. 321,322, 474

Easley, D., s e e Bray, M. 474
Easterly, W. 277-279, 281, 675, 703, 1538,
1547, 1553, 1560, 1561
Easterly, W., s e e Bruno, M. 1553
Eaton, J. 719
Eberly, J.C. 801,802, 1344
Eberly, J.C., s e e Abel, A.B. 831, 834, 835,
994
Echenique, E 1551, 1561
Eckstein, O. 1344
Eden, B. 1019, 1023
Edin, D.A. 1457
Edwards, S. 1538, 1543, 1554, 1555, 1575,
1578-1580
Edwards, S., s e e Cukierman, A. 1456, 1465
Edwards, W. 1322
Eichenbaum, M. 83, 94, 96, 99, 100, 137, 184,
549, 550, 785, 799, 800, 803, 885, 888,
905407, 912, 957, 1084
Eichenbaum, M., s e e Aiyagari, S.R. 1140
Eichenbaum, M., s e e Burnside, C. 399, 930,
980-985, 994, 1078, 1142, 1162
Eichenbaum, M., s e e Chaff, VV 72, 1449
Eichenbaum, M., s e e Christiano, L.J. 43, 6770, 83, 84, 89, 91-94, 99, 108, 115, 124,
137, 143, 144, 376, 377, 379, 764, 974,
1011, 1021, 1038, 1089, 1100, 1365, 1369,
1708, 1736
Eichenbaum, M.S., s e e Christiano, L.J. 881,
888

I-8
Eichengreen, B. 152, 154-157, 160, 162 164,
168, 178, 185, 187, 189, 204, 208, 209,
211,219, 1449, 1465, 1590
Eichengreen, B., s e e Bayolmai, T. 211, 216,
217, 219
Eichengreen, B., s e e Bordo, M.D. 162
Eichengreen, B., s e e CaseUa, A. 1463, 1465
Eijffinger, S. 1404, 1432, 1438
Eisner, R. 817, 1310, 1621, 1622
Ekeland, I. 1689
E1 Karoui, N. 835
Elias, V.J. 673
Ellison, G. 475, 1124
Ellson, R.E., s e e Bordo, M.D. 157
Elmendorf, D.W. 1439
Elmendorf, D.W., s e e Ball, L. 1650, 1651
Elmendorf, D.W., s e e Feldstein, M. 1656
Emery, K.M. 215
Emery, K.M., s e e Balke, N.S. 114
Engel, E., s e e Caballero, R.J. 801, 802, 821,
835-838, 840-842, 994, 1032, 1158
Engelhardt, G. 1344
Engle, R., s e e Bollerslev, T. 1280
Engle, R.E 50
Engle, R.E, s e e Chou, R.Y. 1236, 1280
Englund, E 9
Epstein, L.G. 556, 558, 564, 565, 744, 769,
1250, 1256
Erceg, C. 1041
Erceg, C.J., s e e Bordo, M.D. 182
Eriksson, C. 1208
Erlieh, D. 1314
Ermoliev, Y.M., s e e Arthur, W.B. 476
Escolano, J. 1718
Esquivel, G., s e e Caselli, E 277-279, 283,284,
286
Esteban, J.-M. 264
Estrella, A. 43, 1281, 1485
Evans, C. 982
Evans, C.L. 105
Evans, C.L., s e e Bordo, M.D. 182
Evans, C.L., s e e Christiano, L.J. 67, 68, 70, 83,
84, 89, 91-94, 99, 108, 137, 143, 144, 1011,
1021, 1038, 1089, 1100, 1365, 1369
Evans, C.L., s e e Eiehenbaum, M. 83, 94, 96,
137
Evans, G.W. 425, 426, 453-455, 461-465, 468,
470, 472-478, 480, 481, 483, 484, 487,
489-492, 495-497, 500, 502, 504-507,
509-513, 516, 518-521,526-528, 530-532,
1025, 1125

Author

Index

Evans, M. 182
Evans, P. 283, 1635, 1647, 1656-1659
Faig, M. 1675, 1720
Fair, R. 1416, 1425
Fair, R.C. 876, 1077, 1491
Fair, R.C., s e e Dominguez, K. 182
Falcone, M. 326
Fallick, B.C. 855
Fama, E.E 1235, 1280, 1281, 1307, 1316,
1320-1323
Farber, H. 1200
Farmer, R. 662, 1002
Farmer, R.E. 391,395, 396, 411-414, 427-430,
434, 437, 500, 505
Farmer, R.E., s e e Benhabib, J. 395, 399-402,
408, 412-414, 417, 425,427, 431,433-435,
442, 505
Farrell, J. 1121
Faust, J. 69, 217, 1416, 1425, 1437
Fanvel, Y. 1573
Favaro, E. 1554, 1555
Fay, J.A. 1077, 1103
Fazzari, S.M. 818, 1344
Fazzari, S.M., s e e Carpenter, R.E. 881,912,
1344
Fazzari, S.M., s e e Chirinko, R.S. 1066, 1086
Featherstone, M. 1332
Federal Reserve Board 176
Feenberg, D. 60
Feenstra, R. 1569
Feenstra, R.C., s e e Bergen, ER. 1041
Feiwel, G.R. 535
Feldman, M. 474
Feldstein, M. 44, 197, 1485, 1497, 1498, 1622,
1631, 1633, 1636, 1637, 1639, 1656, 1660
Feldstein, M.S. 904, 906
Felli, E. 1083, 1122
Fellner, W. 641,657
Ferejohn, J. 1425
Fernald, J.G., s e e Basu, S. 399, 402, 433, 994,
1117, 1142
Fernandez, R. 1543, 1562
Ferris, S.P. 1314
Ferson, W.E. 1284
Festinger, L. 1314
Fethke, G. 1037
Fiebig, D.G., s e e Domberger, S. 1019
Filippi, M., s e e Contini, B. 1177, 1178, 1180,
1222
Fillion, J.E 1498

Author

Index

Finch, M.H.J. 1543

Finegan, T.A, s e e Bowen, W. 619
Finn, M. 981, 1091
Fiorina, M. 1425
Fischer, A.M., s e e Dueker, M.J. 1485
Fischer, S. 182, 197, 202, 215, 216, 1025,
1026, 1155, 1404, 1405, 1438, 1449, 1489,
1496, 1498, 1538, 1542, 1547, 1561, 1582
Fischer, S., s e e Blanchard, O.J. 471,643, 660,
1013, 1033, 1034, 1036, 1491, 1635
Fischer, S., s e e Bruno, M. 1538
Fischer, S., s e e Debelle, G. 1489, 1518, 1522
Fischhoff, B, 1319, 1326
Fischhoff, B., s e e Lichtenstein, S. 1318
Fishe, R.P.H. 173
Fisher, I, 154, 157, 203, 1316, 1321, 1343,
1372, 1377, 1485
Fisher, J. 92
Fisher, J., s e e Boldrin, M. 962, 1284, 1297
Fisher, J., s e e Christiano, LA. 314, 347, 349,
350, 355, 362, 364, 962, 1296
Fisher, J.D.M. 910, 1368, 1375, 1376, 1378
Fisher, J.D.M., s e e Campbell, J.R. 846
Fishlow, A. 155
Flandreau, M. 154
Flannery, B.P., s e e Press, W.H. 329-334, 343,
348, 356, 365
Flavin, M. 572, 749, 763, 784
Flemming, J.S. 773
Flood, R.R 152, 158, 202, 408, 1428, 1429,
1438, 1507, 1595, 1596
Flood, R.P., s e e Garber, P.M. 165
Florovsky, G. 1326
Forbes, K. 277, 278
Ford, A.G. 155
Fore, D., s e e Roseveare, D. 1626
Foresi, S., s e e Backus, D.K. 1316
Forteza, A., s e e Echenique, E 1551, 1561
Fortune, P. 1310
Foufoula-Georgiou, E., s e e Kitanidis, EK.
326
Fourgeaud, C. 454, 465, 473, 475
Fox, B.L. 326
Foxley, A. 1543
Frankel, J. 1497
Frankel, J.A. 280, 281, 1590, 1637
Franses, RH. 289
Fratianni, M. 1431
Freeman, R, 577
Fregert, K. 1016
French, K. 1280

I-9
French, K.R., s e e Fama, E.E 1235, 1281, 1320,
1323
Frenkel, J.A. 203, 1630
Frenkel, J.A., s e e Aizenman, J. 1497
Frennberg, P. 1238
Friedman, B.M. 43, 44, 1632, 1642
Friedman, D. 475
Friedman, J.H, s e e Breiman, L. 289
Friedman, M. 46, 48, 61, 137, 154, 160, 162,
168, 172, 176, 179, 180, 185, 189, 195, 203,
222, 275, 376, 572, 761, 762, 943, 1011,
1173, 1325, 1485, 1488, 1496, 1537, 1674,
1720
Froot, K. 1266, 1316
Frydman, R. 453, 454, 474, 528, 536, 539
Fuchs, G. 464, 474
Fudenberg, D. 455, 475, 1155
Fudenberg, D., s e e Ellison, G. 475
Fuerst, T. 99, 974, 1378
Fuerst, T.~ s e e Carlstrom, C, 1348, 1357, 1368~
1378, 1379
Fuhrer, J.C. 454, 905, 908, I039, 1040, 149I,
1518
Fuhrer, J.C., s e e Carroll, C.D. 769, 785
Fukuda, S.-i, 875
Fuller, W.A., s e e Dickey~ D.A. 53, 54, 212
Fullerton, D. 576, 588, 616
Funldaouser, R. 699
Futia, C. 299
Galbraith, J.K. 1182
Gale, D. 389, 475, 849, 851, 1376
Gale, D., s e e Chamley, C. 851
Gale, W.G. 1646
Galeotti, M. 909, 1086, 1124
Gali, J. 395, 405~407, 426, 429, 434, 993, 994,
1117, 1119, 1120, 1129
Gali, J. 67, 69, 217
Gali, J., s e e Benhabib, J. 424
Gali, J., s e e Clarida, R. 96, 136, 422, 1364,
1368, 1486
Gallarotti, G.M. 154
Gallego, A.M. 321,322
Galor, O. 262, 263, 272, 660
Gandolfi, A.E., s e e Darby, M.R. 166
Garber, P.M. 165, 1323, 1543
Garber, EM., s e e Eichengreen, B. 187, 189
Garber, P.M., s e e Flood, R.P. 408, 1595, 1596
Garcia, R. 790
Garibaldi, P. 1180 1222
Garratt, A. 504

1-10
Garratt, A., s e e Carrie, D. 454, 504
Garriga, C. 1675, 1718
Gaspar, J. 324, 369
Gastil, R.D. 689
Gatti, R., s e e Alesina, A. 1432
Gavin, W. 1485
Geanakoplos, J.D. 395, 458, 1322
Gear, C.W. 346
Geczy, C.C., s e e Brav, A. 1290
Gelb, A., s e e De Melo, M. 1535, 1551
Genberg, H. 165, 1428
Geoffard, RY., s e e Chiappori, RA. 391
Gerlach, S., s e e Baechetta, E 1344
Gersbach, H. 1376
Gertler, M. 83, 92-94, 1040, 1343, 1348, 1366,
1373, 1374, 1376-1378
Gertler, M., s e e Aiyagari, S.R. 1293, 1631
Gertler, M., s e e Bernanke, B.S. 92, 144, 183,
856, 857, 1036, 1345, 1346, 1352, 1357,
1365, 1369, 1371, 1373, 1376-1378, 1578
Gertler, M., s e e Clarida, R. 95, 96, 136, 422,
1364, 1368, 1486
Geweke, J. 34, 334
Geweke, J., s e e Barnett, W. 540
Geweke, J.E 89
Ghali, M., s e e Surekha, K. 908
Ghez, G. 615, 752, 759
Ghezzi, E 1572
Ghosh, A.R. 202, 207, 208
Giavazzi, E 167,203, 1438, 1446, 1449, 1580
Giavazzi, E, s e e Missale, A. 1450
Gibson, G.R. 1307
Gigerenzer, G. 1308, 1318
Gilbert, R.A. 195
Gilchrist, S. 847, 1344
Gilchrist, S., s e e Bernanke, B.S. 856, 1036,
1345, 1373, 1376
Gilchrist, S., s e e Gertler, M. 83, 92-94, 1366,
1373, 1374, 1376
Gill, EE. 329
Gilles, C., s e e Coleman II, W.J. 114
Gilson, R.J. 1154
Giovannini, A. 156, 158, 160, 166, 169, 380
Giovannini, A., s e e Giavazzi, F. 167
Gizycki, M.C., s e e Gruen, D.K. 1316
Glasserman, E, s e e Boyle, E 380
Glazer, A. 1456, 1465
Glomm, G. 712, 1472
Glosten, L. 1280
Goetzmann, W., s e e Brown, S. 1242

Author

Index

Goetzmann, W.N. 1242, 1252, 1314, 1320,

1333
Goff, B.L. 159
Gokhale, J. 750
Gokhale, J., s e e Auerbach, A.J. 1624
Goldberg, RK., s e e Attanasio, O.P. 777
Goldfajn, I., s e e Dornbusch, R. 1590
Goldstein, M., s e e Mussa, M. 208, 1637
Gomes, J. 994, 1159
Gomme, R 962, 1062
Gomme, R, s e e Andolfatto, D. 1173
Gomme, R, s e e MacLeod, W.B. 1157
Goodfriend, M. 88, 120, 121, 156, 173, 191,
194-196, 764, 1013, 1117, 1346, 1509,
1514, 1515
Goodhart, C., s e e Capie, E 154
Goodhart, C.A.E. 193
Goodhart, C.A.E., s e e Almeida, A. 1432,
1495
Goodhart, C.E.A. 1438, 1495, 1507, 1508,
1514
Goodman, A. 797
Goolsbee, A. 839, 843, 848
Gordon, D.B. 128, 134
Gordon, D.B., s e e Barro, R.J. 158, 1155, 1405,
1411, 1415, 1438, 1485-1489
Gordon, D.B., s e e Leeper, E.M. 69
Gordon, R. 1030
Gordon, R.H. 1637
Gordon, R.J. 40, 46, 48, 49, 181, 1542
Gordon, R.J., s e e Balke, N.S. 6, 61,204, 205,
221
Gorman, W.M. 553, 556, 782, 803
Gorton, G., s e e Calomiris, C.W. 181
Gottfries, N. 463, 1121, 1122
Gould, D.M. 1551, 1559, 1561
Gourieroux, C. 487
Gourieroux, C., s e e Broze, L. 487, 488
Gourieroux, C., s e e Fourgeaud, C. 454, 465,
473, 475
Gourinchas, E-O. 609, 1344
Graham, B. 1323
Graham, EC. 1656, 1657
Grandmont, J.-M. 439, 454, 460, 464, 474,
475, 481,507, 514, 526, 661
Granger, C. 34
Granger, C.W.J. 881,903
Granger, C.W.J., s e e Engle, R.E 50
Gray, J.A. 1025, 1026, 1038
Green, D., s e e MaCurdy, T.E. 619, 620
Green, E. 575

Author

Index

Green, I-I., s e e Beaudry, P. 592

Greenberg, D., s e e Burtless, G. 618
Greenberg, D.H., s e e DaVanzo, J. 618
Greenspan, A. 199, 798, 844, 847, 1630
Greenwald, B. 857, 1122, 1377
Greenwood, J. 380, 550, 576, 664, 692, 962,
980, 995
Greenwood, J., s e e Cooley, T.E 847
Greenwood, J., s e e Gomes, J. 994, 1159
Greenwood, J., s e e Gomme, P. 962, 1062
Gregory, A.W. 376, 377
Gregory, A.W., s e e Devereux, M. 952
Grier, K.B. 253
Griffiths, M., s e e Dolado, J. 1437
Griliches, Z. 541
Grilli, V. 95, 1404, 1432, 1438, 1439, 1465
Grilli, V., s e e Alesina, A. 1430
Gfilli, V., s e e DeKock, G. 158
Grilli, V., s e e Drazen, A. 1463, 1465, 1541
Grilli, V.U. 169
Gros, D., s e e Adams, C. 1538
Gross, D. 857, 1344
Gross, D.B., s e e Goolsbee, A. 839
Grossman, G.M. 264, 639, 672, 715, 1210,
1464
Grossman, H.J. 158, 1415, 1449
Grossman, S.J. 801, 1237, 1242, 1246, 1268,
1291, 1293
Grout, EA. 852
Gruen, D.K. 1316
Guerra, A. 1546, 1606, 1607
Guesnerie, R. 439, 454, 460, 464, 465, 474,
475, 506, 511,516, 526
Guesnerie, R., s e e Chiappori, P.A. 391, 395,
516
Guesnerie, R., s e e Evans, G.W. 464
Guidotti, EE. 1537, 1588, 1603, 1675, 1720
Guidotti, EE., s e e Calvo, G.A. 1447, 1450
Guidotti, EE., s e e De Gregorio, J. 1546, 1551,
1573, 1575, 1577
Guiso, L. 772
Guiso, L., s e e Galeotti, M. 909
Gulde, A.M., s e e Ghosh, A.R. 202, 207, 208
Gultekin, M. 1317
Gultekin, N.B., s e e Gultekin, M. 1317
Guo, J.-T., s e e Farmer, R.E. 395, 427-430, 434,
505
Guo, J.-T. 416, 427
Gurley, J.G. 1507
Gust, C. 1041
Guttman, E, s e e Erlich, D. 1314

1-11
Haberler, G. 185
Hahn, E 661
Hahn, T., s e e Cook, T. 194, 1493
Hahn, W. 479
Hairault, J.-O. 1036
Haldane, A.G. 1432, 1438, 1485, 1495, 1497
Haley, W.J. 585
Hall, G. 911
Hall, R.E. 399, 556, 573, 595, 607, 608, 673,
679, 680, 683-686, 702, 765, 767-769,
784, 789, 791, 794, 817, 856, 930, 982,
1068, 1070, 1079, 1089, 1092, 1095, 1096,
1141-1143, 1145, 1151-1153, 1157, 11601164, 1200, 1261, 1485, 1493, 1498, 1655,
1656
Hall, S., s e e Currie, D. 454, 504
Hall, S., s e e Garratt, A. 504
Hailerberg, M. 1460, 1465
Haltiwanger, J., s e e Caballero, R.J. 821, 837,
838, 840-842, 1158
Haltiwanger, J., s e e Cooper, R. 824
Haltiwanger, J.C. 881
Haitiwanger, J.C., s e e Abraham, K.G. 1058
Haltiwanger, J.C., s e e Davis, S.J. 1151, 1152,
1160, 1161, 1176, 1178, 1180, 1194, 1199
Hamermesh, D. 577
Hamilton, A. 1659
Hamilton, J. 963
Hamilton, J.D. 12, 72, 80, 182, 1118, 1265
Harnmerlin, G. 344
Hammour, M.L., s e e Caballero, R.J. 846, 847,
852, 855, 856, 1157, 1158, 1160, 1187,
1210, 1211, 1213, 1472
Hannerz, U. 1332
Hansen, B. 1194
Hansen, B.E. 38, 39
Hansen, G.D. 547, 55l, 602, 976, 977, 1200
Hansen, G.D., s e e Cooley, T.E 69, 97, 101,
115, 124, 137, 380, 408, 411,974, 1736
Hansen, L.P. 547, 555, 556, 558, 572-574, 768,
769, 784, 882, 915, 1234, 1246, 1249, 1250,
126l, 1294, 1295
Hansen, L.P., s e e Anderson, E.W. 368, 369
Hansen, L.P., s e e Cochrane, J.H. 1234, 1246,
1249
Hansen, L.P., s e e Eichenbaum, M. 549, 550,
785, 799, 800, 803
Hanson, J. 1543
Hansson, B., s e e Frennberg, P. 1238
Harberger, A.C. 1554, 1590

1-12
Harden, I., s e e von Hagen, J. 1439, 1460,
1465
Hardouvelis, G.A. 1281
Hardouvelis, G.A., s e e Estrella, A. 43, 1281
Harris, R., s e e Cox, D. 705
Harrison, A. 277, 279, 280
Harrison, S.G., s e e Christiano, L.J. 426
Harrison, S.H. 402
Harrod, R. 640
Hart, O. 852, 1154
Hartwick, J. 656
Harvey, A.C. 9
Harvey, C.R. 1236, 1280
Hashimoto, M. l 152
Hassett, K.A. 815, 818, 843, 1344
Hassett, K.A., s e e Auerbach, A.J. 821
Hassett, K.A., s e e Cummins, J.G. 822, 856,
1344
Hassett, K.A., s e e Fallick, B.C. 855
Hassler, J. 9, 1238
Haug, A.A., s e e Dezhbakhsh, H. 1039
Haugen, R.A., s e e Ferris, S.P. 1314
Hause, J.C. 569
Hausman, J. 620
Hausman, J., s e e Burtless, G. 620
Hawley, C.B., s e e O'Brien, A.M. 776
Hayashi, E 773, 775, 776, 785, 788, 790, 796,
800, 818, 1649
Head, A., s e e Devereux, M.B. 1126
Heal, G., s e e Dasgupta, E 655, 656
Heal, G.M., s e e Ryder Jl, H.E. 1284
Heaton, J. 380, 547, 569, 803, 1242, 1255,
1284, 1293
Heckman, J.J. 576, 578, 579, 582, 584-587,
590, 592, 593, 595, 601-603, 605, 615-617,
620-624, 752, 759, 1166
Heckman, J.J., s e e Ashenfelter, O. 618
Heckman, J.J., s e e Cameron, S. 589
Heckman, J.J., s e e Cossa, R. 584
Heckman, J.J., s e e Killingsworth, M.R. 550,
601, 1148
Heijdra, B.J. 1119, 1120, 1126
Heinemann, M. 495, 525
Hellwig, M., s e e Gale, D. 1376
Helpman, E. 203, 1580
Helpman, E., s e e Coe, D.T. 265
Helpman, E., s e e Drazen, A. 1580
Helpman, E., s e e Grossman, G.M. 264, 639,
672, 715, 1210, 1464
Hendershott, RH. 1333
Henderson, D.W. 1497

Author

Index

Henderson,D.W., s e e Bryant, R.C. 1491, 1497,

1516
Henderson, D.W., s e e Canzoneri, M.B. 160,
1507, 1508
Hendry, D., s e e Davidson, J. 750
Hercowitz, Z. 664
Hercowitz, Z . , s e e Barro, R.J. 1023
Hercowitz, Z., s e e Greenwood, J. 550, 664,
962, 980
Herrendorf, B. 1415, 1436, 1438
Hess, G.D. 9, 1485, 1509
Hester, D.A. 871
Heston, A., s e e Summers, R. 238, 301, 640,
673-675, 677, 680, 681,689, 720
Hetzel, R.L. 180
Heymann, D. 506, 1539, 1540, 1543
Hibbs, D. 1400, 1425
Hildenbrand, W. 535, 537
Himarios, D., s e e Graham, EC. 1656, 1657
Himmelberg, C.R, s e e Gilchrist, S. 1344
Hiriart-Urruti, J.B. 331
Hirschhorn, E., s e e Cox, W.M. 1621
Hirschman, A. 1540
Hirshleifer, D., s e e Bikhchandard, S. 1332
Hirshleifer, D., s e e Daniel, K. 1322
Hobijn, B., s e e Franses, EH. 289
Hodrick, R. 9, 12, 34, 428, 931,932
Hodrick, R.J., s e e Bekaert, G. 128l
Hodrick, R.J., s e e Flood, R.P. 1507
Hoelscher, G. 1658
Hoffmaister, A. 1561, 1589
Hoffman, D.L. 51,412
Hoffmann, K.-H., s e e Hammerlin, G. 344
Holbrook, R. 569
Holmstrom, B. 1376, 1417, 1418, 1425
Holt, C.A., s e e Davis, D. 1033
Holt, C.C. 882, 885, 888, 909, 910, 912
Holtham, G., s e e Bryant, R.C. 1491, 1497,
1516
Holtz-Eakin, D., s e e Blinder, A.S. 41
Hommes, C.H. 529, 532
Hommes, C.H., s e e Brock, W.A. 455, 528,
532
Honkapohja, S. 464, 481,507, 535
Honkapohja, S., s e e Evans, G.W. 425, 426,
454, 455, 46I, 464, 465, 468, 470, 472-478,
480, 481,483,484, 487, 489-492, 495-497,
502, 504-507, 509-513, 516, 518-521,
526-528, 530-532, 1025
Hooker, M.A., s e e Fuhrer, J.C. 454

Author

Index

Hooper, P., s e e Bryant, R.C. 1043, 1491, 1497,

1516-1518
Hopenhayn, H. 672, 708, 994
Hopenhayn, H.A. 844
Horioka, C., s e e Feldstein, M. 1636
Horn, H. 1415
Hornstein, A. 549, 996
Hornstein, A., s e e Fisher, J.D.M. 910
Horvath, M. 994
Horvath, M., s e e Boldrin, M. 962, 1062
Hoshi, T. 1344
Hosios, A.J. 1193, 1224
Hotz, V.J. 792, 803
Houthakker, H.S. 803
Howard, R. 336
Howitt, E 389, 399, 455, 506, 507, 514, 515,
517, 521,527, 1174, 1508
Howitt, E, s e e Aghion, P. 264, 665, 672, 715,
719, 1208, 1210, 1213
Howrey, E.P., s e e Fair, R.C. 1491
Hoynes, H.W., s e e Attanasio, O.P. 753
Hsieh, C.-T. 673,687
Hubbard, R.G. 567, 569, 572, 573, 593, 771,
776, 794, 797, 856, 1344, 1376, 1660
Hubbard, R.G., s e e Cummins, J.G. 822, 1344
Hubbard, R.G., s e e Domowitz, I. 1020, 1083,
1093
Hubbard, R.G., s e e Fazzari, S.M. 818, 1344
Hubbard, R.G., s e e Gertler, M. 1376
Hubbard, R.G., s e e Hassett, K.A. 815, 818,
843, 1344
Huberman, G., s e e Kahn, C. 1154
Huffrnan, G.W. 437
Huffrnan, G.W., s e e Greenwood, J. 380, 962,
980
Huggett, M. 380, 576, 593
Hulten, C. 664
Hultgren, T. 1100
Humphrey, T.M. 1485
Humphreys, B.R. 909
Hurd, M.D. 780
Hybels, J., s e e Kallick, M. 1325
Hyslop, D., s e e Card, D. 1016
Ibbotson, R. 1321
Iden, G., s e e Barth, J.R. 1657
Ikenberry, G.J. 163
Im, K. 283
Imrohoroglu, A. 797
Ingberg, M., s e e Honkapohja, S. 535
Ingram, B. 984

1-13
Inman, R., s e e Bohn, H. 1465
Intriligator, M., s e e Griliches, Z. 541
Ireland, P.N. 129, 194, 1036, 1492, 1494,
1497
Irish, M., s e e Browning, M. 611, 612, 752,
787, 792
Irons, J., s e e Faust, J. 1416, 1425
Irwin, D.A. 178
Isard, E, s e e Flood, R.P. 158, 1429, 1438
Islam, N. 283-285, 287, 653
Ito, T. 1425
Iwata, S., s e e Hess, G.D. 9
Jackman, R. 1221
Jackxnan, R., s e e Layard, R. 1098, 1176, 1177,
1221
Jackwerth, J.C. 1310
Jaeger, A., s e e Harvey, A.C. 9
Jaffee, D.M. 1376
Jagannathan, R., s e e Glosten, L. 1280
Jagannathan, R., s e e Hansen, L.E 547, 1234,
1246, 1249
James, H., s e e Bernanke, B.S. 183, 184
James, W. 1330
Janis, I. 1332
Jappelli, T. 776, 780, 790, 1344
Jappelli, T., s e e Guiso, L. 772
Jeanne, O. 156, 1041
Jeanne, O., s e e Bensaid, B. 1446, 1449
Jefferson, P.N. 1485, 1509
Jegadeesh, N. 1321
Jegadeesh, N., s e e Chan, L. 1321
Jensen, H. 1415, 1427
Jensen, H., s e e Beetsma, R. 1436, 1438
Jensen, M. 1344
Jeon, B.N., s e e von Fttrstenberg, G.M. 1333
Jermann, U.J. 1296
Jermalm, U.J., s e e Alvarez, E 575
Jermann, U.J., s e e Baxter, M. 980, 992
Jewitt, I., s e e Buiter, W. 1030
Jimeno, J.E, s e e Blanchard, O.J. 1214
Jimeno, J.E, s e e Dolado, J.J. 1214
John, A., s e e Cooper, R. 398
Johnson, H.G. 702, 704, 705
Johnson, E, s e e Goodman, A. 797
Johnson, P.A., s e e Durlauf, S.N. 254, 263, 264,
270, 271,289, 303
Johnson, EG., s e e Banks, J. 751
Johnson, S.A. 345, 381
Jones, C.I. 237, 264, 290, 292, 672, 696,
714-716, 718, 719

1-14
Jones, C.I., s e e Hall, R.E. 673, 679, 680,
683-686, 702, 856
Jones, L.E. 245, 257, 261, 380, 672, 709,
711-713, 720, 1675, 1711
Jones, L.E., s e e Chaff, V.V. 715, 1578
Jones, M. 1540
Jonsson, G. 1404, 1411, 1415, 1426, 1438
Jonung, L. 159, 1485
Jonung, L., s e e Bordo, M.D. 152, 215, 217,
220, 221
Jonung, L., s e e Fregert, K. 1016
Jorda, O. 881
Jorgenson, D. 664
Jorgenson, D.W. 817
Jorgenson, D.W., s e e Christensen, L.R. 673,
688
Jorgenson, D.W., s e e Hall, R.E. 817
Jorion, P., s e e Goetzmann, W.N. 1242, 1252,
1320
Jovanovic, B. 702, 848, 1200
Jovanovic, B., s e e Greenwood, J. 664, 692
Judd, J.P. 1485, 1487, 1512, 1516
Judd, K. 590, 1652
Judd, K., s e e Bizer, D. 380
Judd, K.J., s e e Gaspar, J. 324, 369
Judd, K.L. 314, 324, 340, 343, 347, 348, 350,
354, 1673, 1675, 1694
Judson, R. 663
Judson, R., s e e Porter, R. 1509
Juhn, C. 569, 619
Jun, B. 474
Juster, ET. 777
Juster, T., s e e Barsky, R. 558, 564, 565
Kaas, L., s e e B6hm, V 646
Kafka, A. 1543
Kahaner, D. 329, 333
Kahn, C. 1154
Kahn, C.M., s e e Blanchard, O.J. 391,504
Kahn, J., s e e Crucini, M.J. 178, 705
Kahn, J.A. 897, 910
Kahn, J.A., s e e Bils, M. 910, 912, 1053, 1078,
1079, 1085
Kahneman, D. 1308, 1309, 1311
Kahneman, D., s e e Thaler, R.H. 1313
Kahneman, D., s e e Tversky, A. 1308, 1315,
1319, 1330
Kalaba, R., s e e Bellman, R. 340
Kaldor, N. 237, 238, 240, 640, 941
Kalecki, M. 1054
Kallick, M. 1325

Author

Index

Kamihigashi, T. 428
Kaminsky, G.L. 1550, 1553, 1590
Kandel, S. 1235, 1252, 1253, 1265, 1270,
1272
Kandoff, M. 475
K a n e , A . , s e e Chou, R.Y. 1236, 1280
Kaniovski, Y.M., s e e Arthur, W.B. 476
Kaplan, S.N. 856, 1344
Karatzas, I., s e e E1 Karoui, N. ' 835
Karras, G., s e e Cecchetti, S.G. 217
Kashyap, A.K. 137, 877, 88l, 886, 903, 906,
912, 1018, 1344, 1374, 1376
Kashyap, A.K., s e e Cecchetti, S.G. 876
Kashyap, A.K., s e e Hoshi, T. 1344
Kashyap, A.K., s e e Hubbard, R.G. 1344
Katz, L. 577, 578
Katz, L., s e e Autor, D. 577
Katz, L.E, s e e Abraham, K.J. 1183, 1221
Katz, L.E, s e e Cutler, D.M. 797
Katz, L.W., s e e Blmlchard, O.J. 1176
Kaufman, H. 1344
Keane, M.P. 608, 609, 786, 790
Keefer, P., s e e Knack, S. 1466, 1471
Kehoe, EJ., s e e Atkeson, A. 847, 1675, 1718,
1720
Kehoe, P.J., s e e Backus, C.K. 549
Kehoe, P.J., s e e Baekus, D.K. 9, 42, 45, 938,
1708
Kehoe, P.J., s e e Chaff, V.V. 124, 397, 422, 672,
697, 698, 700, 701, 709, 720, 722, 723,
974, 1036, 1037, 1040-1042, 1371, 1448,
1449, 1488, 1489, 1673-1676, 1691, 1699,
1708-1710, 1720, 1723
Kehoe, P.J., s e e Cole, H.L. 1449
Kehoe, T.J. 314, 380, 389, 391,574, 575
Kehoe, T.J., s e e Cole, H.L. 1446, 1449, 1603
Kehrer, K.C., s e e Moffitt, R.A. 618
Kelly, M. 271
Kemmerer, E.W. 173
Kendrick, D.A., s e e Amman, H.M. 535
Kenen, EB. 165, 1496
Kennan, J. 803
Kessler, D. 1646
Keynes, J.M. 158, 161, 1055, 1059, 1537
Kiefer, J. 476
Kiefer, N.M., s e e Burdett, K. 1173
Kiefer, N.M., s e e Devine, T.J. 1166
Kiguel, M. 1535, 1543, 1546, 1554, 1555
Kihlstrom, R.E. 563
Kiley, M.T. 422, 423, 1041, 1117, 1129
Killian, L. 87

Author

Index

Killingsworth, M.R. 550, 601, 1148

Kim, J. 129, 1036
Kim, K. 377, 379
K J m , M . , s e e Nelson, C.R.
1320
Kim, S. 95
Kim, S.-J. 672, 711-714
Kimball, M., s e e Barsky, R. 558, 564, 565
Kimball, M., s e e Carroll, C.D. 762, 771
Kimball, M.S. 556, 770, 1036, 1041, 1056,
1114, 1117, 1127, 1653
Kimball, M.S., s e e Basu, S. 983, 992, 994,
1069, 1080, 1081, 1117
Kimbrough, K.P. 1537, 1675, 1676, 1720,
1732
Kindahl, J., s e e Stigler, G. 1018
Kindleberger, C.R 162
King, M. 199, 1333, 1485, 1489
King, R.G. 9, 46, 54, 69, 101,278, 369, 391,
429, 435, 545, 549, 649, 672, 689, 692,
711-713, 929, 931,932, 939, 941,945, 953,
954, 971, 995, 1036, 1041, 1043, 1062,
1140, 1364, 1367, 1491
King, R.G., s e e Barro, R.J. 974
King, R.G., s e e Baxter, M. 9, 11, 12, 430, 934,
974
King, R.G., s e e Dotsey, M. 974, 1032, 1043
King, R.G., s e e Goodfriend, M. 1013, 1117,
1346, 1515
King, S. 101
Kirby, C. 1320
Kirman, A.P. 475, 528, 536, 539-541
Kitanidis, EK. 326
Kiyotaki, N. 524, 852, 857, 1353, 1356, 1376,
1378, 1379
Kiyotaki, N., s e e Blanchard, O.J. 1033, 1034
Kiyotaki, N., s e e Boldrin, M. 399
Kleidon, A.W. 1320
Klein, B. 202, 215, 216
Klein, L. 941
Klemperer, P.D. 1121
Klenow, EJ. 663, 673, 679, 680, 683-686, 694,
702, 705, 707
Klenow, EJ., s e e Bils, M. 694
Klenow, EJ., s e e Heckman, J.J. 578
Klock, M., s e e Silberman, J. 1316
Knack, S. 1466, 1471
Kneese, A. 656
Knowles, S. 277, 278
Kocherlakota, N. 574, 954, 985, 1234, 1251,
1253
Kocherlakota, N., s e e Cole, H.L. 576

1-15
Kocherlakota, N., s e e Ingram, B. 984
Kocherlakota, N.R. 271,673, 694
Kochin, L., s e e Benjamin, D. 161
Kollintzas, T. 904-907
Kollman, R. 1085
Kon-Ya, E, s e e Shiller, R.J. 1316
Konings, J., s e e Garibaldi, P. 1180, 1222
Koopmans, T. 931,942, 948
Koopmans, T.C. 244, 246, 247, 295, 643, 649,
1673
Koopmans, T.J. 9
Kormendi, R.C. 278-281,671, 1656, 1657
Komai, J. 703
Kortum, S., s e e Eaton, J. 719
Kosobud, R., s e e Klein, L. 941
Kosters, M.H. 618
Kotkin, B., s e e Bellman, R. 340
Kotlikoff, L. 1448, 1449, 1465
Kotlikoff, L., s e e Hayashi, E 796
Kotlikoff, L.J. 780, 1624, 1646
Kotlikoff, L.J., s e e Auerbach, A.J. 380, 549,
576, 588, 590, 591, 593, 616, 1624, 1634,
1635, 1639, 1652, 1718
Kotlikoff, L.J., s e e Gokhale, J. 750
Koyck, L.M. 816
Kramer, C., s e e Flood, R.R 1596
Krane, S.D. 876, 877
Kxemer, M., s e e Blanchard, O.J. 852
Kremer, M., s e e Easterly, W. 277, 278, 281,
675
Kreps, D.M. 540, 557, 1256
Kreps, D.M., s e e Bray, M. 474
Kreps, D.M., s e e Fudenberg, D. 475
Krieger, S. 380, 843, 847
Krishnamurthy, A. 1376, 1378
Kroner, K.E, s e e Bollerslev, T. 1236, 1280
Krueger, A., s e e Autor, D. 577
Krueger, A.O. 673, 679, 699
Krueger, J.T. 104, 105
Krugman, P. 1215, 1536, 1590, 1592, 1594,
1596, 1601, 1605, 1606, 1632
Krusell, E 380, 547, 566, 567, 994, 1293,
1445, 1473
Krusell, P., s e e Greenwood, J. 664
Kuan, C.-M. 476
Kugler, P. 1281
K u h , E . , s e e Meyer, J.R. 817
Kumhof, M. 1596
Kurz, M. 474
Kushner, H. 476
Kushner, H.J. 476

1-16
Kusko, A.L. 1327
Kuttner, K., s e e Evans, C.L. 105
Kuttner, K.N., s e e Friedman, B.M. 43, 44
Kuttner, K.N., s e e Krueger, J.T. 104, 105
Kuznets, S. 941
Kuznets, S., s e e Friedman, M. 572
Kwiatkowski, D. 212
Kydland, EE. 9, 42, 158, 428, 547, 549, 578,
929, 953, 956, 957, 962, 980, 981, 1058,
1059, 1140, 1141, 1145, 1167, 1195, 1400,
1405, 1415, 1449, 1485, 1486, 1488, 1557,
1561, 1673, 1708
Kydland, EE., s e e Backus, C.K, 549
Kydland, EE., s e e Backus, D,K, 1708
Kydland, EE., s e e Bordo, M.D, 158, 160, 185,
215, 1438
Kydland, EE., s e e Hotz, V.J. 792, 803
Kyle, A,S., s e e Campbell, J.Y. 1290
La Porta, R. 1240, 1320
Labadie, P., s e e Giovannini, A. 380
Labadie, P.A., s e e Coleman II, W.J. 114
Lach, S. 1019
Ladron de Guevara, A. 317
Laffont, J., s e e Gourieroux, C. 487
Laffont, J.J., s e e Kihlstrom, R.E. 563
Laffont, J.-J, 538
Lahiri, A. 1539, 1571, 1578, 1579, 1597
Lai, K.S. 876
Laibson, D. 1653
Laidler, D. 1485
Lakonishok, J. 1323
Lakonishok, J., s e e Chan, L. 1321
Lam, P.-S., s e e Cecehetti, S.G. 1251, 1265,
1270, 1272, 1294, 1296
Lam, P.S. 802
Lambert, J.D. 346
Lambertini, L. 1457, 1465
Lamo, A.R. 290
Lamont, O.A., s e e Kashyap, A.K. 881, 912,
1344, 1374
Landi, L., s e e Barucci, E. 525
Lane, P. 1472
Langer, E.J. 1329
Lansing, K . , s e e Guo, J.-T. 416
Lapham, B.J., s e e Devereux, M.B. 1126
Laroque, G., s e e Fuchs, G. 464, 474
Laroque, G., s e e Grandmont, J.-M. 464, 474,
475, 481,507
Laroque, G., s e e Grossman, S.J. 801
Lau, L. 664

Author

Index

Lau, S.H.P. 1037

Lawrance, E. 607 609
Layard, R. 1098, 1176, 1177, 1221
Layard, R., s e e Jackman, R. 1221
Layne-Farrar, A., s e e Heckman, J.J. 578
Lazaretou, S. 159
Lazear, E.P. 1660
Lazear, E.E, s e e Hall, R.E. 1152
League of Nations 162
Leahy, J. 844, 1332
Leahy, J., s e e Caballero, RA. 823, 828, 830
Leahy, J., s e e Caplin, A. 849, 850
Leamer, E.E. 282
Lebow, D.E. 215, 1016
Lebow, D.E., s e e Blinder, A.S. 1018, 1118
Lee, C. 1324
Lee, J.-W., s e e Barro, R.J. 277~81, 671, 681,
683-685, 688, 689, 691-694
Lee, J.-W. 703
Lee, J.Y. 395
Lee, K. 284
Lee, T.H., s e e Granger, C.W.J. 881,903
Leeper, E.M. 69, 74, 83, 93, 101, 128, 132,
134, 137, 418, 420, 1036, 1089, 1369, 1518,
1520, 1631
Leeper, E.M., s e e Faust, J. 69, 217
Leeper, E.M., s e e Gordon, D,B. 128, 134
Lefort, E, s e e Caselli, E 277-279, 283, 284,
286
Lehmann, B.N. 1321
Leibfritz, W., s e e Roseveare, D. 1626
Leiderman, L. 1432, 1438, 1495, 1543
Leiderman, L., s e e Bufman, G. 1543
Leiderman, L., s e e Calvo, G.A. 1552, 1600
Leiderrnan, L., s e e Kaminsky, G.L. 1550
Leijonhufvud, A. 152, 202, 215
Leijonhufvud, A., s e e Heymarm, D. 1539,
1540
Lemareehal, C., s e e Hiriart-Urruti, J.B. 331
LeRoy, S.E 1235, 1319
Lettau, M. 470, 472, 524, 527, 1293, 1297
Leung, C. 271
Levhari, D. 1450, 1465
Levin, A. 283, 1017, 1031, 1035, 1036, 1038
Levin, A., s e e Brayton, E 1043, 1344, 1485
Levine, D.K., s e e Fudenberg, D. 455, 475
Levine, D.K., s e e Kehoe, T.J. 380, 389, 391,
574, 575
Levine, J. 1332
Levine, P,, s e e al Nowaihi, A. 1415, 1422,
1437

Author

Index

Levine, R. 269, 277-282, 390, 423, 671, 694,

1376
Levine, R., s e e King, R.G. 278, 689, 692
Levy, D. 1014, 1015, 1019
Levy, D., s e e Carpenter, R.E. 876
Levy, D., s e e Dutta, S. 1019, 1020
Levy-Leboyer, M. 222
L6vy-Strauss, C. 1331
Lewis-Beck, M. 1425
Li, J.X. 326
Li, Y., s e e Johnson, S.A. 345, 381
Lichtenstein, S. 1318
Lichtenstein, S., s e e Fischhoff, B. 1319
Lilien, D.M. 1160, 1183, 1221
Lilien, D.M., s e e Hall, R.E. 1153
Lillard, L. 569, 572
Limongi, E, s e e Przeworski, A. 1466
Lin, C., s e e Levin, A. 283
Lindbeck, A. 1098, 1425, 1465
Lindert, E 156
Lioni, G., s e e Contini, B. 1177, 1178, 1180,
1222
Lippi, E 1432
Lippi, E, s e e Cukierman, A. 1438
Lippi, M. 217
Lipsey, R.E., s e e Blomstrom, M. 277, 279,
280
Liu, C.Y., s e e Conlon, J.R. 1032
Liviatan, N., s e e Cukierrnan, A. 1437
Liviatan, N., s e e Kiguel, M. 1535, 1543, 1546,
1554, 1555
Lizondo, J.S. 1538
Lizzeri, A. 1459
Ljung, L. 474, 476, 481,482
Ljungqvist, L. 1214
Lo, A.W. 1321
Lo, A.W., s e e Campbell, J.Y. 1255, 1257, 1258,
1261, 1266, 1270, 1320
Loayza, N.V. 708
Lochner, L., s e e Cossa, R. 584
Lochner, L., s e e Heckman, J.J. 576, 578, 582,
584, 586, 587, 590, 592, 593
Lockwood, B. 1411, 1415
Lockwood, B., s e e Herrendorf, B. 1436, 1438
Lohman, S. 1416-1418, 1425, 1431, 1438
Londregan, J., s e e Alesina, A. 1425
Long, J. 929, 952, 953, 994
Loomes, G. 1313
Lopez-de-Silanes, E, s e e La Porta, R. 1240
Lorentz, A.L. 344
Lothian, J.R., s e e Darby, M.R. 166

1-17
Loury, G.C. 299
Lovell, M.C. 881,893,908, 910
Lown, C., s e e Bernanke, B.S. 1343
Lucas, DA. 1035, 1036, 1042
Lucas, D.J., s e e Heaton, J. 380, 547, 569, 1255,
1293
Lucas, R. 398, 424, 425, 641, 651,929, 932,
953
Lucas, R.E. 46, 50, 380, 1158, 1446, 1449
Lucas, R.E., s e e Stokey, N.L. 314, 318-321,
346, 951,998, 999
Lucas J1, R.E. 67, 88, 158, 238, 245, 264, 265,
293, 454, 457, 463, 474, 545, 547, 554,
559, 561, 575, 578, 582, 583, 615, 616,
672, 710-715, 720, 797, 102~1024, 1043,
1195, 1268, 1489, 1490, 1495, 1500, 1592,
1673, 1675, 1699, 1711, 1723, 1728
Lucas Jr, R.E., s e e Atkeson, A. 575
Lucas Jr, R.E., s e e Stokey, N.L. 271,299
Ludvigson, S. 785, 788, 1344, 1652
Lundvik, E, s e e Hassler, J. 9, 1238
Lusardi, A. 608, 790, 791
Lusardi, A., s e e Browning, M. 606, 771
Lusardi, A., s e e Garcia, R. 790
Luttmer, E.G.J. 575
Lyons, R.K., s e e Caballero, R.J. 399

Maberly, E.D., s e e Dyl, E.A. 1334

Macaulay, ER. 173
MacAvoy, P.W., s e e Funkhouser, R. 699
Maccini, L.J. 881,893, 894, 903,907
Maccini, L.J., s e e Blinder, A.S. 887, 904, 910,
1344
Maccini, L.J., s e e Durlauf, S.N. 905-907
Maccini, L.J., s e e Haltiwanger, J.C. 881
Maccini, L.J., s e e Humphreys, B.R. 909
MacDonald, R., s e e Bordo, M.D. 156
Mace, B.J. 796
Mackay, D. 1307
MacKinlay, A.C., s e e Campbell, J.Y. 1255,
1257, 1258, 1261, 1266, 1270, 1320
MacKinlay, A.C., s e e Lo, A.W. 1321
MacLeod, W.B. 1157, 1186
MaCurdy, T.E. 551, 567-569, 572, 592, 595,
615, 616, 619-621,752, 759, 767, 792, 975,
1148, 1149
MaCurdy, T.E., s e e Attanasio, O.E 792
MaCurdy, T.E., s e e Blundell, R. 602, 620
MaCurdy, T.E., s e e Heckman, J.J. 615
Maddala, G.S. 275

1-18
Maddison, A. 288, 673-675, 677, 678, 720,
721
Madison, J. 1659
Mailath, G.J., s e e Kandori, M. 475
Makhija, A.K., s e e Ferffs, S.E 1314
Malcomson, J.M., s e e MacLeod, W.B. 1157,
1186
Malinvaud, E., s e e Blanchard, O.J. 1214
Malkiel, B. 1316
Mankiw, N.G. 135, 158, 159, 173, 216, 244246, 252-255, 269-271,277-279, 289, 397,
567, 653, 655, 660, 673, 679-686, 694,
749, 785, 790, 800, 961, 1281, 1290, 1292,
1638, 1702, 1742
Mankiw, N.G., s e e Abel, A.B. 1266, 1651
Mankiw, N.G., s e e Ball, L. 42, 1023, 1632,
1650, 1651
Mankiw, N.G., s e e Barro, R.J. 1637
Mankiw, N.G., s e e Barsky, R.B. 1653
Mankiw, N.G., s e e Campbell, J.Y. 769, 784,
1261, 1264, 1290, 1655
Mankiw, N.G., s e e Elmendorf, D.W. 1439
Mankiw, N.G., s e e Hall, R.E. 1485, 1493,
1498
Mankiw, N.G., s e e Kimball, M.S. 1653
Mann, C.L., s e e Bryant, R.C. 1043, 1491,
1497, 1516-1518
Manuelli, R.E., s e e Chari, VV. 715, 1578
Manuelli, R.E., s e e Jones, L.E. 245, 257, 261,
380, 672, 709, 711-713, 720, 1675, 1711
Man, C.S., s e e Dotsey, M. 370, 952
Marcet, A. 314, 326, 348, 351,454, 455, 464,
465, 468, 473-476, 480, 494, 499, 525,
528-530, 532, 1675, 1705, 1707
Marcet, A., s e e Canova, E 283
Marcet, A., s e e den Haan, W.J. 347, 354, 369
Margarita, S., s e e Beltratti, A. 524, 525
Margaritis, D. 474
Mariano, R.S., s e e Seater, J.J. 1656, 1657
Mariger, R.R 1344
Marimon, R. 455, 464, 472, 475, 523, 531,
1214
Marimon, R., s e e Evans, G.W. 483, 509, 527,
528, 531
Marion, N., s e e Flood, R.P. 1429, 1438
Mark, N.C., s e e Cecchetti, S.G. 1251, 1265,
1270, 1272, 1294, 1296
Marris, S. 1632
Marschak, J. 582, 1043
Marshall, A. 203
Marshall, D.A., s e e Bekaert, G. 1281

Author

Index

Marshall, D.A., s e e Marcet, A. 326, 348, 351,

455
Marston, R., s e e Bodnar, G. 1318
Marston, R.C. 164
Martin, J.P. 1181
Mas-Colell, A., s e e Kehoe, T.J. 380
Masciandaro, D., s e e Grilli, V 1404, 1432,
1438, 1439, 1465
Masson, A., s e e Kessler, D. I646
Masson, E, s e e Chadha, B. 1542
Masson, P.R. 1554, 1588
Matheny, K.J. 395, 441
Matsukawa, S. 1037
Matsuyama, K. 395, 399
Matthieson, D., s e e Mussa, M. 208
Mauro, P. 277
Mauro, P., s e e Easterly, W. 1538
Maussner, A. 528
Mayhew, S. 1310
McAfee, R.P., s e e Howitt, E 389, 399, 506,
517, 521
McCallum, B.T. 83, 173, 184, 198, 203, 408,
487, 488, 496, 503, 1022, 1026, 1043,
141l, 1426, 1432, 1437, 1438, 1485, 1487,
1488, 1490, 1491, 1493, 1495, 1500, 1502,
1506-1510, 1512, 1515-1519, 1631
McCulloch, J.H., s e e Dezhbakhsh, H. 1039
McElroy, M. 619
McFadden, D. 1314, 1316, 1328
McGrattan, E.R. 348, 974
McGrattan, E.R., s e e Anderson, E.W. 368,
369
McGrattan, E.R., s e e Chaff, V.V. 124, 397, 422,
672, 697, 698, 700, 701, 709, 720, 722,
723, 974, 1036, 1037, 1040-1042, 1371
McGrattan, E.R., s e e Marimon, R. 455, 475,
523
McGuire, W.J. 1332
McIntire, J.M., s e e Carlson, J.B. 104
McKelvey, R.D. 380
McKibbin, W.J., s e e Henderson, D.W. 1497
McKinnon, R. 1496
McKinnon, R.I. 166, 207
McLaughlin, K.J. 1016, 1152
McLean, I., s e e Eichengreen, B. 157
McLennan, A. 474
McLennan, A., s e e McKelvey, R.D. 380
McManus, D.A. 908
Means, G.C. 1082
Meckling, W., s e e Jensen, M. 1344
Medeiros, C. 1554, 1555

Author

Index

Medoff, J.L., s e e Fay, J.A. 1077, 1103

Meehl, P. 1319
Meghir, C. 611,613, 775, 804
Meghir, C., s e e Arellano, M. 787
Meghir, C., s e e Attanasio, O.P. 793, 794
Meghir, C., s e e Blundell, R. 611, 612, 779,
781, 783, 790-792
Meghir, C., s e e Browning, M. 607, 611,778
Meguire, E, s e e Kormendi, R.C. 278-281,671,
1656, 1657
Mehra, R. 547, 961, 1234, 1236, 1249, 1251,
1264, 1268, 1270, 1272, 1289, 1312
Mehra, R., s e e Constantinides, G.M. 1293
Mehra, R., s e e Danthine, J.-E 329, 370, 952
Meigs, A.J. 191
Melenberg, B., s e e Alessie, R. 774
Melino, A., s e e Blanchard, O.J. 912
Melino, A., s e e Epstein, L.G. 558, 565
Melino, A., s e e Grossman, S.J. 1242
Melnick, R., s e e Bruno, M. 1539
Meltzer, A.H. 162, 169, 17~176, 178, 179,
185, 204, 215-217, 222, 1466, 1485, 1543
Meltzer, A.H., s e e Brunner, K. 179, 183, 191,
1025
Meltzer, A.H., s e e Cukierman, A. 1414, 1450,
1463
Mendoza, E. 1439, 1571, 1579
Mendoza, E., s e e Calvo, G.A. 1591, 1600,
1601
Meredith, G., s e e Chadha, B. 1542
Merton, R. 1275
Merton, R.K. 389, 1333
Merz, M. 994, 1158, 1173, 1203, 1207
Metivier, M., s e e Benveniste, A. 476, 531
Metzler, L.A. 867
Meyer, J.R. 817
Mihov, I., s e e Bernanke, B.S. 72, 76, 83, 89,
114, 1365, 1369
Milesi-Ferretti, G.-M., s e e Mendoza, E. 1439
Milesi-Ferretti, G.-M. 1425, 1426, 1597
Milgrom, P. 475, 1322
Millard, S.P. 1217, 1220
Miller, B.L. 566
Miller, M., s e e Lockwood, B. 1411, 1415
Miller, M., s e e Modigliani, E 1343
Miller, R.A., s e e Altug, S. 584, 595, 611,612,
785, 786, 792
Mills, E 1082
Mills, J., s e e Erlich, D. 1314
Mills, L.O., s e e Boschen, J.E 139
Mills, T.C. 204

1-19
Mills, T.C., s e e Capie, E 163, 1438
Mincer, J. 581,592, 684
Minehart, D., s e e Bowman, D. 1313
Mirman, L., s e e Levhari, D. 1450, 1465
Mirman, L.J., s e e Brock, W.A. 319, 547, 552,
556, 942, 951
Miron, J.A. 173, 216, 876, 907, 1242
Miron, J.A., s e e Barsky, R.B. 1149
Miron, J.A., s e e Beaulieu, J.J. 876
Miron, J.A., s e e Feenberg, D. 60
Miron, J.A., s e e Mankiw, N.G. 173, 216,
1281
Mirrlees, J.A. 1154
Mirrlees, J.A., s e e Diamond, P.A. 1684
Mishkin, ES. 101, 183,216, 1023, 1380, 1432,
1438
Mishkin, ES., s e e Bernanke, B.S. 1495
Mishkin, ES., s e e Estrella, A. 1485
Mishkin, ES., s e e Hall, R.E. 607, 608, 789,
1655
Mishra, D. 1416, 1425
Missale, A. 1450
Mitchell, B.R. 222
Mitchell, W.C. 8, 44, 1053
Mitchell, W.C., s e e Burns, A.E 5, 8, 931,934
Mitra, K. 530, 532
Mnookin, R.H., s e e Gilson, R.J. 1154
Modiano, E.M. 1543
Modigliani, E 761,762, 780, 1321, 1343, 1646,
1656, 1657
Modigliani, E, s e e Dreze, J. 770
Modigliani, E, s e e Holt, C.C. 882, 885, 888,
909, 910, 912
Modigliani, E, s e e Jappelli, T. 780
Modigliani, E, s e e Samuelson, P.A. 643
Moffitt, R. 752, 787
Moffitt, R.A. 618
Moler, C., s e e Kahanel, D. 329, 333
Mondino, G. 1540
Monfort, A., s e e Gourieroux, C. 487
Monro, S., s e e Robbins, H. 476, 478
Montgomery, E. 1017, 1018
Montiel, P. 1539
Montiel, P., s e e Ag6nor, ER. 1543
Montrucchio, L. 330
Montrucchio, L., s e e Boldrin, M. 362
Moore, B.J. 455, 475, 496
Moore, G.H. 1059
Moore, G.H., s e e Zarnowitz, V. 40
Moore, G.R., s e e Fuhrer, J.C. 905, 908, 1039,
1040, 1518

1-20
Moore, J., s e e Kiyotaki, N. 852, 857, 1353,
1356, 1376, 1378, 1379
Moreno, D. 481
Morgan, D. 1374
Morrison, C.J. 1086
Mortensen, D.T. 1157, 1158, 1162, 1163, 1173,
1182, 1183, 1187, 1188, 1194, 1198, 1203,
1208, 1217, 1220, 1222
Mortensen, D.T., s e e Burdett, K. 1173, 1196
Mortensen, D.T., s e e Millard, S.P. 1217, 1220
Morton, T.E. 338
Mosser, RC. 910
Motley, B., s e e Judd, J.P. 1485, 1487, 1512,
1516
Mroz, T.A. 618
Mroz, T.A., s e e MaCurdy, T.E. 592, 752
Muellbauer, J., s e e Deaton, A. 783
Mueller, D. 1464
Mulligan, C.B. 346, 1150
Mundell, R.A. 1496
Murphy, K. 581
Murphy, K., s e e Juhn, C. 569, 619
Murphy, K., s e e Katz, L. 577, 578
Murphy, K.M. 262, 278, 1082
Murray, C.J., s e e Nelson, C.R. 11
Murray, W., s e e Gill, EE. 329
Musgrave, R.A. 1631, 1661
Mussa, M. 208, 1404, 1637
Mussa, M., s e e Flood, R.R 152, 202, 1428
Mussa, M.L., s e e Frenkel, J.A. 203
Muth, J.E 457, 473, 484
Muth, J.E, s e e Holt, C.C. 882, 885, 888, 909,
910, 912
Myerson, R. 1459
Nakamura, A. 618
Nakamura, M., s e e Nakamura, A. 618
Nalebuff, B., s e e Bliss, C. 1461, 1465
Nance, D.R. 1318
Nankervis, J.C., s e e McManus, D.A. 908
Nash, S., s e e Kahaner, D. 329, 333
Nason, J.M., s e e Cogley, T. 395, 547, 967,
1142, 1503
Natanson, I.P. 342
NBER 8
Neale, M.A., s e e Northcraft, G.B. 1315
Negishi, T. 559
Nelson, C.R. 11, 211, 213, 264, 969, 1264,
1320
Nelson, C.R., s e e Beveridge, S. 1062, 1143
Nelson, D.B. 182

Author

Index

Nelson, E. 1035
Nerlove, M. 283, 284
Neumann, G.R., s e e Burdett, K. 1173
Neusser, K. 941
Neves, J., s e e Correia, I. 974
Neves, P., s e e BlundeU, R. 792
Ng, S., s e e Garcia, R. 790
Nickell, S., s e e Layard, R. 1098, 1176, 1177,
1221
Niekell, S.J. 823
Nicolini, J.P., s e e Marcet, A. 455, 530, 532
Niederreiter, H. 334
Nilsen, O.A., s e e Askildsen, J.E. 1074
Nishimura, K., s e e Benhabib, J. 403-405, 425,
435
Nordhaus, W. 1400, 1425
North, D. 1449
Northcraft, G.B. 1315
Novales, A. 803
Nurkse, R. 163, 203
Nyarko, Y. 465, 474
O'Barr, W.M. 1332
O'Brien, A.M. 776
O'Brien, A.E 181
Obstfeld, M. 159, 164, 165, 407, 1411, 1415,
1429, 1438, 1449, 1507, 1571, 1588, 1590,
1592, 1630
Obstfeld, M., s e e Froot, K. 1266
O'Connell, S.A. 1650
Odean, T. 1314, 1323
O'Driseoll, G.P. 1643
OECD 1181, 1182, 1215, 1620
Office of Management and Budget 1622
Officer, L. 155
Ogaki, M., s e e Atkeson, A. 610, 786
Ohanian, L.E. 1036
Ohanian, L.E., s e e Cooley, T.E 42, 962, 974
O'Hara, M., s e e Blume, L.E. 321,322
Ohlsson, H., s e e Edin, D.A. 1457
Okina, K. 1508
Okun, A.M. 1014, 1541
Oliner, S.D. 137, 820, 1374, 1376
Oliner, S.D., s e e Cummins, J.G. 856
Olsder, G., s e e Basar, T. 1449
Olshen, R.A., s e e Breiman, L. 289
Oppers, S. 154
Orphanides, A. 198, 1485
Ortega, E., s e e Canova, E 376, 377, 379
Ortigueira, S., s e e Ladron de Guevara, A. 317
Ostry, J. 1568

Author

Index

Ostry, J., s e e Montiel, P. 1539

Ostry, J.D., s e e Ghosh, A.R. 202, 207, 208
Owen, ED., s e e Knowles, S. 277, 278
Ozler, S. 1457, 1465
Ozler, S., s e e Alesina, A. 277-279, 1460, 1466,
1471
Paarsch, H., s e e MaCurdy, T.E. 619, 620
Paeelli, L., s e e Contini, B. 1177, 1178, 1180,
1222
Packal~n, M. 525
Padilla, J., s e e Dolado, J. 1437
Pagan, A., s e e Kim, K. 377, 379
Pagan, A.R. 9, 69, 108
Pagano, M., s e e Giavazzi, E 203, 1438, 1446,
1449, 1580
Pagano, M., s e e Jappelli, T. 776
Papageorgiou, A. 334
Papageorgiou, C., s e e Duffy, J. 257
Paquet, A., s e e Ambler, S. 944
Parekh, G. 87, 109
Parente, S.L. 672, 674, 702, 708
Parke, W.R., s e e Davutyan, N. 156
Parker, Jr., s e e Barsky, R. 43
Parker, J., s e e Gourinchas, P.-O. 609, 1344
Parker, J.A. 1120
Parker, J.A., s e e Solon, G. 579, 1058, 1102,
1106

Parkin, M. 1037, 1412, 1415, 1506

Parkin, M., s e e Bade, R. 1432, 1438
Pashardes, E, s e e Blundell, R. 781
Paskov, S.H. 334
Patel, J., s e e Degeorge, E 1321
Patinkin, D. 407, 1506, 1507, 1630, 1643
Paulin, G. 751
Paxson, C., s e e Deaton, A. 798
Paxson, C., s e e Ludvigson, S. 788
Pazos, E 1534
Peles, N., s e e Goetzmann, W.N. 1314
Pencavel, J. 550, 601,605, 975, 1148
Peralta-Alva, A. 374
Perli, R. 402, 431,435
Perli, R., s e e Benhabib, J. 425, 426, 437
Perotti, R. 1466, 1469, 1472
Perotti, R., s e e Alesina, A. 1439, 1464, 1465
Perron, R 264
Perry, G.L., s e e Akerlof, G.A. 198
Persson, M. 1447, 1449
Persson, T. 278, 692, I400, 1403, 1413,
1415-1418, 1420, 1421, 1425, 1433, 1435,
1437-I440, 1442, 1445, 1448-1450, 1454,

1-21
1456, 1459, 1460, 1465, 1466, 1469, 1470,
1490
Persson, T., s e e Englund, E 9
Persson, T., s e e Hassler, J. 9, 1238
Persson, T., s e e Horn, H. 1415
Persson, T., s e e Kottikoff, L. 1448, 1449,
1465
Persson, T., s e e Persson, M. 1447, 1449
Pesaran, H. 487
Pesaran, M.H., s e e Binder, M. 271
Pesaran, M.H, s e e Im, K. 283
Pesaran, M.H., s e e Lee, K. 284
Pestieau, EM. 1718
Petersen, B.C., s e e Carpenter, R.E. 881,912,
1344
Petersen, B.C., s e e Domowitz, I. 1020, 1083,
1093
Petersen, B.C., s e e Fazzari, S.M. 818, 1344
Petterson, E 1457
Pflug, G., s e e Ljung, L. 476
Phaneuf, L. 1028, 1039, 1041
Phelan, C. 380, 575, 796
Phelan, C., s e e Atkeson, A. 1298
Phelps, E. 944, 1025, 1026, 1039
Phelps, E.E., s e e Frydman, R. 453, 454, 474,
528, 536, 539
Phelps, E.S. 46, 168, 1059, 1098, 1121, 1122,
1157, 1173, 1176, 1192, 1220, 1537, 1538,
1720, 1724
Philippopoulus, A., s e e Lockwood, B. 1415
Phillips, A.W. 1510
Phillips, A.W.H. 46
Phillips, L.D., s e e Lichtenstein, S. 1318
Phillips, EC.B., s e e Kwiatkowski, D. 212
Pieard, P. 1157
Pieper, EJ., s e e Eisner, R. 1621
Pierce, J.L. 195
Piketty, T., s e e Aghion, E 1377
Pindyck, R. 1072
Pindyek, R.S. 835, 910, 912
Pindyck, R.S., s e e Abel, A.B. 835
Pindyck, R.S., s e e Caballero, R.J. 844
Pippenger, J. 156
Pischke, J.-S., s e e Jappelli, T. 790
Pischke, J.-S. 764
Pissarides, C.A. 774, 1163, 1173, 1183, 1184,
1188, 1193, 1194, 1200, 1203, 1207, 1209,
1220
Pissarides, C.A., s e e Garibaldi, P. 1180, t222
Pissarides, C.A., s e e Jacl~anan,R. 1221

1-22
Pissarides, C.A., s e e Mortensen, D.T. 1158,
1182, 1183, 1194, 1198, 1203, 1208
Plosser, C.I. 952, 954, 958, 961, 963, 1094,
1658
Plosser, C.I., s e e King, R.G. 9, 54, 369, 391,
429, 435, 549, 929, 931, 941, 945, 954,
995
Plosser, C.I., s e e Long, J. 929, 952, 953, 994
Plosser, C.I., s e e Nelson, C.R. 11,211, 213,
264, 969
Plutarchos, S., s e e Benhabib, J. 437
Polemarchakis, H.M., s e e Geanakoplos, J.D.
395, 458
Policano, A., s e e Fethke, G. 1037
Pollak, R.A. 803
Pollard, S. 161
Poole, W. 192, 1514, 1515
Poonia, G.S., s e e Dezhbakhsh, H. 1039
Popper, K. 376
Porter, R. 1509
Porter, R.D., s e e LeRoy, S.F. 1235, 1319
Porteus, E.L., s e e Kreps, D.M. 557, 1256
Portier, E 1068, 1126
Portier, E, s e e Hairault, J.-O. 1036
Posen, A. 1404, 1426, 1432, 1438
Posen, A., s e e Mishkin, ES. 1432, 1438
Poterba, J.M. 159, 1235, 1320, 1465, 1648,
1655
Poterba, J.M., s e e Cutler, D.M. 1290, 1320,
1321
Poterba, J.M., s e e Feldstein, M. 1633
Poterba, J.M., s e e Kusko, A.L. 1327
Power, L., s e e Cooper, R. 824
Pradel, J., s e e Fotu'geaud, C. 454, 465, 473,
475
Praschnik, J., s e e Hornstein, A. 549
Prati, A. 162
Prati, A., s e e Alesina, A. 1446, 1449
Prati, A., s e e Drudi, E 1450
Prescott, E.C. 178, 365, 545, 675, 700, 702,
930, 934, 952, 954, 956, 957, 961, 963,
982, 1033, 1296, 1488, 1489, 1710
Prescott, E.C., s e e Chari, V.V 1488, 1489,
1674
Prescott, E.C., s e e Cooley, T.F. 376, 549, 954
Prescott, E.C., s e e Hansen, G.D. 602
Prescott, E.C., s e e Hodrick, R. 9, 12, 34, 428,
931,932
Prescott, E.C., s e e Kydland, EE. 9, 42, 158,
428, 547, 549, 929, 953, 956, 957, 962,
980, 981, 1058, 1059, 1140, 1141, 1145,

Author

Index

1167, 1195, 1400, 1405, 1415, 1449, 1485,

1486, 1488, 1673, 1708
Prescott, E.C., s e e Lueas Jr, R.E. 547, 554
Prescott, E.C., s e e Mehra, R. 547, 961, 1234,
1236, 1249, 1251, 1264, 1268, 1270, 1272,
1289, 1312
Prescott, E.C., s e e Parente, S.L. 672, 674,
708
Prescott, E.C., s e e Stokey, N.L. 951,998, 999
Prescott, E.S. 380
Press, W.H. 329-334, 343, 348, 356, 365
Preston, I., s e e Banks, J. 759, 783, 790, 791
Preston, I., s e e Blundell, R. 572, 764, 797
Priouret, E, s e e Benveniste, A. 476, 531
Pritchett, L. 237
Pritchett, L., s e e Easterly, W. 277, 278, 281,
675
Przeworski, A. 1466
Psacharopoulos, G. 685
Puterman, M.L. 336, 338, 339
Quadrini, V., s e e Cooley, T.E 1376
Quadrini, V., s e e Krusell, P. 1445, 1473
Quah, D. 254, 263, 268, 272, 275, 283, 287,
288, 290292, 294, 299
Quah, D., s e e Leung, C. 271
Quail, D.T., s e e Blanehard, O.J. 211, 216, 217
Quah, D.T., s e e Durlauf, S.N. 550
Quandt, R.E. 34
Quattrone, G.A. 1329
Rabin, M. 1319
Rabin, M., s e e Bowman, D. 1313
Rabinowitz, P., s e e Davis, PJ. 333
Radner, R. 952
Radner, R., s e e Benhabib, J. 1465
Ramey, G. 281,852, 1157, 1159
Ramey, G., s e e den Haan, W.J. 994, 1166,
1194, 1203, 1204, 1206, 1207
Ramey, G., s e e Evans, G.W. 455, 461,462
Ramey, V.A. 67, 876, 885, 897, 902, 905-907,
909, 911,914, 1084, 1089
Ramey, V.A., s e e Bresnahan, T.E 911,912
Ramey, VA., s e e Chah, E.Y. 775
Ramey, V.A., s e e Ramey, G. 281
Ramos, J. 1543
Ramsey, E 643, 649
Ramsey, EP. 1673
Rankin, N. 1025
Rankin, N., s e e Dixon, H. 537
Rapping, L., s e e Lucas Jr, R.E. 615, 616

Author

1-23

Index

Rasche, R.H., s e e Hoffman, D.L. 51,412

Ratti, R.A. 1497
Ravikumar, B., s e e Chatterjee, S. 1126
Ravikumar, B., s e e Glomm, G. 712, 1472
Rawls, J. 1662
Ray, D., s e e Esteban, J.-M. 264
Rayack, W. 579
Razin, A. 1715
Razin, A., s e e Frenkel, J.A. 1630
Razin, A., s e e Helpman, E. 203, 1580
Razin, A., s e e Mendoza, E. 1439
Razin, A., s e e Milesi-Ferretti, G.-M. 1597
Rebelo, S.T. 245, 260, 261, 709, 952, 1546,
1568, 1578-1581, 1606
Rebelo, S.T., s e e Burnside, C. 399, 930, 980,
982-985, 994, 1078, 1142
Rebelo, S.T., s e e Correia, I. 974
Rebelo, S.T., s e e Easterly, W. 703
Rebelo, S.T., s e e Gomes, J. 994, 1159
Rebelo, S.T., s e e King, R.G. 9, 54, 369, 391,
429, 435, 545, 549, 649, 672, 711-713, 929,
932, 945, 954, 995, 1062, 1140
Rebelo, S.T., s e e Stokey, N.L. 578, 583, 672,
709, 711,714, 954
Redish, A. 154, 155, 166
Redish, A., s e e Betts, C.M. 217
Redmond, J. 161
Reichenstein, W. 101
Reichlin, L., s e e Evans, G.W. 1125
Reichlin, L., s e e Lippi, M. 217
Reid, B.G., s e e Boothe, EM. 1658
Reinhart, C.M. 1545, 1546, 1551, 1553, 1561,
1572, 1573
Reinhart, C.M., s e e Calvo, G.A. 1538, 1539,
1552, 1588, 1600
Reinhart, C.M., s e e Kaminsk-y, G.L. 1553,
1590
Reinhart, C.M., s e e Ostry, J. 1568
Renelt, D., s e e Levine, R. 269, 277-282, 390,
423, 671,694
Reserve Bank of New Zealand 1500
Resnick, L.B., s e e Levine, J. 1332
Restoy, E 1272
Revelli, R., s e e Contini, B. 1177, 1178, 1180,
1200, 1222
Revenga, A., s e e Blanchard, O.J. 1214
Rey, E, s e e Aghion, E 1157
Ricardo, D. 1642
Rich, G. 1514
Richard, S.E, s e e Hansen, L.P. 556
Richards, S., s e e Meltzer, A.H. 1466

Rietz, T. 1252, 1272, 1296

Riley, J. 1461, 1465
Rios-Rull, J. 943
Rios-Rull, J.-V., s e e Castafieda, A. 380
Rios-Rull, J.-V. 380
Rios-Rull, V., s e e Krusell, P. 1445, 1473
Ritter, J.R. 1321
Ritter, J.R., s e e Ibbotson, R. 1321
Rivers, D. 840
Rivlin, T.J. 343
Rob, R., s e e Jovanovic, B. 702
Rob, R., s e e Kandori, M. 475
Robb, R., s e e Heckman, J.J. 752
Robbins, H. 476, 478
Roberds, W., s e e Hansen, L.E 573, 574
Roberts, H.V. 1307
Roberts, J., s e e Milgrom, E 475
Roberts, J.M. 1013, 1033, 1040, 1116, 1118,
1505

Roberts, J.O., s e e Lebow, D.E. 215

Roberts, K. 1466
Robertson, J.C., s e e Pagan, A.R. 69, 108
Robinson, D. 217
Robinson, J. 1054, 1120
Robinson, S., s e e Meltzer, A.H. 204, 216, 217,
222
Rockafellar, R.T. 325
Rockoff, H. 155, 157
Rockoff, H., s e e Bordo, M.D. 160
Rodriguez, C.A. 1562, 1563, 1565, 1568
Rodriguez-Clare, A., s e e Klenow, EJ. 663, 673,
679, 680, 683 686, 694, 702, 705, 707
Rodrik, D., s e e Alesina, A. 278, 692, 1466,
1469
Rogers, C. 1449, 1450
Rogers, D., s e e Fullerton, D. 576, 588, 616
Rogerson, R. 551,602, 976-978, 1145
Rogerson, R., s e e Benhabib, J. 402, 550, 1145
Rogerson, R., s e e Bertola, G. 1222
Rogerson, R., s e e Cho, J.O. 976
Rogerson, R., s e e Cole, H.L. 1163, 1194,
1201-1203, 1207
Rogerson, R., s e e Greenwood, J. 550, 995
Rogerson, R., s e e Hopenhayn, H. 672, 708,
994
Rogerson, R., s e e Parente, S.L. 702
Rogoff, K. 961, 1415-1418, 1420, 1422, 1425,
1429, 1432, 1434, 1438
Rogoff, K., s e e Bulow, J. 1448, 1449
Rogoff, K., s e e Canzoneri, M.B. 1507, 1508

1-24
Rogoff, K., s e e Obstfeld, M. 407, 1507, 1590,
1630
Rojas-Suarez, L. 1575
Roland, G., s e e Persson, T. 1460
Roldos, J. 1578
Roll, R. i328
Romer, C.D. 6, 69, 92, 137, 183, 187, 204,
205, 1618
Romer, D. 237, 643, 649, 651,661,930, 1013,
1034, 1140, 1157, 1163, 1635, 1661
Romer, D., s e e Ball, L. 1023, 1037, 1041,
1127
Romer, D., s e e Frankel, J.A. 280, 281
Romer, D., s e e Mankiw, N.G. 244-246, 252255, 269-271,277-279, 289, 653, 655, 660,
673, 679-683, 685, 686, 1638
Romer, D.H., s e e Romer, C.D. 69, 92, 137
Romer, EM. 238, 245, 260, 261,264, 265, 271,
278, 280, 398, 424, 425, 641, 651, 665,
672, 705-707, 715-717, 719, t638
Romer, EM., s e e Evans, G.W. 425, 426, 506,
521
Rose, A., s e e Akerlof, G.A. 1200
Rose, A.K., s e e Eichengreen, B. 1590
Rose, A.K., s e e Frankel, J.A. 1590
Rosen, A., s e e Meehl, E 1319
Rosen, S. 584, 5 8 5 , 976
Rosensweig, J.A. 1659
Rosenthal, H., s e e Alesina, A. 1425, 1426
Roseveare, D. 1626
Ross, L. 1319
Ross, S., s e e Brown, S. 1242
Ross, S.A. 1331
Rossmla, R.J. 879, 881,886, 907
Rossana, R.J., s e e Maccini, L.J. 881, 893, 894,
903, 907
Rossi, EE., s e e Jones, L.E. 380, 672, 711-713,
1675, 1711
Rotemberg, J.J. 67, 68, 395, 397, 406, 407,
423, 429, 434, 838, 910, 974, 996, 1020,
1033, 1034, 1036, 1040, 1041, 1043, 1044,
1055, 1056, 1058, 1062, 1063, 1067-1069,
1074, 1081, 1082, 1088-1090, 1092, 1093,
1106, 1t07, 1114, 1116, 1118, 1123-1125,
1129, 1143, 1144, 1365, 1464, 1492, 1494,
1497
Rotemberg, J,J., s e e Mankiw, N.G. 785
Rotemberg, J.J., s e e Pindyck, R. 1072
Rotemberg, J.J., s e e Poterba, J.M. 159
Rothschild, M. 823
Rotwein, E. 1011

Author

Index

Roubini, N. 1439, 1465

Roubini, N., s e e A|esina, A. 277-279, 1404,
1423, 1425, 1460, 1466, 1471
Roubini, N., s e e Grilli, V 95
Roubini, N., s e e Kim, S. 95
Rouwenhorst, K.G. 1296
Royer, D., s e e Balasko, Y. 506
Rubinstein, A. 1188
Rubinstein, A., s e e Binmore, K.G. 1188
Rubinstein, M. 554-556
Rubinstein, M., s e e Jackwerth, J.C. 1310
Rudd, J.B., s e e Blinder, A.S. 1018, 1118
Rudebusch, G.D. 69, 104, 196, 1493
Rudebusch, G.D., s e e Diebold, EX. 6
Rudebusch, G,D., s e e 0liner, S.D. 137, 820,
1374, 1376
Rudebusch, R.G. 11
Rudin, J. 1040
Ruhm, C. 1152
Runkle, D., s e e Glosten, L. 1280
Rtmkle, D., s e e Keane, M.E 608, 609, 786,
790
Runkle, D.E, 789, 790, 1655
Runkle, D.E, s e e Geweke, J.E 89
Rtmkle, D.E., s e e Mankiw, N.G. 135
Russek, ES., s e e Barth, J.R. 1657
Rust, J. 314, 317, 336
Rust, J., s e e Amman, H.M. 535
Rustichini, A., s e e Benhabib, J. 400, 847, 1449,
1467, 1472
Rustichini, A., s e e Boldrin, M. 400, 1465
Ryder, H. 587
Ryder Jr, H.E. 1284

Sabelhaus, J., s e e Gokhale, J. 750

Sachs, J. 1590, 1591
Sachs, J., s e e Bruno, M. 1090
Sachs, J., s e e Roubini, N. 1439, 1465
Sachs, J.D. 252, 703
Sack, B., s e e Galeotti, M. 909
Sadka, E., s e e Razin, A. 1715
Sahay, R. 1535
Sahay, R., s e e Fischer, S, 1538, 1547, 1561
Saint Marc, M. 222, 223
Saint-Paul, G. 1162, 1472
Saint-Paul, G., s e e Blanchard, O.J. 1214
Sakellaris, E, s e e Barnett, S. 831
Sala-i-Martin, X. 269, 277, 279 282, 659,
694

Author

1-25

Index

Sala-i-Martin, X., s e e Barro, R.J. 237, 245,

246, 252, 269, 271, 272, 278, 284, 643,
651,657, 659, 671,675, 1637
Salge, M . 499
Salmon, C.K., s e e Haldane, A.G. 1485, 1497
Salmon, M. 525
Salmon, P., s e e Kirman, A.P. 536, 539-541
Saloner, G., s e e Rotemberg, J.J. 910, 1058,
1093
Salter, W.E.G. 848
Sampson, L., s e e Fanvel, Y. 1573
Samuelson, P.A. 46, 643, 661, 1311, 1634
Samwick, A. 609
Samwick, A.A., s e e Carroll, C.D. 567
Sandmo, A., s e e Atkinson, A.B, 1718
Sandroni, A. 1293
Sanguinetti, E 1540
Sanguinetti, P., s e e Heymann, D. 506
Sanguinetti, R, s e e Jones, M. 1540
Santaella, J. 1543
Santos, M., s e e Caballe, J. 578
Santos, M.S. 321-323, 326, 327, 335, 353,
354, 382, 590, 1266
Santos, M.S., s e e Bona, J.L. 313
Santos, M.S., s e e Ladron de Guevara, A. 317
Santos, M.S., s e e Peralta-Alva, A. 374
Sargent, T. 162, 198, 929
Sargent, T., s e e Ljungqvist, L. 1214
Sargent, T., s e e Lucas Jr, R.E. 582
Sargent, T., s e e Marimon, R. 455, 523
Sargent, T.J. 73, 121, 135, 417, 418, 453, 455,
457, 458, 464, 465, 489, 504, 523, 524,
529-531,763, 888, 1023, 1024, 1145, 1506,
1507, 1519, t542, 1543,-t630;.t631
Sargent, T.J., s e e Anderson, E.W. 368, 369
Sargent, T.J., s e e Cho, I.-K. 455, 465, 524,
525
Sargent, T.J., s e e Evans, G.W. 530
Sargent, T.J., s e e Hansen, L.R 558, 573, 574,
882, 915, 1294, 1295
Sargent, T.J., s e e Marcet, A. 454, 464, 465,
468, 473~476, 480, 494, 499, 525, 528, 529,
532, 1675, 1705, 1707
Sattinger, M. 577, 578
Satmders, A. 181
Sauvy, A. 222
Savage, L.J. 1308, 1324
Savage, L.J., s e e Friedman, M. 1325
Savastano, M.A. 1589
Savastano, M.A., s e e Masson, RR. 1554,
1588

Savin, N., s e e Bray, M. 454, 465, 466, 473,

475, 527
Savin, N., s e e Ingram, B. 984
Savin, N.E., s e e McManus~ D.A. 908
Savouri, S., s e e Jackman, R. 1221
Sayers, R.S. 156
Sbordone, A. 983
Sbordone, A., s e e Cochrane, J. 1120
Sbordone, A.M. 1078, 1099, 1108, 1118,
1128
Scammell, W.M. 156
Scarpetta, S. 1214
Schaling, E. 1437
Schaling, E., s e e Eijffinger, S. 1432, 1438
Schaller, H., s e e Moore, B.J. 455
Scharfstein, D., s e e Chevalier, J.A. 1122,
1123

Scharfstein, D., s e e Hoshi, T. 1344

Scheinkman, J., s e e Ekeland, I. 1689
Scheinkman, J., s e e Heckman, J.J. 579
Scheinkman, J.A. 566
Scheinkman, J.A., s e e Benveniste, L.M. 321
Schiantarelli, E, s e e Galeotti, M. 909, 1086,
1124

Schrnidt, R, s e e Kwiatkowski, D. 212

Schmidt-Hebbel, K., s e e Easterly, W. 1538
Schmitt-Groh6, S. 406, 407, 416, 418, 429,
431,435
Schmitt-Groh6, S., s e e Benhabib, J. 419, 421,
423
Schmitz Jr, J.A. 672, 695-697, 699
Schnadt, N., s e e Capie, F. 154
Scholes, M., s e e Black, E 1310, 1331
Scholz, J.K., s e e Gale, W.G. 1646
Sch6nhofer, M. 515
Schopenback, P., s e e Erlich, D. 1314
Schotter, A. 1415
Schuh, S. 877, 881,912
Schuh, S., s e e Davis, S.J. 1151, 1152, 1160,
1161, 1178, 1194, 1199
Schuh, S., s e e Fuhrer, J.C. 905, 908
Schuh, S., s e e Humphreys, B.R. 909
Schultz, T.W. 653
Schumaker, L.L. 344, 345
Schwartz, A., s e e Thaler, R.H. 1313
Schwartz, AJ. 156, 161, 173, 180, 204, 1515
Schwartz, A.J., s e e Bordo, M.D. 159, 165, 184,
194, 203, 204, 208, 217, 1404, 1590
Schwartz, A.J., s e e Darby, M.R. 166
Schwartz, A.J., s e e Friedman, M. 61, 137, 154,
162, 172, 176, 179, 180, 185, 189, 222

1-26
Schwert, G.W. 1236, 1280
Schwert, G.W., s e e French, K. 1280
Seater, I I 1621, 1654, 1656, 1657
Sedlacek, G., s e e Heckman, I I 578, 579
Sedlacek, G.J., s e e Hotz, VJ. 792, 803
Segal, I.B. 1157
Senhadji, A.S., s e e Diebold, EX. 11
Sentana, E., s e e King, M. 1333
Seppala, J., s e e Marcet, A. 1675, 1705, 1707
Seslnick, D. 746, 751
Shafir, E. 1316, 1324, 1329
Shafir, E., s e e Tversky, A. 1324
Shapiro, C. 1157
Shapiro, C., s e e Farrell, J. 1121
Shapiro, M. 938, 980
Shapiro, M., s e e Barsky, R. 558, 564, 565
Shapiro, M.D. 138, 818, 1069, 1075, 1655
Shapiro, M.D., s e e Dominguez, K. 182
Shapiro, M.D., s e e Mankiw, N.G. 135
Shapiro, M.D., s e e Ramey, VA. 67, 1089
Sharma, S., s e e Masson, P.R. 1554, 1588
Sharpe, S. 1344
Shaw, E.S., s e e Gurley, J.G. 1507
Shaw, K. 584
Shay, R.P., s e e Juster, ET. 777
Shea, J. 402, 608, 790, 983, 1117
Sheffrin, S.M., s e e Driskill, R.A. 1042
Shefrin, H. 1313, 1317, 1321, 1330
Shell, K. 389, 391,516
Shell, K., s e e Balasko, Y. 427
Shell, K., s e e Barnett, W. 540
Shell, K., s e e Cass, D. 389, 516, 662
Shepard, A., s e e Borenstein, S. 1124
Sherali, D.H., s e e Bazaraa, M.S. 331
Sheshinski, E. 1031, 1037
Sherry, C.M., s e e Bazaraa, M.S. 331
Shiller, R.J. 173, 1234, 1235, 1238, 1249, 1290,
1316, 1317, 1319, 1320, 1323, 1324, 1327,
1330-1332
Shiller, R.J., s e e Campbell, J.Y. 1235, 1265,
1280, 1320
Shiller, R.J., s e e Case, K.E. 1323
Shiller, R.J., s e e Grossman, S.J. 1242, 1246,
1268, 1291
Shin, M.C., s e e Puterman, M.L. 339
Shin, Y., s e e Im, K. 283
S l f m , Y . , s e e Kwiatkowski, D. 212
Shleifer, A. 1317, 1324
Shleifer, A., s e e Barberis, N. 1294, 1322
Shleifer, A., s e e Bernheim, B.D. 1646
Shleifer, A., s e e DeLong, J.B. 1290, 1324

Author

Index

Shleifer, A., s e e La Porta, R. 1240

Shleifer, A., s e e Lakonishok, J. 1323
Shleifer, A., s e e Lee, C. 1324
Shleifer, A., s e e Murphy, K.M. 262, 278,
1082
Shoemaker, C.A., s e e Johnson, S.A. 345, 381
Shor, N.Z. 331
Shoven, J.B. 705, 708
Shoven, J.B., s e e Ballard, C. , 1639
Sibert, A., s e e Rogoff, K. 1416, 1417, 1420,
1425
Sichel, D., s e e Oliner, S.D. 820
Siegel, i i 1312, 1313
Silberman, J. 1316
Simldns, S. 931
Simmons, B. 163
Simon, H.A., s e e Holt, C.C. 882, 885, 888,
909, 910, 912
Simons, H.C. 852, 1485
Simonsen, M.H., s e e Dornbusch, R. 1543,
1565
Sims, C.A. 34, 44, 69, 83, 93, 95, 99, 105, 121,
128, 129, 131, 132, 134, 144, 397, 418,
539, 673, 694, 1509, 1518, 1520, 1631
Sims, C.A., s e e Hayashi, E 788
Sims, C.A., s e e Leeper, E.M. 69, 74, 83, 93,
101, 128, 132, 134, 1036, 1089, 1369
Sinai, A., s e e Eckstein, O. 1344
Singer, B. 292
Singer, B., s e e Heckman, I I 1166
Singleton, K. 1270
Singleton, K.J., s e e D u n n , K.B. 800, 1284
Singleton, K.J., s e e Hansen, L.P. 547, 555,
556, 768, 769, 784, 882, 1234, 1246, 1250,
1261
Siow, A., s e e Altonji, J.G. 789
Skinner, B.E 1328
Skinner, J.S. 771,772
Skinner, J.S., s e e Hubbard, R.G. 567, 569, 572,
573, 593, 771,776, 794, 797, 1660
Slade, M.E. 1015
Slemrod, J., s e e Shapiro, M.D. 1655
Slovic, P., s e e Fischhoff, B. 1319
Small, D.H., s e e Hess, G.D. 1485, 1509
Small, D.H., s e e Orphanides, A. 1485
Smetters, K.A. 1647
Smith, A.A., s e e Krusell, P. 380, 547, 566, 567,
994
Smith Jr, A.A., s e e Krusell, P. 1293
Smith, C.W., s e e Nance, D.R. 1318
Smith, E.L. 1312

Author

Index

Smith, G.W., s e e Devereux, M. 952

Smith, G.W., s e e Gregory, A.W. 376, 377
Smith, R., s e e Alogoskoufis, G.S. 166, 214
Smith, R.P., s e e Lee, K. 284
Smithson, C.W., s e e Nance, D.R. 1318
Snower, D., s e e Blanchard, O.J. 1214
Soares, J., s e e Cooley, T.E 1463
S6derlind, R, s e e Hassler, J. 9, 1238
S6derstr6m, T., s e e Ljung, L. 476
Soerensen, J.E 528
Solnick, A., s e e Judd, K.L. 340
Solon, G. 579, 1058, 1102, 1106
Solon, G., s e e Barsky, R. 43
Solow, R.M. 237, 244, 246, 257, 643, 656, 664,
681, 929, 930, 942, 950-952, 1140, 1207,
1638
Solow, R.M., s e e Blanchard, O.J. 1214
Solow, R.M., s e e Blinder, A.S. 1660
Solow, R.M., s e e Hahn, E 661
Solow, R.M., s e e Samuelson, P.A. 46
Sommariva, A. 222
Sonnenschein, H., s e e Hildenbrand, W. 535,
537
Sorger, G., s e e Hommes, C.H. 529, 532
Souleles, N., s e e Jappelli, T. 790
Spear, S.E. 465
Spear, S.E., s e e Marimon, R. 455, 531
Spiegel, M.M., s e e Benhabib, J. 283
Spilerman, S., s e e Singer, B. 292
Spulber, D.,see Caplin, A.S. 801, 1031, 1032
Spynnewin, E 803
Srba, E, s e e Davidson, J. 750
Srinivasan, T.N. 705
Stacchetti, E., s e e Jones, L.E. 720
Stafford, E, s e e Holbrook, R. 569
Stafford, E, s e e Ryder, H. 587
Staiger, D. 49, 50
Staiger, R. 1415
Staiger, R.W., s e e Bagwell, K. 1125
Stambaugh, R.E, s e e French, K. 1280
Stambaugh, R.E, s e e Kandel, S. 1235, 1252,
1253, 1265, 1270, 1272
Stark, T., s e e Croushore, D. 1485
Starr, R.M., s e e Chah, E.Y. 775
Startz, R., s e e Nelson, C.R. 1264
Statman, M., s e e Shefrin, H. 1313, 1317,
1330
Stedinger, J.R., s e e Johnson, S.A. 345, 381
Stein, J.C., s e e Kashyap, A.K. 137, 881,912,
1344, 1374, 1376
Stengel, R.E 904

1-27
Stephen, P., s e e Ryder, H. 587
Sterling, A., s e e Modigliani, E 1656, 1657
Stigler, G. 1018
Stigler, G.J. 1173
Stigler, S.M. 275
Stiglitz, J., s e e Dixit, A. 1115, 1121, 1126
Sfiglitz, J., s e e Greenwald, B. 857, 1122,
1377
Stiglitz, J., s e e Jaffee, D.M. 1376
Stiglitz, J.E. 1675, 1696, 1718
Stiglitz, J.E., s e e Atkinson, A.B. 1673, 1676,
1680, 1682, 1718
Stiglitz, J.E., s e e Shapiro, C. 1157
Stock, J.H. 9, 11, 39, 43, 45, 50-54, 821,
878, 919, 934, 938, 939, 1011, 1021, 1404,
1674
Stock, J.H., s e e Feldstein, M. 44, 1485, 1497,
1498
Stock, J.H., s e e King, R.G. 54, 941
Stock, J.H., s e e Staiger, D. 49, 50
Stockman, A. 1578
Stockman, A.C. 549
Stockman, A.C., s e e Baxter, M. 203, 938,
1404
Stockman, A.C., s e e Darby, M.R. 166
Stockman, A.C., s e e Gavin, W. 1485
Stockman, A.C., s e e Ohanian, L.E. 1036
Stocks, Bonds, Bills and Inflation 1639
Stockton, D.J., s e e Lebow, D.E. 215, 1016
Stoer, J. 334
Stoker, T., s e e Blundell, R. 770, 788
Stokey, N., s e e Alvarez, E 996
Stokey, N., s e e Lucas Jr, R.E. 559, 561
Stokey, N., s e e Milgrom, R 1322
Stokey, N.L. 271,299, 314, 318-321,346, 578,
583, 672, 705, 709, 711, 714, 951, 954,
998, 999, 1674
Stokey, N.L., s e e Lucas, R.E. 380, 1446, 1449
Stokey, N.L., s e e Lucas Jr, R.E. 158, 1673,
1675, 1699, 1723, 1728
Stone, C.J., s e e Breiman, L. 289
Strang, G. 82
Strongin, S. 83-85, 87, 114
Strotz, R.H. 1653
Strotz, R.H., s e e Eisner, R. 1310
Stroud, A.H. 334
Stuart, A. 1485
Stulz, R.M. 1317
Sturzenegger, F., s e e Dornbusch, R. 1543
Sturzenegger, E, s e e Guo, J.-T. 427
Sturzenegger, E, s e e Mondino, G. 1540

1-28
Suarez, J. 1378
Subrahmanyam, A., s e e Daniel, K. 1322
Sugden, R., s e e Loomes, G. 1313
Suits, D., s e e Kallick, M. 1325
Summers, L.H. 961
Summers, L-.H., s e e Abel, A.B. 1266, 1651
Summers, L.H., s e e Alesina, A. 1432
Summers, L.H., s e e Bernheim, B.D. 1646
Summers, L.H., s e e Blanchard, O.J. 416,
1635
Summers, L.H., s e e Carroll, C.D. 759, 793,
1655
Summers, L.H., s e e Clark, K.B. 602, 1173
Summers, L.H., s e e Cutler, D.M. 1290, 1320,
1321
Summers, L.H., s e e DeLong, J.B. 279, 695,
1042, 1290, 1324
Summers, L.H., s e e Easterly, W. 277, 278, 281,
675
Summers, L.H., s e e Kotlikoff, L.J. 780, 1646
Summers, L.H., s e e Mankiw, N.G. 785
Summers, L.H., s e e Poterba, J.M. 1235, 1320,
1648
Summers, R. 238, 301, 640, 673-675, 677,
680, 681,689, 720
Sun, T. 1270
Sundaram, R.K., s e e Dutta, RK. 380
Sundaresan, S.M. 1284
Sunder, S., s e e Marimon, R. 455, 472, 531
Surekha, K. 908
Sussman, O., s e e Suarez, J. 1378
Svensson, J. 1466, 1471, 1472
Svensson, L.E.O. 156, 197, 417, 1033, 1034,
1273, 1411, 1432, 1434, 1489, 1493, 1494,
1498, 1504
Svensson, L.E.O., s e e Englund, E 9
Svensson, L.E.O., s e e Kotlikoff, L. 1448, 1449,
1465
Svensson, L.E.O., s e e Leiderman, L. 1432,
1438, 1495
Svensson, L.E.O., s e e Persson, M. 1447, 1449
Svensson, L.E.O., s e e Persson, T. 1449, 1450,
1454, 1456, 1465
Swagel, P., s e e Alesina, A. 277-279, 1460,
1466, 1471
Swan, T.W. 244, 246, 247, 643
Sweeney, J., s e e Kneese, A. 656
Swoboda, A., s e e Genberg, H. 165
Symansky, S.A., s e e Bryant, R.C. 1491, 1497,
1516
Szafarz, A., s e e Adam, M. 500

Author

Szafarz, A.,

see

Index

Broze, L. 487, 488

Tabellini, G. 1414, 1415, 1450, 1456, 1464,

1465
Tabellini, G., s e e Alesina, A. 1446, 1449, 1450,
1454, 1465, 1518, 1522
Tabellini, G., s e e Cukierman, A. 1456, 1465
Tabellini, G., s e e Daveri, E 1220
Tabellini, G., s e e Edwards, S. 1538
Tabellini, G., s e e Grilli, V. 1404, 1432, 1438,
1439, 1465
Tabellini, G., s e e Ozler, S. 1457, 1465
Tabellini, G., s e e Persson, T. 278, 692, 1400,
1403, 1413, 1415 1418, 1420, 1421, 1425,
1433, 1435, 1437-1440, 1442, 1445, 1448,
1449, 1459, 1460, 1466, 1469, 1470, 1490
Taber, C., s e e Heckman, J.J. 576, 578, 582,
584, 586, 587, 590, 592, 593
Taguas, D., s e e Blanchard, O.J. 1214
Tallarini Jr, T.D., s e e Hansen, L.R 558, 1294,
1295
Tallman, E.W., s e e Rosensweig, J.A. 1659
Talvi, E. 1543, 1571, 1604
Tan, K.S. 334
Tanner, S., s e e Banks, J. 758, 792
Tanzi, V 1741
Tarshis, L. 939, 1059
Tauchen, G. 367
Taylor, A., s e e Obstfeld, M. 164, 165
Taylor, C. 1330
Taylor, J.B. 46, 182, 314, 397, 408, 417, 422,
454, 474, 487, 489, 495, 545, 1011, 1013,
1015, 1017, 1025, 1027-1031, 1037-1039,
1042, 1043, 1113, 1364, 1411, 1485, 1487,
1488, 1490, 1497, 1505, 1507, 1512, 1513,
1516, 1518, 1542, 1582
Taylor, J.B., s e e Phelps, E. 1025, 1026
Taylor, L.D., s e e Houthakker, H.S. 803
Taylor, S.E. 1330
Tejada-Guibert, J.A., s e e Johnson, S.A. 345,
381
Teles, R, s e e Correia, I. 1537, 1675, 1720,
1733
Telmer, C.I., s e e Backus, D.K. 1316
Temin, E 162, 179, 180, 183, 184
Temple, J. 276
Terlizzese, D., s e e Guiso, L. 772
Terna, R, s e e Beltratti, A. 524, 525
Terrones, M. 1425
Teruyama, H., s e e Fukuda, S.-i. 875
Tesar, L., s e e Mendoza, E. 1439

Author

Index

Tesar, L., s e e Stockman, A.C. 549

Tetlow, R., s e e Fillion, J.E 1498
Teukolsky, S.A., s e e Press, W.H. 329-334, 343,
348, 356, 365
Thaler, R., s e e Froot, K. 1316
Thaler, R., s e e Lee, C. 1324
Thaler, R.H. 1313, 1317
Thaler, R.H., s e e Benartzi, S. 1290, 1312,
1313
Thaler, R.H., s e e De Bondt, W.E 1307, 1320,
1323
Thaler, R.H., s e e Shefrin, H. 1317
Thaler, R.H., s e e Siegel, J.J. 1312
The Economist 1238, 1632
Theunissen, A.J., s e e Whittaker, J. 1508
Thomas, J. 994
Thomas, J.K., s e e Bernard, VL. 1321
Thomas, T.J. 161
Thompson, S.C., s e e Taylor, S.E. 1330
Thomson, J.B., s e e Carlson, J.B. 104
Thornton, H. 1485
Thurow, L. 759
Tieslau, M.A., s e e Hoffman, D.L. 412
Tillmann, G. 474
Timberlake, R.H. 169, 174
Timmermann, A.G. 454, 455, 500, 530
Tinbergen, J. 817
Tirole, J. 1266, 1650
Tirole, J., s e e Fudenberg, D. 1155
Tirole, J., s e e Holmstrom, B. 1376
Titman, S., s e e Jegadeesh, N. 1321
Tobin, J. 773, 817, 818, 1643
Tobin, J., s e e Brainard, W.C. 817
Tobin, J., s e e Eichengreen, B. 168
Todd, R, s e e Heckman, J.J. 578, 582
Todd, R., s e e Cl~istiano, L.J. 1365
Toharia, D., s e e Blanchard, O.J. 1214
Toma, M. 174, 177, 187, 190
Toma, M., s e e Goff, B.L. 159
Tommasi, M. 1540
Tommasi, M., s e e Jones, M. 1540
Tommasi, M., s e e Mondino, G. 1540
Topel, R. 578
Topel, R., s e e Juhn, C. 619
Topel, R., s e e Murphy, K. 581
Tornell, A. 1466, 1472, 1590
Tornell, A., s e e Lane, E 1472
Tornell, A., s e e Sachs, J. 1590, 1591
Townsend, R.M. 453, 461,474, 529, 795, 796,
1350, 1376

1-29
Townsend, R.M., s e e Phelan, C. 380, 575,
796
Traub, J.E 338
Traub, J.E, s e e Papageorgiou, A. 334
Trehan, B. 159
Tria, G., s e e Felli, E. 1083, 1122
Triffin, R. 157, 165
Trostel, RA. 1652
Tryon, R., s e e Brayton, E 1043, 1344, 1485
Tsiddon, D. 1031
Tsiddon, D., s e e Lach, S. 1019
Tsitsiklis, J.N., s e e Chow, C.-S. 326, 334
Tsutsui, Y., s e e Shiller, R.J. 1316
Tullio, G. 156
Tullio, G., s e e Sommariva, A. 222
Tullock, G., s e e Grier, K.B. 253
Tuncer, B., s e e Krueger, A.O. 699
Yurnovsky, S. 474
Tversky, A. 1308, 1315, 1319, 1324, 1330
Tversky, A., s e e Kahneman, D. 1308, 1309,
1311
Tversky, A., s e e Quattrone, G.A. 1329
Tversky, A., s e e Shafir, E. 1316, 1324, 1329
Tversky, A., s e e Thaler, R.H. 1313
Tybout, J., s e e Corbo, V. 1543
Tylor, E.B. 1331
Uhlig, H. 70
Uhlig, H., s e e Lettau, M. 524, 1297
Uhlig, H., s e e Taylor, J.B. 314
United Nations 681
Uppal, R., s e e Dumas, B. 564
Uribe, M. 1539, 1578, 1589
Uribe, M., s e e Benhabib, J. 419, 421,423
Uribe, M., s e e Mendoza, E. 1571, 1579
Uribe, M., s e e Schmitt-Groh~, S. 416, 418,
431
US Bureau of the Census 585
Uzawa, H. 578, 651,710
Valdes, R., s e e Dornbusch, R. 1590
Valdivia, V, s e e Christiano, L.J. 504
Van Huyck, J.B., s e e Grossman, H.J. 158, 1415,
1449
van Wineoop, E., s e e Beaudry, E 1264
Van Zandt, T., s e e Lettau, M. 470, 472
Vasicek, O. 1270
V6gh, C., s e e Guidotti, EE. 1675, 1720
V6gh, C.A. 1535, 1538, 1542, 1543, 1546,
1550, 1554, 1588
V6gh, C.A., s e e Bordo, M.D. 158

1-30
V6gh, C.A., s e e Calvo, G.A. 1428, 1535, 1538,
1539, 1546, 1554, 1557, 1563, 1564, 1568,
1571, 1572, 1582, 1587-1589, 1597, 1605
Vdgh, C.A., s e e De Gregorio, J. 1546, 1551,
1573, 1575, 1577
V6gh, C.A., s e e Edwards, S. 1578-1580
V6gh, C.A., s e e Fischer, S. 1538, 1547, 1561
V6gh, C.A., s e e Guidotti, EE. 1537, 1588,
1603
V6gh, C.A., s e e Hoffiaaaister, A. 1561, 1589
V6gh, C.A., s e e Lahiri, A. 1597
V~gh, C.A., s e e Rebelo, S.T. 1546, 1568, 1578,
1579, 1581, 1606
V~gh, C.A., s e e Reinhart, C.M. 1545, 1546,
1551, 1553, 1561, 1572, 1573
V6gh, C.A., s e e Sahay, R. 1535
Vela, A., s e e Santaella, J. 1543
Velasco, A. 416, 1446, 1449, 1450, 1459, 1465,
1540
Velasco, A., s e e Sachs, J. 1590, 1591
Velasco, A., s e e Tommasi, M. 1540
Velasco, A., s e e Tomell, A. 1466, 1472, 1590
Venable, R., s e e Levy, D. 1014, 1015, 1019
Venegas-Martinez, E 1571
Ventura, G., s e e HuggeR, M. 380
Veracierto, M. 994
Verdier, T., s e e Saint-Paul, G. 1472
Vetterling, WT., s e e Press, WH. 329-334, 343,
348, 356, 365
Viana, L. 1543
Vickers, J. 1414, 1415
Vigo, J., s e e Santos, M.S. 321,322, 326, 327,
335
Vinals, J., s e e Goodhart, C.E.A. 1438, 1495
Vishny, R.W., s e e Barberis, N. 1294, 1322
Vishny, R.W., s e e La Porta, R. 1240
Vishny, R.W, s e e Lakonishok, J. 1323
Vishny, R.W, s e e Murphy, K.M. 262, 278,
1082
Vishny, R.W, s e e Shleifer, A. 1324
Visscher, M., s e e Prescott, E.C. 700
Vives, X. 474, 532
Vives, X., s e e Jun, B. 474
Volcker, P.A. 1630
von Furstenberg, G.M. 1333
von Hagen, J. 1439, 1460, 1465
von Hagen, J., s e e Eiehengreen, B. 1465
von Hagen, J., s e e Fratianni, M. 1431
yon Hagen, J., s e e Hallerberg, M. 1460, 1465
von Weizs/icker, C. 641,650, 657
Vredin, A.E., s e e Bergstr6m, V. 538

Author

Index

Vuong, Q.H., s e e Rivers, D. 840

Wachtel, E 1658
Wachtel, E, s e e Evans, M. 182
Waehter, S.M., s e e Goetzmann, WN. 1333
Wadhwani, S., s e e King, M. 1333
Wagner, R.E., s e e Buchanan, J.M. 1631
Waldmann, R.J., s e e DeLong, J.B. 1290, 1324
Walk, H., s e e Ljung, L. 476
Walker, M., s e e Moreno, D. 481
Wallace, N., s e e Sargent, T.J. 417, 418, 489,
1024, 1506, 1507, 1519, 1630
Waller, C. 1431
Waller, C., s e e Fratianni, M. 1431
Wallis, K., s e e Kreps, D.M. 540
Walsh, C.E. 1433, 1434, 1437, 1438, 1490
Walsh, C.E., s e e Trehan, B. 159
Walsh, C.E., s e e Waller, C. 1431
Wang, EA. 1322
Wang, J. 1237, 1293
Wang, L.-T., s e e Dezhbakhsh, H. 1039
Wang, T., s e e Dumas, B. 564
Warner, A.M., s e e Sachs, J.D. 252, 703
Warner, E.J. 1019
Wascher, W., s e e Lebow, D.E. 1016
Watson, J., s e e den Haan, W.J. 994, 1166, 1194,
1203, 1204, 1206, 1207
Watson, J., s e e Ramey, G. 852, 1157, 1159
Watson, M.W 6, 50, 547, 931
Watson, M.W, s e e Bernanke, B.S. 144
Watson, M.W., s e e Blanchard, O.J. 1266
Watson, M.W., s e e Canjels, E. 55
Watson, M.W, s e e King, R.G. 46, 54, 939,
941
Watson, M.W, s e e Staiger, D. 49, 50
Watson, M.W, s e e Stock, J.H. 9, 43, 45, 50-52,
821, 878, 919, 934, 938, 939, 1011, 1021,
1404, 1674
Webb, S., s e e Goodman, A. 797
Webber, A., s e e Capie, E 222
Weber, G. 774
Weber, G., s e e Alessie, R. 774, 775
Weber, G., s e e Attanasio, O.P. 611-613, 756,
769, 781, 783, 784, 787, 790, 791, 793,
794, 1264, 1655
Weber, G., s e e Blundell, R. 781
Weber, G., s e e Brugiavini, A. 775
Weber, G., s e e Meghir, C. 611,613, 775, 804
Weber, M. 1331
Weder, M. 403, 437
Wehrs, W, s e e Carlson, J.A. 904

Author

Index

Weibull, J., s e e Lindbeck, A. 1465

Weil, D.N., s e e Mankiw, N.G. 173, 216, 244~
246, 252-255, 269-271,277-279, 289, 653,
655, 660, 673, 679-683, 685, 686, 1638
Weil, E 547, 1235, 1250, 1253, 1256, 1647
Weil, R, s e e Blanchard, O.J. 1650
Weil, E, s e e Restoy, E 1272
Weingast, B., s e e North, D. 1449
Weinstein, M.M. 182
Weisbrod, S.R., s e e Rojas-Suarez, L. 1575
Weiss, A., s e e Greenwald, B. 1122
Weiss, L., s e e Scheinkman, J.A. 566
Weiss, Y. 583
Weiss, Y., s e e Blinder, A. 587
Weiss, Y., s e e Lillard, L. 569, 572
Weiss, Y., s e e Sheshinski, E. 1031, 1037
Weitzman, M.L. 1689
Welch, E 579
Welch, I., s e e Bikhchandani, S. 1332
Wen, J.E, s e e Devereux, M. 1466, 1471
Wen, L. 427, 431
Wenzelburger, J., s e e Brhm, V 475
Wemer, A., s e e Dombusch, R. 1543, 1563,
1568
West, K.D. 871, 876, 880, 882, 885, 887, 888,
894, 896, 897, 900, 902, 905-908, 913, 919,
1028, 1041, 1320, 1497
Whalley, J. 705
Whalley, J., s e e Ballard, C. 1639
Whalley, J., s e e Shoven, J.B. 705, 708
Whalley, J., s e e Srinivasan, T.N. 705
Wheatley, S. 1242, 1261
Wheelock, D.C. 177, 179
Wheelock, D.C., s e e Calomiris, C.W 187,
191
Whinston, M.D., s e e Segal, I.B. 1157
White, E., s e e Bordo, M.D. 159
White, E.N. 180
White, H. 524
White, H., s e e Chen, X. 476, 532
White, H., s e e Kuan, C.-M. 476
Whited, T. 1344
Whited, T., s e e Hubbard, R.G. 1344
Whiteman, C. 487
WhiR, W. 326
Whittaker, J. 1508
Wickens, M.R., s e e Robinson, D. 217
Wicker, E. 162, 176, 177, 179-181, 1543
Wicksell, K. 203, 1485, 1631
Wieland, V., s e e Orphanides, A. 1485
Wigmore, B.A. 163, 183

1-31
Wilcox, D. 1242
Wilcox, D., s e e Kusko, A.L. 1327
Wilcox, D.W 1655
Wilcox, D.W., s e e Carroll, C.D. 769, 785
Wilcox, D.W., s e e Cecchetti, S.G. 876
Wilcox, D.W, s e e Kashyap, A.K. 137, 877,
886, 903, 906, 912
Wilcox, D.W, s e e Orphanides, A. 198, 1485
Wilcox, D.W., s e e West, K.D. 908
Wildasin, D., s e e Boadway, R. 1463
Wilkinson, M. 881
Williams, J.C., s e e Brayton, E 1043, 1344,
1485
Williams, J.C., s e e Gilchrist, S. 847
Williams, J.C., s e e Wright, B.D. 347, 348
Williamson, J. 1597
Williamson, O.E. 852
Williamson, S. 1376
Willis, R., s e e Heckrnan, J.J. 602, 623
Wilson, B., s e e Saunders, A. 181
Wilson, C.A. 408
Wilson, R. 554, 796
Winter, S.G., s e e Phelps, E.S. 1121
Woglom, G. 1127
Wohar, M.E., s e e Fishe, R.P.H. 173
Wojnilower, A. 1344
Wolf, H., s e e Dornbusch, R. 1543
Wolf, H., s e e Ghosh, A.R. 202, 207, 208
Wolff, E. 664
Wolfowitz, J., s e e Kiefer, J. 476
Wolinsky, A. 1188
Wolinsky, A., s e e Binmore, K.G. 1188
Wolinsky, A., s e e Rubinstein, A. 1188
Wolman, A.L., s e e Dotsey, M. 974, 1032,
1043
Wolman, A.L., s e e King, R.G. 1036, 1041,
1043, 1364, 1367
Wolters, J., s e e Tullio, G. 156
Wong, K.-E 108
Wood, G.E., s e e Capie, E 163, 1438
Wood, G.E., s e e Mills, T.C. 204
Woodford, M. 389, 395, 406, 407, 409, 418,
421-423, 439, 454, 473-476, 481,483, 507,
516, 518, 521,662, 1036, 1157, 1507, 1509,
1518-1520, 1537, 1630, 1675, 1676, 1720,
1731
Woodford, M., s e e Bernanke, B.S. 1361, 1363
Woodford, M., s e e Boldrin, M. 506
Woodford, M., s e e Farmer, R.E. 395, 396
Woodford, M., s e e Guesnerie, R. 439, 454,
460, 465, 474, 475, 506, 511,516, 526

1-32
Woodford, M., s e e Kehoe, T.J. 380
Woodford, M., s e e Lucas Jr, R.E. 1023
Woodford, M., s e e Rotemberg, J.J. 67, 68,
395, 406, 407, 429, 434, 974, 996, 1020,
1041, 1043, 1044, 1055, 1056, 1062, 1063,
1067-1069, 1074, 1081, 1082, 1088-1090,
1092, 1093, 1106, 1107, 1118, 1123-1125,
1129, 1143, 1144, 1365, 1492, 1494, 1497
Woodford, M., s e e Santos, M.S. 1266
Woodward, P.A., s e e Baker, J.B. 1125
Wooldridge, J., s e e Bollerslev, T. 1280
Wozniakowski, H., s e e Traub, J.E 338
Wright, B.D. 347, 348
Wright, M.H., s e e Gill, RE. 329
Wright, R. 1158
Wright, R., s e e Benhabib, J. 402, 550, 1145
Wright, R., s e e Boldrin, M. 399
Wright, R., s e e Burdett, K. 1196
Wright, R., s e e Greenwood, J. 550, 995
Wright, R., s e e Hansen, G.D. 976
Wright, R., s e e Kiyotaki, N. 524
Wright, R., s e e Parente, S.L. 702
Wright, R., s e e Rogerson, R. 978
Wurzel, E., s e e Roseveare, D. 1626
Wynne, M. 974
Wyrme, M.A., s e e Huffman, G.W 437
Wyplosz, C., s e e Eichengreen, B. 168, 1590
Xie, D. 425
Xie, D., s e e Benhabib, J. 425
X i e , D . , s e e Rebelo, S.T. 952
Xu, Y. 344
Yashiv, E. 1200
Yellen, J.L., s e e Akerlof, G.A. 397, 1034, 1035,
1039, 1157, 1200
Yeo, S., s e e Davidson, J. 750
Yi, K.-M., s e e Kocherlakota, N.R. 271
Yin, G.G., s e e Kushner, H.J. 476
Yong, W., s e e Bertocchi, G. 474
Yorukoglu, M., s e e Cooley, T.E 847

Author

Index

Yorukoglu, M., s e e Greenwood, J. 576

Yotsuzuka, T. 1649
Young, A. 664, 672, 673, 687, 716
Young, J., s e e Wachtel, R 1658
Yu, B., s e e Hashimoto, M. 1152
Yun, T. 1026, 1036

Zarazaga, C.E. 1540

Zarazaga, C.E., s e e Kydland, EE. 1557, 1561
Zarnowitz, V 9, 40
Zeckhauser, R., s e e Degeorge, E 1321
Zeckhauser, R.J., s e e Abel, A.B. 1266, 1651
Zeira, J., s e e Galor, O. 262, 263
Zejan, M., s e e Blomstrom, M. 277, 279, 280
Zeldes, S.P. 566, 607 609, 771,789, 790, 802,
1344, 1655
Zeldes, S.P., s e e Barsky, R.B. 1653
Zeldes, S.R, s e e Hubbard, R.G. 567, 569, 572,
573, 593, 771,776, 794, 797
Zeldes, S.P., s e e Mankiw, N.G. 790, 1290
Zeldes, S.P., s e e Miron, J.A. 876, 907
Zetdes, S.R, s e e O'Connell, S.A. 1650
Zellner, A. 34
Zenner, M. 497
Zha, T., s e e Cushman, D.O. 95, 96
Zha, T., s e e Leeper, E.M. 69, 74, 83, 93, 101,
128, 132, 134, 1089, 1369
Zha, T., s e e Sims, C.A. 69, 83, 93, 99, 128,
129, 131, 132, 134, 144
Zhang, L., s e e Lockwood, B. 1411, 1415
Zhou, Z., s e e Grossman, S.J. 1237, 1293
Zhu, X. 1708
Zilcha, I., s e e Becker, R. 369
Zilibotti, E, s e e Gali, J. 405, 426
Zilibotti, E, s e e Marimon, R. 1214
Zin, S.E., s e e Epstein, L.G. 556, 558, 564, 744,
769, 1250, 1256
Zingales, L., s e e Kaplan, S.N. 856, 1344

SUBJECT INDEX

accelerator 884, 890, 896, 909

accelerator model 816, 817
accelerator motive 867, 902
activist vs. non-activist policies 1485
actual law of motion (ALM) 466, 472, 490,
511
adaptive expectations 453, 465
adaptive learning 464, 472, 493, 510
stability under 471
adaptively rational expectations equilibrium
532
adjustment
costs 800, 1072
employment 1075
hours 1075
in investment 1296
non-convex 821,839
production 867, 892, 893, 900
hazard 835, 836, 840
speed of 881,889, 908
age distribution 753, 848
aggregate convexity 843
aggregate demand 1617, 1628, 1630
aggregate human capital 583, 590-593
aggregate productivity 1195
aggregate productivity shock 1204
heterogeneous 1214
aggregate shocks 578, 582, 865
aggregation 548-594, 604, 605, 614, 615, 745,
781, 804, 836, 849, 910
across commodities 782
AK model 672, 673, 709-715, 720, 733
allocation rules 1688, 1723
alternative dating 499
amplification 841, 1145, 1158, 1159, 1161
anchoring 1314-1317, 1322
animal spirits 395, 517, 521,941
anomalies 1307, 1308, 1316, 1317, 1321, 1322,
1333, 1334
approximation error 326-345, 351-382
arbitrage 1246
ARMA models 489, 496, 501
Arrow-Debreu equilibrium 795

asset-price channel 1378

asset prices, variable 1356
asset pricing models with feedback 500
asset pricing with risk neutrality 498
associated differential equation 519
asymmetric fixed costs 825
asymmetry in adjustment of employment
1158
asymptotic stability 479, 639
autarky 853
automatic stabilizers 1660
average cohort techniques 787

backlog costs 884

backstop technology 656
balance-of-payments (BOP) crises 1534, 1535,
1553
balanced-budget rule 1631
balanced growth path 50, 392, 393, 424, 425,
427
band-pass filter, s e e BP filter
bank lending channel 1376
Barro, R. 1640, 164~1646
Bayesian learning 474
Bayesian updating 461,465
Belgium 1619
Bellman's Principle of Optimality 998
bequest motive 745, 780, 1624, 1646,
1647
strategic 1646
best practice 848
/3-convergence 659
Beveridge curve 1194, 1196, 1221, 1222
bilateral bargaining problem 1157
black market premium 671,688, 689, 691-694,
703
Blanchard-Kahn technique 505
Bolivia 1631
boom-recession cycle 1550, 1552, 1581
bootstrap methodology 79
BOP crises, s e e balance-of-payments crises
borrowers' net worth 1345
1-33

1-34
borrowing constraint 566, 575, 593, 595, 597,
598, 772, 775, 1293
see also capital market imperfections;
credit market imperfections; liquidity
constraints
Boschen-Mills index 139-142
bottlenecks 842, 843
bounded rationality 454, 464
BP (band-pass) filter 12, 933, 934
Bretton Woods 152, 153, 163-168, 188, 190,
192, 199, 202-204, 206~09, 211,213, 215,
218-220
Brownian motion 825, 845
regulated 845
bubble-free solution 1524
bubble solutions 1522
bubbles 499
explosive 499
budget deficit 1619
budget surplus 1619
buffer-stock saving 771, 1653, 1654
building permits 45
Burns-Mitchell business cycle measurement
932
business cycles 865, 927-1002, 1620, 1621,
1659
s e e also cycles; fluctuations in aggregate
activity
facts about 934, 938, 939, 956
general equilibrium models 67
in RBC model 968
measuring 932
persistence of 939
table of summary statistics 956, 957
US facts 934
USA 935-938, 956
Cagan model of inflation 497
calculation equilibrium 462
calibration 545, 550, 567, 601,614, 616
Canada 45
capacity utilization 41,427, 431,930
modeling of 980
rate of 981
steady-state rate of 984
capital 1617, 1687
broad measure 701
desired 816, 842
frictionless 832, 838
human 673, 678, 679, 681-687, 701, 710,
713, 714, 716-718, 720, 732, 734

Subject I n d e x
see also human capital
organizational 700, 701
physical 678-683, 701,710, 713, 714, 721,
732
specific 1154
stock of 1629, 1630, 1632, 1633, 1636-1638,
1648, 1652, 1656
target 820
unmeasured 701,702
vintage 702
capital accumulation 942, 1203
general equilibrium nature of 946
optimal 946
perpetual inventory method 944
capital budgeting 1623
capital controls 1588
capital imbalances, establishments' 837
capital intensities 641,644, 679, 680, 682, 685,
686
capital investment decision 1349
capital/labor substitution 856
capital market imperfections 1648, 1649
s e e also borrowing constraint; credit market
imperfections
capital taxation 1661, 1708
optimality of zero 1693
capital utilization 848
CARA utility 794
cash-in-advance constraint 397, 1722
cash-credit model 1720, 1721
"catching up with the Joneses" 1284
certainty equivalence 762
Chamley result 1698
characteristics model 578, 579, 582, 602
characterization of equilibria 487, 489
Cholesky factor 80
classification 262, 289, 303
classifier systems 465, 523
closed economy 1714
closed-form solution 769
club-convergence 660
Cobb-Douglas production function in RBC
model 944, 950
"cobweb" model 456
coefficient of relative risk aversion 1249
cohort data 78t
cohort effects 576, 577, 590-592, 617, 753,
754
cointegration 50, 750, 820, 838, 877-881,
885-887, 903, 1266
collateral 857

1-35

Subject lndex

commitment 574, 575, 1488, 1523

technology 1688, 1723
vs. flexibility 1489
commodity space 1686
comparative advantage 547, 548, 577-579,
584, 587
comparative dynamics measured by impulse
response 967, 968, 970
competitive equilibrium 844, 845, 1677, 1688,
1722
competitive trajectory 650
complementarity 1161
complements 599, 601,611-613, 855
complete markets 553, 558, 563, 595, 602,
786, 1688
computation of (approximate) solutions 525
computational general equilibrium (CGE) 705,
708
computational intelligence 465
computational tool 455
conditionally linear dynamics 475, 481
conditioning 556, 594, 597-599, 601,605, 612,
613
consistent expectations equilibria 529
constant returns to scale 639, 831, 1687
in RBC model production fimction 995
consumer expectations 45
consumer theory 603
consumer's budget constraint 1264, 1712,
1728
consumption 40, 545, 546, 548-558, 560-564,
566, 567, 572-576, 587, 590, 594-603,
605-614, 616, 621, 1276
behavior in US business cycles 938
empirical 1344
estimates 605-614
'excess' sensitivity 524
growth 1233, 1242, 1276
inequality in 797
permanent-income hypothesis 943
private 1687
procyclical 433~435
smoothing 805
in RBC model 967
time-averaged data 1242
consumption-based asset pricing 1249
consumption expenditure 745
Consumption Expenditure Survey (CEX) 750
consumption per capita 643
consumption taxes 1692
contract multiplier 1028

contractual problems 849

control rights 852
control variables 688, 689
convergence 240, 245-276, 284-288, 290, 295,
296, 659
global 486
local 519
probability of 480
speed of 531,659
convergence analysis 454, 477-479
convertibility 153, 160
convertibility rules 209, 213
convex adjustment costs 818, 823
coordination failures 461
coordination of beliefs 391
comer solutions 804
cost &capital 817, 1344
cost shifters 906, 912
cost shock 867, 884, 899, 907, 908, 912
Costa Rican tariff reform 707
costly state verification 1349
creative destruction 848, 1210, 1213
credibility 1536, 1603
credit chains 1378
credit constraints 856
credit market 847
imperfections 1343
see also borrowing constraint; capital
market imperfections
segmentation 1575, 1577
cross-country regression 276, 281
cross-section least-squares regression 269
cross-sectional density 840
of establishments' capital imbalances 837
cross-sectional growth regression 252, 269273, 275, 276, 284-289, 671, 675, 694
literature 688
crossover 522
crowding out 1632, 1633, 1636, 1638, 1648,
1652, 1654
currency crises 1534
current account deficit 1598
Current Population Survey 796
curse of dimensionality 843, 847
customer markets 1120
cycles 460, 507, 509, 526, 865
deadweight loss 1631, 1632, 1639, 1640,
1662
debt contract 1350
debt-deflation 1372

1-36
debt neutrality 1644
debt-income ratio 1630
debt--output ratio 1619
decentralized economy 547, 575, 576, 602
decision rule 888-890
deficits 1617
nominal 1621
real 1621
demand shocks 865, 884, 889 892, 895, 898,
1055
demographic transition 658
demographic variables 793
demographics 547, 551-615, 744
and retirement behavior 758
depreciation 642, 1633
detrending and business cycle measurement
932
difference models of habit 1284
difference-stationary models 764
difference-stationary process 211,215, 1497
differential equation 472
diminishing returns 639
separately to capital and augmented labor
653
dirty floating 1587
discount factor 548, 555-557, 561,567, 588,
595, 606, 607, 609, 610, 616
disinflation, output costs of 1542
disjunction effect 1324
disparity in GDP 675
disparity in incomes 674
distribution dynamics 263, 290-295, 299
distribution of country incomes 674
distribution of relative GDP 674
dividend growth 1233, 1242, 1276
dollarization 1589
domestic debt 1595, 1601
domestic policy regime 153, 202
Dornbusch-type model 502
DSGE, s e e dynamic stochastic general
equilibrium models
durability 798, 1242
durable goods 549, 746, 799, 1550, 1552, 1573,
1575
dynamic economic models 312, 313
Dynamic New Keynesian (DNK) framework
1346
dynamic programming 834
dynamic stochastic general equilibrium (DSGE)
models 930, 1139, 1145, 1150, 1157,
1166

Subject Index

models with job search

1158

earnings 546, 567-573, 577-588, 592, 593,

598, 605, 615, 623
s e e also wages
structural equation 582
variance 569 572, 578, 586
econometric approaches 237
economic growth 1617, 1641; 1651
economic relationship 852
education 577, 578, 580, 584, 602, 607, 609,
613, 615, 622, 623, 653
eductive approaches 462, 464
effective labor 650
efficiency of terminations 1152
efficiency units 566, 658
s e e also labor in efficiency units
efficiency wages 577, 578, 1098, 1157, 1159,
1160
efficient equilibrium 854
efficient markets 1307, 1308, 1316, 1319-1322,
1333
elastic labor supply 1145
elasticity 545, 546, 550-552, 563, 579, 580,
592-594, 596-601,605, 607, 610, 614-617,
620
of capital supply 1714
long run 838
of demand, varying 1119
of intertemporal substitution 552, 557, 561,
564, 597, 600, 601,614, 615, 769, 791,
1148, 1250
of investment 857
of labor supply schedule 1147
of substitution 645
election 522
embodied technology 1207
embodiment-effect 664
employment 39
employment contract 1153
employment fluctuations 1173, 1194
employment protection 1215, 1217
employment relationship 1157
endogenous fluctuations 506, 531
endogenous growth models 238, 241,243, 245,
257, 259, 261, 264, 265, 269, 271, 297,
506, 651,653, 1711
entry 1067
variable 1125
entry and exit 551,602, 615, 616, 824, 844
envelope theorem in RBC model 998

1-37

Subject Index

"episodic" approach 1560

e-SSE 520
Epstein-Zin-Weil model 1259
equipment 840
equity premium puzzle 1234, 1245, 1249,
1250
error correction model 750
E-stability 463, 466, 468, 471-473,488, 490,
491,504, 511
iterative 463
strong 473, 483, 491,512
weak 473, 483, 512
Euler equation 314, 345-347, 349-352, 354,
355, 364, 368, 371, 373, 374, 381, 382,
555-558, 566, 567, 575, 597, 598, 606, 607,
609, 611,621,650, 765, 767, 794, 805
undistorted 1713
Euler equations 745, 791
excess bond re~rns 1276, 1277, 1280
excess sensitivity 772, 784, 785, 790
excess smoothness puzzle 747
excess stock returns 1249, 1276, 1277
excess volatility 1319, 1320
excessive destruction 856
exchange rate 527, 531, 1658
anchor 1588
and markups 1122
arrangements 167, 203
exchange-rate-based stabilization 1535, 1543,
1553, 1559
empirical regularities 1546
existence of competitive equilibrium in RBC
model 1002
exit, delayed 850
see also entry and exit
exogenous growth models 261
exogenous technological progress 650
expectation functions 453, 461,464
expectational stability, s e e E-stability
expectations, average 528
expectations hypothesis of term structure
1281
experience 582, 584, 590, 602
experimental evidence 530
exports 41
extensive margins 843
external effects 390, 399-401, 403-405,
424-427, 431,433-435, 437
external finance premium 1345
external habit models 1284
externalities in RBC model 1002

factor-saving bias 641

factors of production 909
Family Expenditure Survey (FES) 746, 750
family income 564, 569, 589
Federal Reserve 153, 168, 169, 172-182,
184~202, 219
feedback
derivative 1510
proportional 1510
feedback rule 68, 71
feedforward networks 524
financial accelerator 1345
financial development 671,688, 692
financial markets, role in economic growth
1376
firing cost 1186, 1214, 1222
fiscal authorities 1524
fiscal deficits 1538, 1594, 1604
fiscal increasing returns 416
fiscal policy 672, 692, 694, 712, 715, 1580,
1617, 1624
countercyclical 1617, 1660
fiscal theory of price-level determination 1520,
1524
fixed costs 390, 426, 435, 828, 848, 911
flow-fixed costs 831
fixed effect 787
flexible accelerator 816, 865, 893, 903
flexible cyclical elasticity 842
flexible neoclassical model 817
floating exchange rate 1582
fluctuations in aggregate activity 547, 549, 552,
556, 569, 1053
s e e also business cycles
induced by markup variation 1055, 1104
France 45
free entry condition 844, 845
frictionless neoclassical model 817
Friedman rule 1720
Frisch demands 595-597, 603
Frisch labor supply 1146
full-order equilibrium 530
functional forms 550, 583, 584, 588, 598, 601,
607, 611,623
fundamental solution 498
fimdamental transformation 852
gain sequence 469, 475
decreasing 469
fixed 469
small 470

1-38
general equilibrium 543-625, 888
generational accounting 1624
genetic algorithms 465, 521,525
Germany 45, 1631
global culture 1332, 1333
GLS 788
gold standard 153-190, 199-220
Golden Rule 1650
Gorman-Lancaster technology 800
government
budget constraint 1687, 1719
consumption 671,691,694, 1687, 1736
rate to GDP 688, 689
debt 1617, 1687
production 672, 695, 701
production of investment 699
purchases 41
purchases and markups 1120
share 692
in GDP 671,689
in investment 695, 696
in manufacturing output 696
in output 693
gradual adjustments 823
gradualism 849
Granger causality 34
Great Depression 153, 163, 175, 178, 180-184,
199, 200, 213, 1343
Great Inflation of the 1970s 153
great ratios of macroeconomics 939, 940
gross domestic product (GDP)
per capita 674
per worker 671
gross substitutes 1731
growth
cycles 9
growth accounting 678, 687, 688
growth miracles in East Asia 709
growth-rate targets 1524
maximum growth rate 677, 726, 728, 732
habit formation 798, 802, 1237, 1284
habits 564, 802
Harrod-Domar models 640
hazard rate
constant 839
effective 836
increasing 840
hedging demand 1275
Herfindahl index 824
heterogeneity 546, 547, 552, 553

Subject lndex

in firms 1366
in learning 527
in values of job matches 1152
of preferences 545, 558, 563
unobserved 779, 831
heterogeneous agents 843, 1237, 1290
heterogeneous consumers 1686
Hicks composite commodity 766
Hicksian demand decomposition in RBC model
971
hiring rate 1161
histogram 840
historical counterfactual simulations 1523
history-dependent aggregate elasticity 841
Hodrick-Prescott filter, see HP filter
hold-up problems 852
home production 402, 417, 431,702
home sector 435
homotheticity 1725, 1728, 1733
Hotelling's rule 657
HP (Hodrick-Prescott) filter 12, 932, 933
human capital 527, 546, 547, 576, 577,
583-592, 594, 639, 653, 1638, 1712
hump-shaped impulse responses 405, 436,
1374
hump-shaped profiles 755
hyperinflation (seignorage) 509, 520, 531,
1631
hysteresis and threshold effects 455, 530
i.i.d, model 1739
identification problem 75-78
global identification 76, 77
local identification 76
underidentification 76, 77
idiosyncratic risk 795, 1290
idiosyncratic shocks 840
in productivity 1183
imbalances 826
imperfect competition 665
implementability constraint 1677, 1689, 1719,
1729
implicit collusion 1123
imports 41
impulse 1140
impulse response
measure of comparative dynamics 967
to productivity in RBC model 967
impulse response functions 74, 81, 85, 86, 90,
98, 100, 102, 107, 110, 112, 133, 140, 397,
411,430, 431,880, 894

Subject Index
inaction range 832
Inada conditions 645
income distribution, cross-country 671
income elasticity 1681
income inequality 797
income processes 569, 574, 610
income tax 672
income uncertainty 1652
incomplete contracts 853, 854, 856
incomplete markets 566-576, 1742
indeterminacy 491, 494, 506, 1161, 1506,
1691
nominal 418, 1506, 1524
of price level 215, 216, 415, 417, 419, 423
real 413, 415, 416, 418, 419, 423
indicator, cyclical 1062
indivisible labor model, role in RBC model
977
industry equilibrium 888, 889
inequality 745, 795
infinite-horizon consumption program 647
inflation 42, 1534, 1536, 1630
and business cycles 939
and markups 1128
inertia 1562
level 198
persistence 166, 211,213-215
rate 1738
autocorrelation 1738, 1739
variability 207
inflation correction 1621
inflation forecast targeting 1504
inflation-indexed bonds 1271
inflation-indexed consol 1269
inflation targeting 1499, 1505
vs. price-level targeting 1497
inflation tax 1538, 1720
inflationary expectations 1281
information externality 849
information pooling 849
information set 455
informational problems 849-851,858
infrequent actions 825
instability 481,519
of interest rate pegging 514
of REE 507
institutional factors 852
instrument feasibility 1507
instrument instability 1517
instrument variable 1492, 1524
instrumental variables (IV) estimator 787

1-39
instrumental variables (IV) regression 1261
insurance 745, 795
integrated world capital market 1297
interest rate 43, 1620, 1621, 1629, 1630,
1634, 1635, 1637, 1639, 1648, 1652, 1653,
1657-1659
nominal 1524
interest rate instrument 1514
interest rate policy 1596
interest rate smoothing 1509
intermediate-goods result 1684, 1720, 1733
intermediate-goods taxation 1676
intermediate input use 1081
internal habit models 1284
international capital flows 1636-1638
International Financial Statistics (IFS) 1238
international reserves 1594
intertemporal allocation 761
intertemporal budget 555, 561,647, 661
intertemporal budget constraint 1259, 1268
intertemporal CAPM 1275
intertemporal channel 1142
intertemporal elasticity
of labor supply 1149
of substitution in leisure 1147
intertemporal marginal rate of substitution
1245
intertemporal non-separabilities 775
intertemporal optimization 745
intertemporal substitution 1055, 1150
"intervention" policy 1587
intradistribution dynamics 274, 292
intratemporal first-order conditions 775
inventories, target 894
inventories of finished goods 887
inventory fluctuations 1084
procyclical 872-882, 898, 900, 909
inventory investment 865
inventory sales ratio 871
inventory-sales relationship 867
investment 40, 641
collapse 851
competitive equilibrium 844
delays 1365
distortions 672, 695 698
empirical 1344
expected 839
frictionless 832
lumpy 822, 823
share in output 693, 699
spike 823, 824, 857

1-40
investment (cont'd)
tax incentives 843
US manufacturing 840
investment episode 823
investment-output ratio 714
irrational expectations 1237, 1293
irregular models 490, 493, 505
irreversibility cons~aint 832
irreversible investment 822, 828, 832
iso-elastic utility function 606, 607, 610
Italy 1619
Ito's lemma 825
Japan 45
Jensen's inequality 1247
job-finding rate, cyclical behavior of 1162
job loss 1151
job search 1143, 1150, 1158, 1162
job-specific capital 1152
job to job flows 1198, 1200
job-worker separations 1184
jobs
creation 846, 1150, 1158, 1161, 1173, 1176,
1178, 1185, 1201, 1219
cost 1187, 1193, 1215, 1222
creation and destruction, international
comparison 1178
destruction 846, 1150, 1158, 1160, 1166,
1173, 1176, 1178, 1185, 1197, 1201,
1219
rate 1151, 1152
flow 1197
international comparison 1180
reallocation 1222
termination 1152
cost 1193
joint production 853
joint surplus 1157
just-in-time 871
Kaldor facts about economic growth 941
Keynes, J.M. 1660
Keynesian analysis 1628
Keynesian consumption function 761
Kreps-Porteus axiomatization 744
Krugman model 1592
Kulm-Tucker multiplier 774
labor 1687
bargaining strength 1219
labor-augmentation 651

Subject Index

labor contract 1154

labor force 1174
labor force status 602, 603, 607, 611, 614,
623
labor hoarding 1076, 1078, 1097
labor in efficiency units 650
see also efficiency units
labor income 1237, 1275, 1290
labor market 855
policy 1214
restrictions 672, 695
labor power 1220
labor productivity 42
labor regulations 852
labor share 1059
labor supply 546-553, 562, 577, 585, 587, 592,
594, 596, 598, 599, 601,602, 605, 606, 608,
610-621,623, 744, 777, 792, 1150, 1296
elasticity 975, 1371
in RBC model 975
empirical 1148
endogenous in RBC model 945
extensive margin 976
female 611
fixed costs of working 976
indivisible labor model 976
male 611
substitution effect 975
unobserved effort of 930
labor tax rate, autocorrelation 1739
lack of credibility 1569, 1572, 1581
Latin America 1543
laws of large numbers 837
leading example 488, 493
learning 453, 488
by doing 664
in games 475
in misspecified models 528
least squares learning 465, 467, 526
social 849
stability under 496
statistical 493
learning dynamics, persistent 455
learning equilibria 515
learning rules 439, 454
econometric 472
finite-memory 474
fixed-gain 511
statistical 465
learning sunspot solutions 494
learning transition 531

Subject Index

Legendre Clebsch condition 904

levels accounting 678-687
leverage 1280
life cycle 583, 586~588, 593, 595, 601, 603,
604, 609, 615, 620, 621, 744, 749, 752,
754, 760, 792, 793
life cycle-permanent income model 760
life expectancy 691-693
lifetime budget constraint 647
see also intertemporal budget
likelihood function 840
linear allocation rules 554, 563, 564
linear commodity taxes 1677
linear filter 11
linear model 467, 487, 842
with two forward leads 501
linear-quadratic model 457, 865, 876, 882, 903,
904
liquidity 1255, 1591
liquidity constraints 745, 772, 773, 789, 1654
see also borrowing constraint
liquidity variables 817
log-linearization 788
long-term bonds 1255, 1280
low-equilibrium trap 646
Lucas aggregate supply model 457
Lucas critique 1491
Lucas program 67
lumpy project 823
Lyapunov theorems 479
M2 44
M1 velocity 50
machinery, price of 696
macroeconomics 639
magical thinking 1328, 1329
maintenance 823
maintenance investment 839
major and infrequent adjustments 823
managed float 152, 153, 167, 202, 204, 207
manufacturers 870
marginal cost schedule 1054
declining 1066
marginal production costs 867, 890, 892, 896,
899, 902, 905, 907
marginal profitability of capital 830
marginal rate of substitution 549, 551,554-557,
559, 560, 598, 622, 765
heterogeneity 620-623
marginal utility 767
market capitalization 1239

1-41
market clearing 1021-1024, 1026, 1035
expected 1021, 1024-1027
market imperfection 390, 405, 424, 426, 433
market structure 546, 553, 558, 575, 598
market tightness 1185
market work 550, 594, 601
Markov chain 1708, 1736
Markov process 1264
markup 399, 400, 406, 407, 426, 429, 431,
1053
average 1068
countercyclical 406, 1113
for France 1068
cyclical 1092
desired 1056
measurement 1058
models of variation 1055, 1112
procyclical 1113, 1128
variable 406, 407
variation in desired 1129
Marshallian demands 597
martingale 767
martingale difference sequence 487
match capital 1152
matching function 1183
matching model 1163
Maximum Principle 650
measure of financial development 691
measurement error 518, 546, 561, 572-574,
609, 616, 1242
"mechanieal" approach 1560
mechanism design 1154
Medicare 1622, 1626
men 550, 552, 607, 615, 620
mental compartments 1317
menu costs 397
microeconomic data 543-625, 745
microeconomic lumpiness 824
microfomadations 761
military purchases 1088
Mincer model 568, 569, 581,582, 584, 592
minimal state variable solutions, see MSV
solutions
mismatch 1221
mismeasurement of average inflation 1254
Modigliani-Miller theorem 1343
monetary accommodation 1539
monetary base 44, 1507, 1524
monetary economies 1720
monetary model with mixed datings 500

1-42
monetary policy 692, 695, 715, 1012, 102Zl~
1037, 1281, 1630, 1660, 1720
optimal, cyclical properties of 1736
monetary policy rule 1364
monetary policy shocks 65-145
effect 69
on exchange rates 94-96
on US domestic aggregates 91 94
on volatility 123-127
identification schemes 68-70, 1369
Bernanke-Mihov critique 115-123
Bernanke-Mihov test 119-121
empirical results 121 123
Coleman, Gilles and Labadie 114, 115
narrative approach 136 141
s e e also Romer and Romer shock
pitfalls 134-136
plausibility 100-104
assessment strategies 114-123
problems 143-145
interpretations 71 73
non-recursive approaches 127-134
output effects 1129
recursiveness assumption 78-127
s e e also recursiveness assumption
responses to 1368
monetary regimes 153, 168, 178, 202, 204,
211,216, 220
money 44, 1011-1013, 1020-1029, 1031-1033,
1035, 1036, 1040, 1041
money anchor 1588
money-based stabilization 1535, 1543, 1554,
1558, 1582
money demand 50, 598, 1603, 1736
consumption elasticity of 1725
interest elasticity of 1736
money growth rate 1738
money-in-the-ufility-ftmction model 1720,
1728
money supply 1536
money velocity 1588
s e e also M1 velocity
monopolies 695
monopolistic competition 1033-1036, 1041,
1042
monotonicity 830
Morgan Stanley Capital International (MSCI)
1238
MSV (minimal state variable) solutions 488,
493, 502
and learning 503

Subject Index

locally (in)determinate 490

non-MSV solutions 493
multiple competitive equilibria 1679
multiple equilibria 1539, 1603
multiple REE, see u n d e r R E E
multiple solutions 487, 1506, 1524
multiple steady states 460
multiple strongly E-stable solutions 501
multiplicity of steady states 658, 662
multivariate models 502
with time t dating 505
mutation 522
Muth model 465, 484, 525
myopia 1653, 1654
Nash bargain, generalized 1189
National Account 751,752
national accounting identities 1628
National Bureau of Economic Research (NBER)
6, 8
national income 1617
national saving 1628, 1629, 1637, 1639, 1641,
1652, 1659-1662
natural experiments 822
natural rate 1176
natural resources 639
negative income tax experiments 1148
neoclassical exogenous growth model 243,261,
673
neoclassical growth model 245, 246, 252, 259,
269, 272, 276, 639, 695, 697, 701, 1140
basis for RBC model 942
neoclassical theory of investment 817
net convergence effect 692, 693
net present value rule 835
net worth and the demand for capital 1352
neural networks 465, 524
neurons 524
noise
case of small 513
intrinsic 507
noise traders 1290
noisy k-cycle 513
noisy steady states 483, 509
nominal anchor 207, 211, 215, 216, 1535,
1542, 1557
nominal income targeting 1505
non-durables 746
non-nested models 840
non-random attrition 787
non-Ricardian policy 418

1-43

Subject Index

non-Ricardian regime 418

non-separability of consumption and leisure
759
non-state-contingentnominal claims 1722
Non-Accelerating Inflation Rate of Unemployment (NAIRU) 46
nonlinear models 468
nonlinearity 828, 839
nonparametric techniques 532
numerical algorithms 320, 324, 326, 328, 348,
358, 378
numerical solutions 318, 326, 352, 805
obsolescence 848
OECD 685, 718, 719, 1174
OECD adult equivalence scale 757
oil prices, effects of 1089
one-sector model 639
one-step-ahead forward-looking reduced form
506
open economy 1714
open market operations 1722
openness 703
operationality 1486, 1523
opportunism 851, 858
opportunity costs 854
optimal control 1490
optimal debt policy 1639, 1659, 1660, 1662
optimal fiscal policy 1686
optimal investment path 834
optimal national saving 1617
optimal tax theory 1692
optimal trajectory 650
optimal wedges 1692
optimum quantity of money rule 1537
option to wait 832, 834
ordinary differential equation (ODE)
approximation 468, 478
orthogonality conditions 785
out-of-sample forecasting 840
out-of-steady-state behavior 649
output 1687
output levels 206
output variability 208, 211
overconfidence 1319-1323, 1325, 1326, 1328
overhead labor 1065
overidentifying restrictions 768
overlapping contracts models 495, 1582
overlapping generations model 390, 395, 397,
398, 427, 458, 546, 549, 576~94, 660,
1634, 1635, 1645-1647

overparametrization 473
overreaction 1319-1322
overtaking 650
overvaluation 1563
panel data 275, 283-287, 295, 781
Pareto weights 559-564, 796
partial adjustment model 821,838
participation 574, 601, 1218
path dependence of adaptive learning dynamics
455
peacetime 1699
Penn World Table 674, 680
pent-up demand 841
perceived law of motion (PLM) 466, 472, 490,
511
perceptron 524
perfect competition 831
perfect foresight 650
perfect insulation 846
perfect-insurance hypothesis 796
periodic or chaotic dynamics 646
see also cycles
permanent-income hypothesis 749, 1641,
1662
permanent shocks 216-219
perpetual inventory method 680
persistence 870-882, 891, 893, 900, 902, 904,
1142, 1162, 1166, 1739
of business cycles, see persistence under
business cycles
of fluctuations 527
of inflation 1537
peso problem 1252
pessimism 1295
Phillips curve 46, 1056, 1363, 1542
planner's problem in RBC model 997, 1002
policy 455
affecting labor markets 672
distorting investment 695
impeding efficient production 672
policy accommodation 1538
policy function 320-381
political rights 671, 689
political stability 671,688, 692
Ponzi scheme 1650
population aging 1625, 1640
population growth 941
endogenous 639
power utility 1249

1-44
precautionary saving 744, 770, 1253, 1288,
1653
preference parameters 550, 555, 556, 558, 567,
601, 605
preferences 546-550, 552, 553, 556-558, 564,
565, 567, 572, 582, 593, 601, 604, 605,
607, 608, 610, 614, 616, 617, 623
additive 594
conditional 778
functional forms 550
Gorman polar 766, 783
heterogeneity 545, 552, 558-565, 567, 593,
594, 609, 621,623
homogeneity 553-556, 577
of representative agent in RBC model 942
quadratic 762, 770
present-value model of stock prices 1264
log-linear approximation 1265
present-value neutrality 573
price elasticity 1681
price functions 1723
price puzzle 97-100
price rules 1688
price-cost margin 1053
s e e also markup
price-dividend ratio 1265, 1266, 1276
prices 42
of machinery 696
of raw materials 1082
pricing, equilibrium 555, 602, 845
primal approach 1676
primary budget 1619
principal-agent problems 1345
principles of optimal taxation 1676
private and public saving 1629
private information 574-576, 849
production costs, non-convex 897, 911
production economy 1686
production efficiency 1684, 1735
production function 548-550, 578, 579, 581,
583-586, 588, 590, 591,594
non-Cobb-Douglas 1064
production possibilities surface 401
production smoothing 876, 877, 884, 895,
1085
production to order 887
production to stock 887
productivity 552, 553, 566, 583, 602, 1057
cyclical 938, 1094
deterministic growth of 943
general 1192, 1193

Subject lndex

growth of 942
shocks 930, 943, 965, 972
amplification of 963
modeled as first-order autoregressive process
963
persistence of (serial correlation) 952,
963
RBC model's response to 964
remeasurement of 982,
slowdown 664
profit function 830
profits 1057
cyclical 1100
projection facility (PF) 480
propagation of business cycles 865
propensity to consume 762
property rights 852, 856
proportional costs 825
proportional taxes 1687
prospect theory 1308-1313
protection of specific investments 1154
"provinces" effect 1540
proxies for capital utilization 1080
prudence 771
PSID 783
public consumption 1581
public debt 1601, 1603
public finance 1676
public saving 1629, 1641
putty-clay models 847, 848
q-theory 817
s e e also Tobin's q
average q 817, 818
"flexible q" 818
marginal q 818
fragility of 828
quadratic adjustment cost model 823, 838
Quandt Likelihood Ratio (QLR) 34
quantitative performance 1578, 1581
quantitative theory 671-673, 695-719
see also dynamic stochastic general
equilibrium models
quasi-magical thinking 1329, 1330
Ramsey allocation problem 649, 1679, 1691,
1692, 1713, 1719, 1723, 1729
Ramsey equilibrium 1678, 1688, 1723, 1729,
1732
Ramsey growth model 1651, 1652
Ramsey prices 1679

1-45

Subject Index

random walk 767, 1316, 1319, 1702, 1706,

1738, 1742
geometric 825
range of inaction 826
rate of arrival of shocks 1193
rate of discount 1193
rate of return 566, 577, 582, 595, 606, 610
ratio models of habit 1284
rational bubbles 499, 1266
rational expectations 453
transition to 454
rational learning 461
rationalizability 464
rationing 857
RBC models, see real business cycle
Reagan, R. 1641
real balance model 489, 496
real business cycle (RBC) 394, 402, 413, 427,
428, 437, 442, 505, 843, 928, 1296
amplification of productivity shocks in 958,
967
as basic neoclassical model 942
baseline model 1143, 1709, 1736
failures 1144
calibration 953-955, 959
competitive equilibrium 999
concave planning problem 1002
contingent rules 1000
criticisms 961
depreciation rate of capital 944
discount factor 942
modified 945
endowments in 943
extensions 994
firm's problem 1001
government spending and taxes in 974
high risk aversion model 1709
high-substitution version
calibration 985, 987
decision rules for 985
ingredients of 984
probability of technical regress 989, 990
role of capacity utilization in 985
role of indivisible labor in 985
sensitivity to measurement of output 992
sensitivity to parameters 990, 991
simulation of 986
household's problem 1000
importance of consumption smoothing in
967

Inada conditions on production function

996
interest rate effects 973
internal propagation in 967
labor
demand for 956
supply of 956
Lagrangian for 946
lifetime utility 996
market clearing 1001
production function in 943
RBC model as basic neoclassical model
942
simulations of 957
solution
certainty equivalence 952
dynamic programming 951
linear approximations 949
loglinear approximations 952
rational expectations 951
steady state of 947
transformation to eliminate growth 944
transitional dynamics of 948
transversality condition for 946
wage effect in 973
wealth effects in 971
with nominal rigidities 974
real exchange rate 1547
real interest rate 1220, 1233, 1276, 1286
measurement of 939
real marginal cost 1053
real shocks 1174
real wage 1296
reallocation of workers 1160, 1183, 1199
recession now versus recession later 1535,
1557
recursive algorithm 468, 475, 479, 486
recursive least squares 467
recursive least squares learning 494
recursive utility 557
recursiveness assumption 68, 73, 78-127
benchmark identification schemes 83 85
F F policy shock 87, 88
influence of federal funds futures data
104-108
NBR policy shock 88
NBR/TR policy shock 89
problems 97
results 85
robustness 96, 97
sample period sensitivity 108-114

1-46
recursiveness assumption (cont'd)
relation with VARs 78-83
REE (rational expectations equilibria) 452
cycles 458
multiple 454, 467
reduced order limited information 529
unique 484
reflecting barriers 828
regime switching 426
regression tree 289
regular models 490
regulation barrier 832
relative price of investment to consumption
696-698, 700, 701
reluctance to invest 828, 832
renegotiation 1153, 1155
renewable/nonrenewable resources 655, 656
rental prices 588, 590, 592
of capital 1000
reorganization 1160, 1161
representative agent 556, 557, 560, 561,563,
587, 601, 838, 1249, 1259, 1268
in RBC model
altered preferences in indivisivle labor
977
altruistic links 943
preferences of 942
representative household 643
representativeness heuristic 1319, 1322, 1327
reproduction 522
research and development (R&D) 664, 672,
692, 695, 708, 709, 715-719
residence-based taxation 1715
restricted perceptions equilibrium 529
restrictions in job separation 1222
restrictions on government policy 1707
retailers 869
retirements 839
returns to scale 639
decreasing 656
increasing 652, 653, 664, 828, 830, 1066
social 460, 509, 521
Ricardian equivalence 418, 1617, 164~1659,
1661
Ricardian regime 418
Ricardo, D. 1640
risk 546, 547, 552, 554-558, 563-567, 569,
572, 575, 593, 606
risk adjustment 555, 557, 558
risk aversion 547, 552, 556-558, 564-566, 606,
771

Subject Index
risk premium 1246, 1247, 1250
risk price 1236, 1280
risk-sharing in indivisible labor version of RBC
model 977
riskfree rate puzzle 1235, 1252
robustness approach 1491, 1523
Romer and Romer shock 137-142
rule-like behavior 1487, 1522
rule-of-thumb decision procedure 524
rules 152-154, 156, 158, 160, 166, 168, 184,
200, 208, 219, 220
rules vs. discretion 1485
Rybczinski theorem 404

(S,s) model 801,802, 831,910, 911

sacrifice ratio 1541
saddle point 405, 649
saddle point stability 490
Sargent and Wallace model 489
saving 641
private 1628, 1629, 1632-1634, 1637, 1641,
1648
'saving for a rainy day' equation 764
scale effects 672, 715, 716, 718, 719
school attainment 691
school enrollment 681,684
post-secondary 683
primary 683
secondary 681-683
schooling 576-578, 581-592
sclerosis 856
scrapping 844, 847, 855, 856
endogenous 844
search and matching approach 1173, 1183
search efficiency 1162
search equilibrium 1186
search externalities 506
seasonal adjustment 1242
seasonal variations in work volume 1149
second-best solutions 849
secondary job loss 1163
sector-specific external effects 402
sectoral shifts hypothesis 1221
securities market 1722
seignorage model 460, 471, 509, 525, 530,
1741
selection criterion 468
selection device 454
self-fulfilling fluctuations 506
separability 556, 602, 603,607, 608, 612, 613,
617, 1725, 1728, 1733

S u b j e c t Index

tests 611
separation rate 1151
Sharpe ratio 1249
shock absorber 1699, 1710, 1739
shock propagation 1203
shocks and accommodation 1539
shopping-time model 1720, 1732
shopping-time monetary economy 1732
short-term bonds 1280
short-term maturity debt 1603
~r-convergence 659
Sims-Zha model 128-134
empirical results 131 134
skill-biased technology shock 1215, 1216,
1218
skills 546, 547, 569, 576-579, 581,582, 584,
586-588, 590-594, 623
slow adaption 480
slow speed of adjustment 877, 894
small durables 798
small open economy 1715
small sample 820
small versus large firms 1373
smooth pasting conditions 827
Social Security 1619, 1622, 1624, 1626, 1635
Solow residual 930, 1140, 1141
as productivity measure 962
in growth accounting 962
mismeasurement 962
solvency conditions 575
specificity 851,852, 856
spectral analysis 11
SSE, s e e stationary sunspot equilibria
stability conditions 454
stabilization 1534, 1562
stabilization goals 153
stabilization time profiles 1547
stable equilibrium point 481
stable roots 393
staggered contracts model 1012, 1013, 1024,
1027, 1030, 1032, 1039
staggered price and wage setting 1012, 1013,
1027, 1030, 1031, 1033, 1035-1037, 1040
staggered price setting 397, 422, 423, 1129,
1363
staggered-prices formulation 1582
standardized employment deficit 1621
state-contingent claims 555, 602
state-contingent returns on debt 1687, 1699
state-dependent pricing 1031, 1032
state dynamics 477

1-47
state prices 1294
stationary distribution of RBC model 999
stationary sunspot equilibria (SSE) 408, 517
c-SSE 517
near deterministic solutions 520
steady states 468, 507, 525, 549-551,576, 592,
598, 639
of RBC model 944
sterilization 1595
sticky price models 503, 1113
stochastic approximation 468, 475, 476
stochastic discount factor 1234, 1245
log-normal 1246
stochastic growth model 546-577, 592
stochastic simulations 1516, 1523
stock market 1310, 1312, 1313, 1315, 1316,
1320-1328, 1331, 1333
stock market volatility puzzle 1235, 1236,
1268, 1276, 1280
stock prices 43
stock return 1233, 1240
stockout costs 884, 885
Stolper-Samuelson theorem 404
Stone price index 783
storage technologies 574, 575
strategic complementarity 1129
strategic delays 858
strong rationality 464
structural model 462
structural shifts 530
structures 840
subgame perfection 1679
subjective discount factor 548, 552, 561,593,
595, 609, 616
subsistence wage 657
substitutes 577, 590, 591,613, 616
sunk costs 858
sunspot equilibria 454, 515
sunspot paths 662
sunspot solutions 495
s e e also learning sunspot solutions
sunspots 489, 515
supply of capital 846
supply price of labor 1192, 1193
supply shocks 1129
supply-side responses 1577
surplus 853
surplus consumption ratio 1286
survivorship bias 1242
sustainability 1597

1-48
T-mapping 467, 471,512
Tanzi effect 1741
target points 826
target variables 1492, 1523
tariff 672, 695, 703-707
taste shift 778
tax
see also labor tax rate; capital taxation
distortionary 1651, 1652, 1654
on capital income 1686
on employment 1220
on international trade 703
policy 672, 708
rate 1441
on private assets 1709
reforms 822
smoothing 1655, 1659, 1662, 1705
intertemporal 1617
source-based 1715
system 1679
Taylor expansion 1265
Taylor rule 1364
technological change 1708
technological embodiment 848
technological progress 641, 1207, 1213
disembodied 1207, 1208
endogenous 639
Harrod-neutral, Hicks-neutral 944
labor-augmenting 944
purely labor-augmenting 650
technological regress, probability of in RBC
models 930
technology adoption 672, 708
technology shocks 1141, 1142, 1736
temporariness hypothesis 1569, 1572
temporary shocks 216
temporary work 1165
term premium 1255
term structure of interest rates 1270
termination costs 708
thick-market externality 1161
threshold externalities 527
thresholds 258-262, 276, 289
time-additive utility function 661
time aggregation 881
time-consistent behavior 1488
time dependency 799
time-dependent pricing 1031, 1032
time-inconsistent behavior 1653
time preference 547, 588
time preference rate 1253

Subject Index

time series 264, 272, 287, 288

time series volatility 756
time to build 832, 850
time-varying aggregate elasticity 841
timing assumption 469
Tobin's q 817, 1296
see also q-theory
total factor productivity (TFP) 42, 673, 678,
687, 688, 702
trade deficit 1630, 1658, 1659
trade policy 672, 692, 694, 702
training 577, 582-584, 586-592, 653
transition rates 1166
transversality conditions 392, 393, 400, 650
Treasury bills 1233
trend-stationary models 764
trend-stationary process 10, 211, 1497
trigger points 830
tuition costs 583, 588, 590
twin deficits 1630
two-stage least squares estimation 1261
uncertainty 545-547, 556, 558, 564, 566, 567,
569, 572, 574, 575, 593, 605, 606, 620,
621,623, 744, 1627, 1653
underinvestment 852, 854
underreaetion 1319-1322
unemployment 546, 569-571, 578, 579, 1143,
1150, 1158, 1161, 1162, 1173, 1174, 1194,
1214
experiences of OECD countries 1213
natural level 1157
rise in 1182
serial correlation 1163
unemployment compensation 1217
unemployment income 1214
unemployment inflow and outflow rates 1181
unemployment rates 1176
unemployment spell duration hazard 1184
unemployment-skill profile 1216
unified budget 1619
uniform commodity taxation 1676, 1726
union bargaining 1098
uniqueness of equilibrium in RBC model
1002
unit root 11
United Kingdom 45
univariate models 488, 497
unstable equilibrium point 481
utility function 548 550, 556 558, 560, 594,
596, 597, 599-601,606, 607, 610

1-49

Subject lndex

momentary in RBC model 944

offsetting income and substitution effects
944
utility recursion 557
utilization of capital 1079
vacancies 41, 1194
vacancy chain 1200
vacancy duration hazard 1184
value function 319-327, 329, 335, 336, 340,
345, 351 355, 357 359, 365, 368, 378
value matching 827
variable costs 828
variety, taste for 705
vector autoregression (VAR) 73, 438
definition 73
vintage capital models 847, 848
volatility
employment 1157
inventories 869, 870
monetary aggregates 1599
vote share 1455
wage bargaining 1130
wage contract 1173, 1186
wage inequality 1182, 1214, 1218, 1219

wages 42, 547, 550-553, 556, 566-569, 572,

577-579, 581,587, 593,595-601,603-607,
611,612, 616, 617, 619, 621,623, 1181,
1629, 1637
see also earnings
cyclical 939
equilibrium 556
fixed 1157
marginal 1069
rigidity 1055
war of attrition 1540
wars 1619, 1642, 1656, 1661 1663, 1699
wealth distribution 556, 561,567, 572, 593
wealth-output ratios 1240
wealth shock 1372
welfare costs of macroeconomic fluctuations
1297
welfare theorems, role in RBC analysis 1001
wholesalers 869
within-period responses 599
women 550, 552, 607, 615, 620, 623
worker flows 1180
into unemployment 1164
worker turnover 1176
works in progress inventories 887
yield spread

1256, 1280