DP12812 Complementarity, Income, and Substitution: A U(C,N) Utility for Macro
Author(s): | Florin Ovidiu Bilbiie |
Publication Date: | March 2018 |
Keyword(s): | business-cycle co-movement, consumption-hours complementarity, elasticity of intertemporal substitution, Fiscal multipliers, income and wealth effects, news shocks |
JEL(s): | D11, E21, E62, H31 |
Programme Areas: | Monetary Economics and Fluctuations |
Link to this Page: | cepr.org/active/publications/discussion_papers/dp.php?dpno=12812 |
In business-cycle, macro models the elasticity of intertemporal substitution (EIS) governs the economy's response to demand shocks and policy changes ("multipliers"). With general non-separable preferences, the EIS is determined by consumption-hours complementarity and the income effect on hours. Complementarity helps generate business-cycle co-movement following demand shocks, fiscal multipliers, and allows reconciling low EIS with low income-wealth effects. Yet existing utility functions restrict either complementarity, or income effects---or both---and artificially imply that EIS is exclusively a function of either. I propose a novel utility function where both complementarity and the income effect are arbitrary and can be calibrated separately.