DP17246 Countercyclical Elasticity of Substitution

Author(s): Dongya Koh, Raül Santaeulàlia-Llopis
Publication Date: April 2022
Keyword(s): Capital, cycle, Elasticity, Labor, Labor market, Labor Share, Short-run, substitution
JEL(s): E13, E32
Programme Areas: Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=17246

We empirically show that the short-run elasticity of substitution between capital and labor is countercyclical. In recessions, capital and labor are more substitutable than in expansions. This countercyclicality of the elasticity of substitution introduces an asymmetry in an otherwise standard competitive-markets business cycle model that contributes to resolve several labor-market puzzles: the labor productivity puzzle, the Dunlop-Tarshis phenomenon, the hours-productivity puzzle, and the labor share puzzle. Interestingly, the cyclicality of the elasticity of substitution is per se not a source of aggregate fluctuations, but it propagates the effects of other shocks.