BUSINESS CYCLES WITH CYCLICAL RETURNS TO SCALE

Abstract

AbstractWe study business cycles with cyclical returns to scale. Contrary to tightly parameterized conventional production functions, we empirically identify strong input complementarity that leads to procyclical returns to scale. We, therefore, propose a flexible translog production function that allows complementarity‐induced procyclical returns to scale. We integrate this function into a standard medium‐scale dynamic stochastic general equilibrium model. Our estimated model with input complementarity (i) features procyclical returns to scale and acyclical price markups, (ii) better matches the cyclicality of factor shares, and (iii) significantly decreases the contribution of markup shocks to output fluctuations relative to those of the standard model.