Capital–skill complementarity and inequality over the business cycle

Abstract

When capital–skill complementarity is present in the production process, changes in the skill premium are driven not only by changes in the ratio of unskilled to skilled labor inputs (as they are in the case with Cobb–Douglas production), but also by changes in the capital–skill ratio. A simple regression analysis demonstrates that the capital–skill ratio has a positive and significant relation to the skill premium at business cycle frequencies as predicted by the capital–skill complementarity hypothesis. This finding motivates the construction of a stochastic dynamic general equilibrium model that allows for capital–skill complementarity in production. The model with capital–skill complementarity can account for the cyclical behavior of the skill premium and much of its volatility. The model without capital–skill complementarity cannot. These results, together with the available empirical evidence, suggest that capital–skill complementarity is an important determinant of wage inequality over the business cycle.