Technology Shocks, Employment, and Labor Market Frictions

Abstract

Working Paper 2008-10 February 2008 Abstract: Recent empirical evidence suggests that a positive technology shock leads to a decline in labor inputs. However, the standard real business cycle model fails to account for this empirical regularity. Can the presence of labor market frictions address this problem without otherwise altering the functioning of the model? We develop and estimate a real business cycle model using Bayesian techniques that allows but does not require labor market frictions to generate a negative response of employment to a technology shock. The results of the estimation support the hypothesis that labor market frictions are responsible for the negative response of employment. JEL classification: E32 Key words: technology shocks, employment, labor market frictions Technology Shocks, Employment, and Labor Market Frictions 1 Introduction A key question in macroeconomics is what driving forces generate aggregate fluctuations. According to the real business cycle (RBC) paradigm initiated by Kydland and Prescott (1982), cycles are generated by persistent shocks to technology; other shocks are either absent or have a minimal role in explaining aggregate fluctuations. A key feature of this theoretical framework is the positive response of employment to technology shocks, as documented by King and Rebelo (2000). Recent empirical evidence, however, conflicts with this prediction. Gali (1999), using long-run restrictions on a structural VAR, where a technology shock is identified as the only shock that affects labor productivity in the long-run, shows that technology shocks have a contractionary effect on employment. In addition, Francis and Ramey (2005), Liu and Phaneuf (2006), Wang and Wen (2007), and Whelan (2004) find that this result is robust to different specifications of the VAR and the measure of productivity used. Moreover, Shea (1998) and Basu, Fernald, and Kimball (2004) find similar evidence by measuring technology with Solow residuals derived from microdata. More recently, Canova, Lopez-Salido and Michelacci (2007) and Lopez-Salido and Michelacci (2007) show that a structural VAR model that incorporates job flows also generates a negative response of employment to technology shocks. (1) On the basis of this stylized fact, the validity of the RBC paradigm could be called into question. A possible way to reconcile the RBC paradigm with this stylized empirical fact is to amend the standard model such that it generates a negative reaction of employment to a technology shock, but still preserves its original functioning. In this spirit, Hairault, Longot and Portier (1997) embed implementation lags in the adoption of new technology into a standard RBC model to make future productivity higher than the current level, thereby decreasing current labor supply for a given increase in labor demand and, consequently, generating a negative response of employment to a technology shock. Francis and Ramey (2005) introduce habit formation in consumption together with adjustment costs on investment, and Leontief technology with variable utilization to match the negative effect of a technology shock on employment. Linde (2004) observes that if the process for a permanent technology shock is persistent in growth rates, labor inputs fall on impact. More recently, Collard and Dellas (2007), using an international RBC model, show that if the degree of substitution between domestic and foreign goods is low, the reaction of employment to a technology shock is negative. Finally, Wang and Wen (2007) show that a RBC model with firm entry and exit in which firms need time-to-build before earning profits also delivers a negative response of employment to a technology shock. All these works show that by appropriately modifying the standard RBC model, the underlying framework can be revalidated. Perhaps surprisingly, all of these contributions affect the response of employment in the RBC framework without changing the functioning of the labor market. …