The Output Gap, the Labor Wedge, and the Dynamic Behavior of Hours

Abstract

We use a standard quantitative business cycle model with nominal price and wage rigidities to estimate two measures of economic inefficiency in recent U.S. data: the output gap---the gap between the actual and efficient levels of output---and the labor wedge---the wedge between households' marginal rate of substitution and firms' marginal product of labor. We establish three results. (i) The output gap and the labor wedge are closely related, suggesting that most inefficiencies in output are due to the inefficient allocation of labor. (ii) The estimates are sensitive to the structural interpretation of shocks to the labor market, which is ambiguous in the model. (iii) Movements in hours worked are essentially exogenous, directly driven by labor market shocks, whereas wage rigidities generate a markup of the real wage over the marginal rate of substitution that is acyclical. We conclude that the model fails in two important respects: it does not give clear guidance concerning the efficiency of business cycle fluctuations, and it provides an unsatisfactory explanation of labor market and business cycle dynamics.