What Prevents a Real Business Cycle Model from Matching the U.S. Data? Decomposing the Labor Wedge

Abstract

I carry out a business cycle accounting exercise (Chari, Kehoe and McGrattan, 2007) on theU.S. data measured in wage units (Farmer (2010)) for the entire postwar period. In contrast toa conventional approach, this approach preserves common medium-term business cyclefluctuations in GDP, its components and the unemployment rate. Additionally, it facilitatesdecomposition of the labor wedge into the labor supply and the labor demand wedges. Usingthis business cycle accounting methodology, I find that in the transformed data, mostmovements in GDP are accounted for by the labor supply wedge. Therefore, I reverse a keyfinding of the real business cycle literature which asserts that 70% or more of economicfluctuations can be explained by TFP shocks. In other words, the real business cycle model fitsthe data badly because the assumption that households are on their labor supply equation isflawed. This failure is masked by data that has been filtered with a conventional approach thatremoves fluctuations at medium frequencies. My findings are consistent with the literature onincomplete labor markets.