Hours elasticity higher in recessions, capacity utilization key
A new Federal Reserve paper finds that the aggregate hours elasticity is significantly higher in recessions than in expansions. The study introduces a business cycle model where production requires a minimum labor input, generating endogenous capacity utilization.
Recessions boost labor response
The paper develops a business cycle model with perfectly competitive product and labor markets, where a minimum labor input generates endogenous capacity utilization.
This results in a kinked aggregate production function: constant returns to scale below capacity (typical in recessions) and decreasing returns at capacity (in expansions).
New empirical evidence shows labor tax shocks have significantly larger effects on hours and output when capacity utilization is below trend.
Calibrated to U.S. data, the model demonstrates that the aggregate hours elasticity is higher in recessions, markedly differing from the micro elasticity implied by preferences.
This nonlinearity stems from transitions between constant-returns and diminishing-returns regimes.
Methodological innovations
The study makes three key contributions: documenting new empirical evidence of state-dependent labor tax effects, proposing a mechanism based on plant-level minimum labor requirements, and adapting the monotone-map method for kinked production environments.
This methodological innovation addresses challenges posed by a kinked aggregate production function and discontinuous marginal product of labor.
The approach ensures a unique and constructive competitive equilibrium, allowing for well-defined generalized impulse response functions for numerical analysis of tax shocks across business cycle phases.
Beyond linear, but still ideal
This paper offers a compelling explanation for state-dependent labor market responses, moving beyond traditional linear models.
Its methodological innovation for kinked production functions is particularly valuable for future research.
However, the reliance on perfectly competitive markets might limit its applicability in real-world scenarios with market imperfections.