Labor Markets and Business Cycles (CREI Lectures in Macroeconomics)

Labor Markets and Business Cycles (CREI Lectures in Macroeconomics)

by Alberto Martín

ISBN: 9780691140223

Publisher Princeton University Press

Published in Business & Money/Human Resources

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Sample Chapter

Chapter One

The Labor Wedge

Throughout this book, I study the interaction of optimizing households and firms in a closed economy. I begin in this chapter by developing a competitive, representative-agent version of the model. The chapter has two objectives. First, I introduce much of the notation that I rely on throughout the book. Because of this, I include details in this chapter that are not really necessary for the second, more substantive objective: I use the model to measure and analyze the behavior of the labor wedge, the wedge between the marginal rate of substitution of consumption for leisure and the marginal product of labor. I confirm the well-known result that the labor wedge tends to rise during recessions, so the economy behaves as if there is a countercyclical tax on labor. The remainder of the book explores whether extending the model to incorporate labor market search frictions can explain the behavior of the labor wedge.

I start the chapter by laying out the essential features of the model: optimizing households, optimizing firms, a government that sets taxes and spending, and equilibrium conditions that link the various agents. In section 1.2, I use pieces of the model to derive a static equation that relates hours worked, the consumption-output ratio, and the labor wedge. Section 1.3 discusses how I measure the first two concepts and uses these measures to calculate the implied behavior of the labor wedge in the United States. I establish the main substantive result: that the labor wedge rose strongly during every recession since 1970. I show the robustness of my results to alternative specifications of preferences in section 1.4 and discuss the possibility that the results are driven by preference shocks in section 1.5. I finish the chapter with a brief discussion in section 1.6 on the empirical relationship between the fluctuations in hours, which I analyze here, and fluctuations in employment and unemployment, which are the main topic of subsequent chapters.

1.1 A Representative-Agent Model

I denote time by t = 0, 1, 2, ... and the state of the economy at time t by [s.sub.t]. Let [s.sup.t] = {[s.sub.0], [s.sub.1], ..., [s.sub.t]} denote the history of the economy and [PHI]([s.sup.t]) denote the time-0 belief about the probability of observing an arbitrary history [s.sup.t] through time t. Exogenous variables like aggregate productivity, government spending, and distortionary tax rates may depend on the history [s.sup.t]. At date 0, there is an initial capital stock [s.sub.0] = k([s.sup.0]) and an initial stock of government debt [b.sub.0] = b([s.sup.0]). The capital stock is owned by firms, while households hold the debt and own the firms.


A representative household is infinitely lived and has preferences over history-[s.sup.t] consumption c([s.sup.t]) and history-[s.sup.t] hours of work h([s.sup.t]). To start, I assume that preferences are ordered by the utility function


where ? [member of] (0, 1) is the discount factor, [gamma] > 0 measures the disutility of working, and, as I show below, [epsilon] > 0 is the Frisch (constant marginal utility of wealth) elasticity of labor supply.

This formulation implies that preferences are additively separable over time and across states of the world. It also implies that preferences are consistent with balanced growth-doubling a household's initial assets and its income in every state of the world doubles its consumption but does not affect its labor supply. This is consistent with the absence of a secular trend in hours worked per household, at least in the United States (Aguiar and Hurst 2007; Ramey and Francis 2009). I maintain both of these assumptions throughout this book. The formulation also imposes that the marginal utility of consumption is independent of the worker's leisure. This restriction is more questionable and so I relax it in section 1.4 below.

The household chooses a sequence for consumption and hours of work to maximize utility subject to a single lifetime budget constraint,


The household has initial assets [a.sub.0] = a([s.sup.0]). In addition, [tau]([s.sup.t]) is the labor income tax rate, w([s.sup.t]) is the hourly wage rate, and T([s.sup.t]) is a lump-sum transfer in history [s.sup.t], all denominated in contemporaneous units of consumption. Thus c-(1-[tau])wh - T represents consumption in excess of after-tax labor income and transfers, which is discounted back to time 0 according to the intertemporal price [q.sub.0]([s.sup.t]). That is, [q.sub.0]([s.sup.t]) represents the cost in history [s.sup.0] of purchasing one unit of consumption in history [s.sup.t], denominated in units of history-[s.sup.0] consumption. Put differently, [q.sub.0]( [s.sup.t]) is the history-[s.sup.0] price of an Arrow-Debreu security that pays one unit of consumption in history [s.sup.t] and nothing otherwise. Equation (1.2) states that the household's net purchase of Arrow-Debreu securities in history [s.sup.0] must be equal to its initial assets [a.sub.0].

It will be useful to define the assets of the household, following history [s.sup.t], as


where the notation [s.sup.t'] | [s.sup.t] indicates that the summation is taken over histories [s.sup.t'] that are continuation histories of [s.sup.t], i.e., [s.sup.t'] = {[s.sup.t], [s.sub.t+1], [s.sub.t+2], ..., [s.sub.t']} for some states {[s.sub.t+1], [s.sub.t+2], ..., [s.sub.t']}. Then [q.sub.t]( [s.sub.t'+1]) is the price of a unit of consumption in history [s.sub.t'+1] = {[s.sup.t], [s.sub.t+1], [s.sub.t+2], ..., [s.sub.t']} paid in units of history-[s.sup.t] consumption. The absence of arbitrage opportunities requires that q0(st)qt(st+1) = q0(st+1) for all st and for all [s.sup.t+1] = {[s.sup.t], [s.sub.t+1]}. Equivalently, the lifetime budget constraint implies a sequence of intertemporal budget constraints,


so assets plus labor income plus transfers in history [s.sup.t] is equal to consumption plus purchases of assets in continuation histories [s.sup.t+1].


The representative firm owns the capital stock [k.sub.0] = k([s.sup.0]) and has access to a Cobb-Douglas production function, producing gross output z([s.sup.t]) k([s.sup.t])[sup.a]h]sup.d] [([s.sup.t]).sup.1-a] in history [s.sup.t], where z([s.sup.t]) is history-contingent total factor productivity, k([s.sup.t]) is its capital stock, [h.sup.d]([s.sup.t]) is the labor it demands, and [alpha] [member of] [0, 1) is the capital share of income. A fraction [delta] of the capital depreciates in production each period, while at the end of period t, the firm purchases any capital that it plans to employ in period t + 1. That is, history-[s.sup.t+1] = {[s.sup.t], [s.sub.t+1]} capital k([s.sup.t+1]) is purchased in history [s.sup.t] and so must be measurable with respect to [s.sup.t]. The present value of the firm's profits is then given by


Note that this expression presumes that the firm does not pay any taxes. I do this for notational simplicity alone. In particular, any payroll taxes are rolled into the labor income tax rate [tau]. The firm chooses the sequences [h.sup.d]([s.sup.t]) and k([s.sup.t+1]) to maximize J.

I can also write the value of the firm's profits from history [s.sup.t] on as


This implies the recursive equation


The value of a firm that starts history [s.sup.t] with capital k([s.sup.t]) comes from current production z([s.sup.t])k ([s.sup.t])[sup.a]h]sup.d] [([s.sup.t]).sup.1-a] minus the cost of investment k([s.sup.t+1]) - (1 - [delta])k([s.sup.t]) minus labor costs w([s.sup.t])[h.sup.d] ([s.sup.t]) plus the value of starting the following period in history [s.sup.t+1] = {[s.sup.t], [s.sub.t+1]} with k ({[s.sup.t+1]}) units of capital.


A government sets the path of taxes, transfers, and government debt to fund some spending g([s.sup.t]). I assume government spending is wasteful or at least is separable from consumption and leisure in preferences. The government faces a budget constraint in any history [s.sup.t],


so debt b([s.sup.t]) is equal to the present value of future tax receipts in excess of spending and lump-sum transfers. Again, this is equivalent to a sequence of budget constraints of the form


so initial debt plus current spending and transfers is equal to current tax revenue plus new debt issues.

Market Clearing

There are three markets in this economy: the labor market, the capital market, and the goods market. All of them must clear in equilibrium. Labor market clearing dictates that labor supply equals labor demand in all histories, h([s.sup.t]) = [h.sup.d] ([s.sup.t]). Capital market clearing dictates that household assets are equal to firms' valuation plus government debt, a([s.sup.t]) = J([s.sup.t], k([s.sup.t])) + b([s.sup.t]). Goods market clearing dictates that output plus undepreciated capital is equal to consumption plus government spending plus next period's capital stock:


One can confirm that goods market clearing is implied by the household budget constraint (equation (1.3)), the firm's value function (equation (1.5)), the government budget constraint (equation (1.7)), and capital and labor market clearing. This is an application of Walras's law.


Given arbitrary paths for government spending g([s.sup.t]), taxes t([s.sup.t]), and government debt b([s.sup.t]), an equilibrium consists of paths for consumption c([s.sup.t]), labor supply h([s.sup.t]), labor demand [h.sup.d]([s.sup.t]), capital k([s.sup.t]), assets a([s.sup.t]), transfers T([s.sup.t]), intertemporal prices [q.sub.0]([s.sup.t]), and the wage rate w([s.sup.t]) such that:

{c([s.sup.t])}, {h([s.sup.t])}, and {a([s.sup.t])} solve the household's utility-maximization problem, maximizing equation (1.1) subject to the budget constraint (1.2) given {q([s.sup.t])}, {w([s.sup.t])}, {[tau]([s.sup.t])}, and {T([s.sup.t])};

{[h.sup.d]([s.sup.t])} and {k([s.sup.t])} maximize firms' profits in (1.4) given {[q.sub.0]( [s.sup.t])} and {w([s.sup.t])};

the government budget is balanced, so equation (1.6) holds; and

the labor, capital, and goods markets clear.

1.2 Deriving the Labor Wedge

To see the implications of this model for the labor wedge, I focus on a subset of the equilibrium conditions. First, consider the household's choice of history-[s.sup.t] consumption and labor supply. These must satisfy the first-order conditions




where [lambda] is the Lagrange multiplier on the budget constraint: equation (1.2). Note from the second equation that a one percent increase in the after-tax wage (1 - [tau])w raises labor supply h by [epsilon] percent, holding fixed the Lagrange multiplier [lambda] and the intertemporal price [q.sub.0]([s.sup.t]). Thus [epsilon] is the Frisch elasticity of labor supply, a key parameter in this chapter.


Excerpted from "Labor Markets and Business Cycles (CREI Lectures in Macroeconomics)" by Alberto Martín. Copyright © 0 by Alberto Martín. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.
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