Money, Banks and Finance in Economic Thought

The two lives of the labor supply elasticity debate

Le Fur Tanguy, Aix-Marseille Université
de Vroey Michel, Economics School of Louvain
Clerc Pierrick, Swiss National Bank

The aggregate labor supply elasticity is a parameter central to modern macroeconomics. Retracing the history of the debate surrounding its value, our surmise is that it evolved over two distinct phases: it first took place within the business cycle fluctuations research program before moving to the context of steady state cross-country differences in aggregate hours of work. We argue that this transition was also accompanied by a shift in the object of study: during the first phase, the explanandum was the difference between individual and aggregate labor supply elasticities, whereas in the second it was the formation of aggregate labor supply itself. The debate was initially initiated by the need for RBC theory to have a much larger value of the aggregate labor supply elasticity than microeconometric estimates to replicate observed employment fluctuations in response to technology shocks (Kydland & Prescott 1982). RBC proponents engaged in theoretically justifying such a discrepancy and thereby save the propagation mechanism - intertemporal substitution of leisure - at the heart of the paradigm (Hansen 1985; Rogerson 1988). When the relevance of technology shocks and the associated propagation mechanism was put into question (Gali 1999), the elasticity of labor supply was no longer a pressing issue in the study of business cycle fluctuations. It however became central in another context, the debate on the role of taxes in cross-country differences in steady state aggregate hours (Prescott 2004). We show how the new questions addressed provoked a shift from the vindication of a large labor supply elasticity to the understanding of aggregate labor supply itself (Ljungqvist & Sargent 2006) and spurred efforts to build a deeper aggregation theory (Prescott et al, 2009; Rogerson & Wallenius 2009).

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Keywords: Labor Supply Elasticity, Real Business Cycle, History of Macroeconomics