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

IMF Working Papers, September 8, 2017

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Business cycle accounting exercise following Chari, Kehoe and McGrattan (2007).
Data measured in wage units following Farmer (2010).
Analysis covers the entire postwar period.
Approach preserves common medium-term business cycle fluctuations in GDP, its components, and the unemployment rate (contrasting with conventional filtering approaches that remove medium-frequency fluctuations).
Decomposition of the labor wedge into:
- labor supply wedge, and
- labor demand wedge.

In the transformed (wage-unit) data, most movements in GDP are accounted for by the labor supply wedge.
This result reverses a central finding of the real business cycle literature that "70% or more" of economic fluctuations can be explained by TFP shocks.
Conclusion: the real business cycle model fits the U.S. data poorly because the assumption that households are on their labor supply equation is flawed.
The poor fit of the real business cycle model is masked when data are filtered with conventional approaches that remove medium-frequency fluctuations.

The evidence points to problems in representing household behavior via the standard labor supply equation used in RBC models.
Findings are consistent with the literature on incomplete labor markets.

Source: Dmitry Plotnikov, IMF Working Paper, September 8, 2017.