Countercyclical Elasticity of Substitution


We empirically show that the short-run elasticity of substitution between capital and labor (σ_t) is countercyclical. In recessions, capital and labor are more substitutable than in expansions. This countercyclicality of σ_t introduces an asymmetry in an otherwise standard competitive-markets business cycle model that contributes to resolve several labor market puzzles: the labor productivity puzzle, the Dunlop-Tarshis phenomenon, the hours-productivity puzzle, and the labor share puzzle.