Abstract

We empirically show that the short-run elasticity of substitution between capital and labor (σt) is countercyclical. In recessions, capital and labor are more substitutable than in expansions. We explore the effects of the countercyclicality of σt on aggregate fluctuations in the context of an otherwise standard competitive-markets business cycle model. The countercyclical σt contributes to resolve four main labor-market puzzles: Dunlop-Tarshis phenomenon, labor-productivity puzzle, hours-productivity puzzle, and labor share puzzle.