The Output Gap, the Labor Wedge, and the Dynamic Behavior of Hours

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Abstract
We use a standard quantitative business cycle model with nominal price and wage rigidities to estimate two measures of economic inefficiency in recent U.S. data: the output gap: the gap between the actual and efficient levels of output -- and the labor wedge -- the wedge between households' marginal rate of substitution and firms' marginal product of labor. We establish three results. (i ) The output gap and the labor wedge are closely related, suggesting that most inefficiencies in output are due to the inefficient allocation of labor. (ii ) The estimates are sensitive to the structural interpretation of shocks to the labor market, which is ambiguous in the model. (iii ) Movements in hours worked are essentially exogenous, directly driven by labor market shocks, whereas wage rigidities generate a markup of the real wage over the marginal rate of substitution that is acyclical. We conclude that the model fails in two important respects: it does not give clear guidance concerning the efficiency of business cycle fluctuations, and it provides an unsatisfactory explanation of labor market and business cycle dynamics.

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