Specification Errors in Models of Aggregate Labor Supply

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Abstract
Previous empirical studies of intertemporal labor substitution under adaptive and rational expectations maintain that current price and output are uncorrelated with the error term. Using tests based on Hausman (1978), we reject that hypothesis and demonstrate that the resulting specification error causes significant bias of the coefficient estimates. Using a set of instrumental variables verified to be contemporaneously uncorrelated with the error, we find no significant short- or long-run aggregate labor supply response to real wages, under both adaptive and rational expectations. Furthermore, we do not reject the hypothesis that real wages are predetermined in the rational expectations model.

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