Econometrica: Mar 1988, Volume 56, Issue 2

An Econometric Analysis of Fluctuations in Aggregate Labor Supply and Demand<317:AEAOFI>2.0.CO;2-P
p. 317-333

John Kennan

The paper contains a simple equilibrium model of the labor market. The supply function allows for intertemporal substitution in response to real wage fluctuations, and the demand function allows for adjustment costs on employment. The supply and demand functions both solve quadratic partial adjustment problems, driven by rational expectations about future real wages. The market equilibrium also solves a partial adjustment problem, driven by rational expectations about future preference and technology shocks. Two related issues are emphasized: the identification of dynamic labor supply and demand functions, and the theoretical interpretation of serial correlation in employment and real wages. When the supply and demand shocks are assumed to be AR(1) processes which are not causally related, the model delivers a simple structure for the equilibrium process for employment and real wages, which is a restricted VAR(2). This simple structure facilitates the interpretation of summary statistics on the time-series properties of observed employment and real wage series. The supply and demand functions can both be (locally) identified using only employment and real wage data. An illustrative application is presented, using U.S. manufacturing data for the period 1948-1971.

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