Elasticities of substitution in real business cycle models with home production

John Y. Campbell, Sydney Ludvigson

    Research output: Contribution to journalArticlepeer-review

    Abstract

    This paper constructs a simple model of home production that demonstrates the connection between the intertemporal elasticity of substitution in market consumption (IES) and the static elasticity of substitution between home and market consumption (SES). Understanding this connection is important because there is a large body of empirical evidence suggesting that the IES is small, but little evidence on the size of the SES. We use our framework to shed light on the properties of a home production model with a low IES. We find that such a model must have three fundamental properties in order to match key aspects of aggregate U.S. data. First, the steady-state growth rate of technology must be the same across sectors. Second, shocks to technology must be sufficiently positively correlated across sectors. Third, capital must be used more intensively in the market sector than in the home sector. A home production model with these three properties can be surprisingly successful at reconciling the RBC paradigm with evidence for a low IES.

    Original languageEnglish (US)
    Pages (from-to)847-875
    Number of pages29
    JournalJournal of Money, Credit and Banking
    Volume33
    Issue number4
    DOIs
    StatePublished - Oct 1 2001

    ASJC Scopus subject areas

    • Accounting
    • Finance
    • Economics and Econometrics

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