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The research catalogue is an archive of ESRC-funded grants and outputs. Links, files and other content will no longer be maintained or updated after April 2014.

Monetary and Fiscal Policy Rules with Labour Market and Financial Frictions

Grant reference: RES-062-23-2451

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Conference paper/presentation details

CES technology and business cycle fluctuations
This paper contributes to a rapidly rising literature that brings the 'Constant-Elasticity-of-Substitution' (CES) specification of the production function into the analysis of business cycle fluctuations. Using US data, we estimate by Bayesian methods a medium-sized Dynamic Stochastic General Equilibrium (DSGE) model with a CES rather than Cobb-Douglas (CD) technology. The main empirical result is to confirm decisively the importance of CES rather than CD production functions. We estimate a elasticity of substitution of elasticity well below unity at 0.16 and, in a marginal likelihood race assuming equal prior model probabilities, CES beats the CD production decisively. The principle reason for this result is that the CES specification captures movements of factor shares. The marginal likelihood improvement is matched by the ability of the CES model to fit the data in terms of second moments. . The consequences for optimal monetary policy of different elasticities of substitution is also examined. We find these not to be significant unless a zero lower bound constraint on the nominal interest rate is imposed. But the main message for DSGE models is that we should dismiss once and for all the use of CD for business cycle analysis.

Primary contributor

Author Cristiano Cantore

Additional contributors

Contributor Paul Levine
Contributor Bo Yang

Additional details

14 September 2012
Centre for International Macroeconomic Studies (CIMS) conference : monetary and fiscal policy rules with labour market and financial frictions
14 September 2012