Academic journal article Economic Inquiry

Intertemporal Substitution and Constraints on Labor Supply: Evidence from Panel Data

Academic journal article Economic Inquiry

Intertemporal Substitution and Constraints on Labor Supply: Evidence from Panel Data

Article excerpt



Through much of the 1970s and 1980s, macroeconomic stabilization analysis has been dominated by equilibrium models in which fluctuations in employment result from "intertemporal substitution": workers voluntarily vary their labor supply over time in response to movements in wages and interest rates. A number of recent empirical tests of intertemporal substitution models (for example, Altonji [1982]; Mankiw et al. [1985]; Ham [1986]) strongly reject the intertemporal substitution approach. These results have led some economists to reject equilibrium macro models in favor of Keynesian models in which workers face quantity constraints on labor supply. In Keynesian models, employment fluctuations result from changes in the severity of constraints - that is, changes in involuntary unemployment - rather than intertemporal substitution.

On the other hand, many economists remain unconvinced by recent rejections of intertemporal substitution models because the results are consistent with many possible explanations. For tractability, empirical studies always impose restrictive assumptions, such as separability of utility over time and between goods, or such as the existence of a "representative consumer." Data also suffer from numerous problems, such as aggregation bias, measurement error, and the use of average rather than marginal wage rates. Consequently, even the authors of the studies seem hesitant to draw firm conclusions. They often simply conclude that workers' behavior is explained either by quantity constraints or by a more complicated intertemporal substitution model than the one they have tested.(1)

This paper attempts to determine which of these explanations is correct. Are changes in employment a sophisticated form of intertemporal substitution, or are they involuntary? The crucial data come from questions in the Panel Study of Income Dynamics about whether workers experience unemployment or are unable to work as many hours as they want. Following Ham [1982; 1986], this information is used to classify workers as quantity constrained in their labor supply or unconstrained. I then test a simple intertemporal substitution model for each group of workers. If the tests suffer from overly restrictive utility functions or data problems, then the model should be rejected for both samples. On the other hand, if some workers truly face quantity constraints, then the model should perform better for the sample of unconstrained workers.(2)

The tests yield two main results. First, the model indeed performs worse for the constrained workers. For this group, the data reject the model's overidentifying restrictions, and the parameter estimates contradict the model. In contrast, the results for the unconstrained workers are weakly consistent with the model. As Keynesian theories suggest, quantity constraints alter workers' behavior.

Second, the estimates of the intertemporal labor supply elasticity (for prime-age men) are close to zero, even for unconstrained workers. Even if workers are free to vary their hours, they apparently choose to respond little to movements in wages.

The paper addresses two other issues. First, do constraints on borrowing influence labor supply? In the intertemporal substitution model, workers borrow and lend to smooth consumption while varying hours of work. As this suggests, the model performs best for workers who not only face no labor supply constraints, but who also own substantial assets and thus are unlikely to face liquidity constraints.

Finally, the paper proposes a new approach to identifying intertemporal labor supply equations. Previous micro studies do not adequately address the problem that wages are correlated with unobservable characteristics that affect tastes for work. I propose two identifying restrictions: (1) changes in tastes are uncorrelated with levels of time-in-variant variables; and (2) changes in tastes have no aggregate component. …

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