Technology shocks and hours: it is the identification, stupid!

There has been an endless debate in macroeconomics about what exogenous variable is supposed to trigger business cycles. While real business cycle models showed some success in matching business cycle features, Jordi Galí used VARs to show that total factor productivity shocks cannot possibly be the right source. It took a few years for the RBC people to recuperate from that blow, but they seem to have found the weak spot in Galí's argument: the data sample is desperately small or it is impossible to go from model to VAR and vice-versa. In other words, the statistical approach is ill-advised.

José-Víctor Ríos-Rull, Frank Schorfheide, Cristina Fuentes-Albero, Raul Santaeulalia-Llopis and Maxym Kryshko now come with yet another argument. The problem is not the econometrics, it is the identification. To be more precise, it all hinges on the labor supply elasticity. And that one is a difficult one, given that macroeconomists and microeconomists do not seem to be able to agree what its ballpark value should be. In particular, they argue that if one uses an elasticity as calibrated in the literature, TFP shocks can explain anything between 1% and 150% of business cycles. However, if this parameter is carefully estimated within a DSGE model using household level data, these shocks explain less than 10%. Will this settle the debate. Surely not. But I am looking forward to more fireworks. I have my popcorn ready.