Labor-Market Wedge under Engel Curve Utility: Cyclical Substitution between Necessities and Luxuries

ne of the leading research questions in macroeconomics concerns the identication of the sources of economic uctuations. 1 Economists often identify these sources through accounting procedures that are based on "wedges," that is, violations of a model economy's equilibrium conditions conditional on data. 2 For example, representative agent models impose tight restrictions on the comovement of consumption, hours, and real wages. For an optimal allocation of consumption and hours worked, the marginal rate of substitution (MRS) between leisure and consumption has to equal the real wage. Conditional on consumption, hours worked should increase with the real wage, but for reasonable parameterizations of the representative household's preferences, this prediction is inconsistent with observed movements in aggregate consumption, hours worked, and real wages over the business cycle. On the one hand, the MRS increases rapidly during expansions, as the marginal utility of consumption rel-We would like to thank Mark Bils, Pete Klenow, John Jones, Nicolas Morales,