What drives fluctuations of labor wedge and business cycles? Evidence from Japan

The literature has empirically shown that the labor wedge worsens during recessions. Taking this statement into consideration, this study poses two questions: First, what is the main driving force of the labor wedge, and second, is the main driver of the labor wedge the same as that of business cycles? In this study, we employ a commonly used medium-scale dynamic stochastic general equilibrium model with nominal and real frictions to analyze which structural shocks drive the fluctuation of the labor wedge and of business cycles. The model is estimated using Japanese data. Our estimation strategy is a particularly novel approach. In standard Bayesian estimation, the prior distribution of the parameters for the standard deviations of the structural shocks is the inverse gamma distribution, which does not support zero value and assumes the existence of structural shocks. By contrast, we employ a more flexible prior distribution of the parameters for the standard deviations of structural shocks and measurement errors to allow for the non-existence of structural shocks. Under the standard prior distribution, the estimation results imply that the labor wedge is mainly driven by preference and transitory technology shocks, whereas the investment adjustment cost shock is the most important for the business cycle fluctuations. However, under our relaxed prior distribution, which allows for the non-existence of structural shocks, the estimation results imply that both the labor wedge and business cycles are mainly driven by permanent technology and investment adjustment cost shocks. •We investigate the main driving source of the labor wedge and business cycles.•Our estimation method allows for the non-existence of structural shocks.•Both the labor wedge and business cycles are mainly driven by the permanent technology and investment adjustment cost shocks.