A Flexible Finite-Horizon Identification of Technology Shocks

Recent empirical studies using in finite horizon long-run restrictions question the validity of the technology-driven real business cycle hypothesis. These results have met with their own controversy, stemming from their sensitivity to changes in model specification and the general poor performance of long-run restrictions in Monte Carlo experiments. We propose an alternative identification that maximizes the contribution of technology shocks to the forecast-error variance of labor productivity at a long, but finite horizon. In small samples, our identification outperforms its in finite horizon counterpart by producing less biased impulse responses and technology shocks that are more highly correlated with the technology shocks from the underlying model. We apply our identification to post-war U.S. data and find that the negative hours response is not robust to allowing a slightly greater role for non-technology shocks in the variance of productivity at long horizons. We conclude that restrictions aimed at isolating the dynamics of productivity beyond business cycle frequencies do not provide information sufficient to robustly predict short-run movements in labor hours.