Labor productivity, effort and the Euro Area business cycle

Abstract

Labor productivity is highly procyclical in the Euro Area. We investigate the sources of this procyclicality in an estimated New Keynesian business cycle model with labor search frictions and variable factor utilization in both capital and labor. Labor input can vary along three margins: employment, hours, and effort (or utilization). We find evidence for a significant use of the effort margin in labor adjustment. Moreover, a model with effort outperforms one with variable capital utilization or dominant technology shocks. Finally, the effort margin dampens inflation volatility.