Capital-Skill Complementarity and Inequality Over the Business Cycle

When capital-skill complementarity is present in the production process, changes in the skill premium are driven not only by changes in the ratio of unskilled- to skilled labor inputs (as they are in the case with Cobb-Douglas production), but also by changes in the capital-skill ratio. A simple regression analysis demonstrates that the capital-skill ratio has a positive and significant relation to the skill premium at business cycle frequencies as predicted by the capital-skill complementarity hypothesis. This finding motivates the construction of a stochastic dynamic general equilibrium model which allows for capital-skill complementarity in production. The model with capital-skill complementarity can account for the cyclical behavior of the skill premium and much of its volatility. The model without capital-skill complementarity cannot. These results, together with the available empirical evidence, suggest that capital-skill complementarity is an important determinant of wage inequality over the business cycle. (Copyright: Elsevier)