Labor, Output and Consumption in Business Cycle Models of Emerging Economies

Motivated by the fact that, over the business cycle, labor dynamics in emerging economies differ in nontrivial ways from those observed in developed economies, we assess the relative importance of trend shocks in emerging economies in the business cycle model of Aguiar and Gopinath (2007) when labor data is explicitly taken into account. We study Mexico and Canada as representatives of emerging and developed economies, respectively. We find for Mexico that, in the benchmark case with Cobb-Douglas preferences, the income effect on consumption of trend shocks is too strong, delivering countercyclical and counterfactual fluctuations in employment. The model faces a trade-off between, on the one hand, having sizeable growth shocks, thereby having a good match in terms of relatively high consumption volatility, and, on the other, having procyclical employment dynamics. This is remedied when both quasilinear preferences are assumed and the econometric identification strategy explicitly takes into consideration labor dynamics. In this case trend shocks continue to be relatively stronger in emerging economies. Additionally, we find that differences in labor dynamics across emerging and developing economies are associated with the relatively large informal labor sector in emerging economies. It is in this dimension, when trying to match the dynamics of formal employment, that we find less evidence supporting an important role of trend shocks as being the main driving force of business cycles in emerging economies