The behaviour of productivity growth rates and composition bias in the labour input

The conventionally calculated Solow residual has been used as a measure of exogenous productivity shocks that contribute to the business cycle. However, recently this residual has been shown to be endogenous and has led to the conclusion that the aggregate economy is characterized by increasing returns to scale and imperfect competition. Another hypothesis is that the Solow residual may fail to be exogenous due to measurement errors in labour and capital. Using an efficiency hours series corrected for the composition bias in the labour force and a capital series adjusted for capacity utilization for Canada, it was found that adjusting the Solow residual for cyclical variations in labour and capital inputs over the business cycle re-establishes exogeneity of productivity shocks.