4. USING THE METHODOLOGY IN BUSINESS CYCLE RESEARCH
Kydland and Prescott (1982) found, as reported in our paper “Time to Build
and Aggregate Fluctuations,” that if elasticity of substitution of labor supply is
3 and TFP shocks are highly persistent and of the right magnitude, then
business cycles are what the neoclassical growth model predicts. This includes
the amplitude of fluctuation of output, the serial correlation properties of
cyclical output, the relative variability of consumption and investment, the
fact that capital stock peaks and bottoms out later than does output, the
cyclical behavior of leisure, and the cyclical output accounting facts.
Subsequently, Prescott (1986) found that the shocks were highly persistent
and the TFP shocks of the right magnitude. Conditional on a labor supply
elasticity close to 3, TFP shocks are the major contributor to fluctuations in
the period 1954–1981 in the United States.