Reexamination of real business . . .

Abstract

Standard dynamic small open economy models have predicted a counterfactual perfectly positive correlation between output and hours worked over the business cycle. In addition, this class of models exhibits a weak internal propagation mechanism. To address these anomalies, this paper incorporates intertemporally non-separable labor supply and variable capital utilization into the canonical Mendoza model with adjustment costs of net investment. Our analysis shows that a dynamic, technology-shock driven small open economy model with internal habit formation in labor hours and endogenous capital utilization is able to account for the main real business-cycle regularities of Canada after 1981