Endogenous Aggregate Elasticity of Substitution

Abstract

In the literature studying aggregate economies the aggregate elasticity of substitution (AES) between capital and labor is often treated as a constant or “deep” parameter. This view contrasts with the conjecture put forward by Arrow et al. (1961) that AES evolves over time and changes with the process of economic development. This paper evaluates this conjecture in a simple dynamic multi-sector growth model, in which AES is endogenously determined. Our findings support the conjecture, and in particular demonstrate that AES tends to be positively related to the state of economic development, a result consistent with recent empirical findings.