| Abstract |
We show that the aggregate elasticity of substitution (AEOS) between capital and labor is countercyclical: capital and labor are more substitutable in recessions than in expansions. We introduce a tractable framework that yields a closed-form expression for the AEOS in competitive markets, building on a nested CES production structure with multiple types of capital and labor. The AEOS depends on technological parameters—pairwise elasticities within nests—and on endogenous weights shaped by (i) the type-specific composition of labor and capital income and (ii) the aggregate labor share of income. In recessions, a higher labor share driven by skilled labor reduces the AEOS toward the relatively low elasticity between skilled labor and equipment, while a simultaneous decline in the equipment share raises the AEOS toward the higher elasticity between structures and the rest of the economy. The latter effect dominates, generating a countercyclical AEOS. We discuss implications for the business cycle and labor share dynamics. |