The Cyclical Behaviour of the Solow Residual

The Cyclical Behaviour of the Solow Residual!

The Solow residual which is taken as a measure of the rate of technological progress refers to that portion of growth in output which cannot be explained by growth in capital or labour.

In other words, it is a measure of intensive growth. The Solow residual is expressed as

where A = TFP, Y = output, K = capital, L = labour, and a is capital’s share of income. In short, the Solow residual is the percentage change in output minus the percentage change in inputs, where each input is weighted by its relative share in output.

Edward Prescott computed the Solow residual for a number of years, in the context of US economy, to demonstrate the role of technology shocks in generating business cycles.

The Solow residual has shown sharp fluctuation over the period 1948 to 1999. Technology worsened in 1982 and improved in 1984. Moreover, there is a close relation between the Solow residual and output. In those years when output fell technology worsened. These fluctuations are an important source of economic fluctuations or business cycles.

Critics of Prescott’s interpretation of actual data suggest that the Solow residual fails to accurately represent changes in technology over a short period of time.

According to them cyclical behaviour of the Solow residual is accounted for by two measurement problems:

1. Labour Hoarding:

During recessions firms employ many workers whom they do not really need. They do this in order is to have sufficient workers in hand when there is shortage of labour in the recovery period. This is why there is overestimation of the labour force. Some workers who are working for shorter hours are also included in the total labour force because they are paid the market wages.

Consequently the Solow residual is more cyclical in its movements than the existing production technology. In recession productivity as measured by the Solow residual falls even if there is no technology shock (adverse or favourable) simply because workers are counting the days, they think, it will take for the recession to subside.

2. Underestimation of Output in Recessions:

Even in the absence of any technological change the measured Solow residual shows cyclical movement due to cyclical mismeasurement of output in times of recessions. During recessions workers do certain things which often go unnoticed. Even if such work is visible no imputation of the value of such output is- possible.

So standard measures of output fail to include the value of many types of work which are done by paid workers. Such residual work is done simply because demand for regular work is low due to low demand for the product of the firms. For example, during recessions workers may clean the factory, organise the inventory and get some off-the-job training, i.e., training outside the factory or work place.

In short, there are two different interpretations of the cyclical behaviour of the Solow residual. According to the real business cycle theories low productivity in recessions is due to adverse technology shocks.

The alternative explanation goes in terms of low measured productivity in recessions due to slackness (laxity) on the part of the workers and mismeasurement of their increased contribution in the standard measures of output.

Unfortunately, data do not suggest that labour hoarding and the cyclical mismeasurement of output are important causes of the cyclical behaviour of the Solow residual. There is need for further research in this area for arriving at any major conclusion.