The Behaviour of Productivity Growth Rates and Composition Bias in the Labour Input
The conventionally calculated Solow residual has been used as a measure of exogenous productivity shocks that contribute to the business cycle. However recently this residual has been shown to be endogenous and has led to the conclusion that the aggregate economy is characterized by increasing returns to scale and imperfect competition. Another hypothesis is that the Solow residual may fail to be exogenous due to measurement errors in labour and capital. Using an efficiency hours series corrected for the composition bias in the labour force and a capital series adjusted for capacity utilization for Canada, we find that adjusting the Solow residualfor cyclical variations in labour and capital inputs over the business cycle re-establishes exogeneity ofproductivity shocks.