GHH preferences

Greenwood-Hercowitz-Huffman(1988)AER
<quote>
Fluctuations in investment played a key role in Keynes' view of the trade cycle. There, shifts in the marginal efficiency of investment impact on investment, aggregate demand and therefore, given the disequilibrium in the labor market, employment and output. The quintessential case of this type is when there is an increase in the marginal efficiency of newly produced capital that does not affect the productivity of the capital stock already on line. When a shock of this type occurs in a standard neoclassical model, employment and output also tend to rise, but the mechanism is very different. The increase in the rate of return on investment stimulates current labor effort and output through an intertemporal substitution effect on leisure. A potential problem with this mechanism, as discussed by Robert Barro and Robert King (1984), is that intertemporal substitution which induces individuals to postpone leisure, also works to cut consumption. This effect would tend to make consumption move countercyclically, which contradicts the evidence. Labor productivity would tend to move in the " wrong" direction, too. An expansion of labor effort, given the fixed supply of capital in the short run, causes labor's productivity to decline.

In contrast to the intertemporal substitution effect mentioned above, the transmission mechanism of the investment shocks works in the present model through the optimal utilization of capital and its positive effect on the marginal productivity of labor. As will be seen, an important aspect of such a change in labor productivity is that it creates intratemporal substitution, away from leisure and toward consumption, generating procyclical effects on consumption and labor effort. Additionally, average labor productivity responds procyclically to these shocks.

That is, labor effort is determined independently of the intertemporal consumption-savings choice, which is very convenient in obtaining results from the model. As a consequence, the intertemporal substitution effect on labor effort, a central ingredient in many macroeconomic models, is eliminated. Rather than being a drawback, this implication of the utility function has the advantage of emphasizing the alternative transmission of investment shocks being studied here. When analyzing fluctuations in labor effort, this framework stresses shifts in the productivity of labor brought about by changes in the optimal rate of capacity utilization, as opposed to intertemporal substitution effects stressed by others.
<unquote>