Countercyclical Elasticity of Substitution

We empirically show that the short-run elasticity of substitution between capital and labor ($\sigma_t$) is countercyclical. In recessions, capital and labor are more substitutable than in expansions. We explore the effects of the countercyclicality of $\sigma_t$ on aggregate fluctuations in the context of an otherwise standard competitive-markets business cycle model. The countercyclical $\sigma_t$ contributes to resolve four main labor-market puzzles: Dunlop-Tarshis phenomenon, labor-productivity puzzle, hours-productivity puzzle, and labor share puzzle