What Is Greenwood–Hercowitz–Huffman Preferences?
Greenwood–Hercowitz–Huffman (GHH) preferences are a specific functional form of utility function used in macroeconomic models within the broader field of [Macroeconomics]. This preference structure, often referred to simply as GHH preferences, allows economists to model household behavior where the decision to supply labor supply is independent of the household's wealth effect on consumption. Instead, labor supply is primarily driven by substitution effects between leisure and consumption. GHH preferences are particularly useful in dynamic general equilibrium models, especially those exploring real business cycle theory and the impact of various economic shocks on labor decisions.
History and Origin
Greenwood–Hercowitz–Huffman preferences were developed by economists Jeremy Greenwood, Zvi Hercowitz, and Gregory Huffman. They introduced this particular utility function in their influential 1988 paper, "Investment, Capacity Utilization, and the Real Business Cycle." The paper a16imed to describe the macroeconomic impact of technological changes that affect the productivity of new capital goods and introduced the concepts of investment-specific technological progress and capacity utilization into modern macroeconomics. The innovation of GHH preferences provided a tractable way to analyze the relationship between consumption and labor decisions in a dynamic setting, specifically by eliminating the income effect on labor supply, which simplified the analysis of how changes in technology or policy might influence work incentives.
Key Takeaways
- No Wealth Effect on Labor Supply: A defining characteristic of GHH preferences is that an individual's decision to work is not influenced by changes in their overall wealth.
- Focus15 on Substitution Effects: Labor supply choices in models using GHH preferences are primarily determined by the trade-off (substitution effect) between leisure and consumption.
- Simpl14ified Macroeconomic Analysis: The absence of a wealth effect on labor supply makes GHH preferences particularly convenient for analytical tractability in certain macroeconomic models, especially those studying business cycles and dynamic labor responses.
- Co-mo13vement of Variables: GHH preferences can help models generate more realistic co-movements among consumption, labor effort, and labor productivity in response to shocks.
- Appli12cation in Real Business Cycle Models: GHH preferences are extensively utilized in real business cycle theory and open economy macroeconomics.
Formula and Calculation
GHH preferences are typically expressed as a non-separable utility function over consumption ($c$) and labor ($l$). A common formulation is:
Where:
- $U(c, l)$ is the utility derived from consumption and labor.
- $c$ represents consumption.
- $l$ represents labor (e.g., hours worked).
- $\gamma$ (gamma) is related to the coefficient of relative risk aversion and the intertemporal elasticity of substitution.
- $\psi$ (psi) is a parameter that scales the disutility from labor.
- $\theta$ (theta) is a parameter governing the elasticity of the disutility of labor with respect to labor.
The key feature of this form is that the marginal rate of substitution between consumption and labor depends only on labor, not on consumption, thus neutralizing the wealth effect on labor supply.
Interpreting the Greenwood–Hercowitz–Huffman Preferences
Greenwood–Hercowitz–Huffman preferences are interpreted as a way to model an economic agent's behavior where their willingness to work (labor supply) is solely determined by the real wage rate, irrespective of their overall financial well-being or wealth. In models that incorporate GHH preferences, if a household becomes wealthier (e.g., through an increase in non-labor income), they will not necessarily choose to reduce their work hours because the marginal utility of leisure is not directly affected by their level of consumption. This implies that changes in wealth do not create an "income effect" that would typically lead individuals to consume more leisure. Instead, labor supply decisions hinge entirely on the relative price of leisure, which is the real wage. This characteristic simplifies the analysis of labor market dynamics and their responses to various economic growth drivers.
Hypothetical Example
Consider an economy modeled with Greenwood–Hercowitz–Huffman preferences. Suppose there is a temporary positive technology shock that increases labor productivity. In a standard model, this shock might lead to an increase in real wages, making people wealthier. This wealth effect could, in turn, lead them to demand more leisure and thus reduce their labor supply. However, with GHH preferences, the increase in productivity and wages solely impacts the substitution effect. Workers are incentivized to work more because the reward for their labor (the real wage) has increased relative to the enjoyment of leisure. Since their decision to work is decoupled from their perceived wealth, the model predicts that the increase in productivity will lead to an unambiguous increase in hours worked, alongside higher consumption.
Practical Applications
Greenwood–Hercowitz–Huffman preferences are widely applied in modern macroeconomics, particularly in dynamic stochastic general equilibrium (DSGE) models. These models are used by central banks and academic researchers to understand and forecast economic phenomena. GHH preferences are often employed when studying:
- Real Business Cycle (RBC) Models: They are a core component of many RBC models, which analyze how real factors like technology shocks drive business fluctuations.
- Fiscal and Monetary P11olicy Analysis: GHH preferences allow economists to isolate the substitution effects of fiscal policy and monetary policy on labor supply, providing clearer insights into how these policies affect work incentives and overall output.
- Open Economy Macroeco10nomics: These preferences are frequently used in models of international business cycles, helping to explain cross-country co-movements of economic activity.
- Portfolio Choice Mode9ls: Recent research has explored the implications of GHH preferences for households' asset pricing and portfolio allocation decisions, especially concerning the interplay between labor income and risky investments.
Limitations and Critici8sms
While Greenwood–Hercowitz–Huffman preferences offer significant analytical advantages, they also have limitations. One primary criticism is their strong assumption that there is no wealth effect on labor supply. In reality, individuals may ind7eed choose to work less if they experience a substantial increase in wealth. This abstraction can limit the empirical realism of models employing GHH preferences in certain economic contexts or demographics.
Furthermore, in some New Keyne6sian models, GHH preferences can lead to unexpectedly large fiscal policy and monetary policy multipliers due to a feedback mechanism from consumption-labor complementarity. This can make the results of su5ch models hard to interpret and potentially undesirable for policy analysis. Critics suggest that alternatives to GHH preferences, such as separable preferences, might be more appropriate in contexts where wealth effects on labor supply are deemed economically significant. Additionally, GHH preferences a4re not always consistent with a balanced growth path where hours worked remain constant over time.
Greenwood–Hercowitz–Huffman3 Preferences vs. King-Plosser-Rebelo Preferences
Greenwood–Hercowitz–Huffman (GHH) preferences and King-Plosser-Rebelo (KPR) preferences are both widely used in macroeconomic models to represent household utility function over consumption and leisure. The primary distinction lies in how they handle the relationship between wealth and [labor supply].
KPR preferences, sometimes referred to as balanced-growth preferences, imply a negative wealth effect on labor supply. This means that as an individual's wealth or permanent income increases, they tend to reduce the amount of labor they supply, opting for more leisure. KPR preferences are consistent with a balanced growth path where hours worked remain constant over time, a stylized fact observed in many developed economies.
In contrast, GHH preferences eliminate2 the wealth effect on labor supply. An increase in wealth does not directly alter an individual's decision to work. Labor supply is solely determined by the real wage (the substitution effect between consumption and leisure). This feature of GHH preferences can lead to different predictions regarding the dynamics of labor supply in response to various [economic shocks], particularly in [real business cycle theory] models. The choice between GHH and KPR preferences often depends on the specific economic question being addressed and the empirical regularities the model aims to match.
FAQs
What is the main characteristic of Greenwood–Hercowitz–Huffman preferences?
The main characteristic of GHH preferences is the absence of a wealth effect on [labor supply]. This means that an individual's decision to work depends solely on the real wage, not on their overall level of wealth or income.
Why are GHH preferences used in macroeconomic models?
GHH preferences are used because they simplify the analysis of [labor supply] decisions in dynamic [macroeconomic models]. By eliminating the wealth effect, economists can more easily isolate and study the substitution effects of wages and productivity shocks on work incentives and [consumption] choices.
Do GHH preferences imply that people never work less when they get richer?
In a model with GHH preferences, an increase in wealth alone does not lead to a reduction in labor supply. However, if a rise in wealth is associated with a change in the real wage, labor supply could adjust due to the substitution effect. The key is that the direct income effect on leisure is removed.
How do GHH preferences relate to real business cycle theory?
GHH preferences are frequently employed in [real business cycle theory] models. Their structure allows these models to generate co-movements between consumption, labor, and productivity that are often more consistent with empirical observations, especially in response to technology shocks that affect [investment] and output.
Are there any drawbacks to using GHH preferences?
Yes, a key drawback is their assumption of no wealth effect on labor supply, which may not always align with real-world behavior. Additionally, in some advanced models, GHH preferences can lead to exaggerated responses of economic activity to [fiscal policy] and [monetary policy] changes, which may be counter-intuitive or require careful interpretation.1