Greenwood hercowitz huffman ghh preferences: Meaning, Criticisms & Real-World Uses

What Is Greenwood Hercowitz Huffman (GHH) Preferences?

Greenwood–Hercowitz–Huffman (GHH) preferences refer to a specific type of utility function employed in macroeconomic models to analyze household choices regarding consumption and labor supply. These preferences are a key component within the broader field of Macroeconomic Modeling, particularly in dynamic stochastic general equilibrium (DSGE) models. A distinguishing feature of GHH preferences is their design to eliminate the wealth effect on labor supply, meaning that an individual's decision to work is driven primarily by the substitution effect between leisure and consumption, rather than by changes in their overall wealth or income. This characteristic simplifies the analysis of how labor supply responds to temporary economic shocks or policy changes.

History and Origin

GHH preferences were introduced by Jeremy Greenwood, Zvi Hercowitz, and Gregory W. Huffman in their seminal 1988 paper, "Investment, Capacity Utilization, and the Real Business Cycle." Thi³⁷s work significantly contributed to real business cycle theory by providing a framework to understand the macroeconomic impact of technological changes affecting the productivity of new capital goods. The³⁶ original paper explored how shocks to the marginal efficiency of investment influence business fluctuations within a neoclassical framework that included endogenous capital utilization. The³⁴, ³⁵ functional form of utility they proposed made it exceptionally convenient to model how labor choice responds primarily to changes in the real wage, rather than being influenced by wealth levels. The³³ original working paper version of their research is accessible via academic archives. [http://hdl.handle.net/1802/2688]

Key Takeaways

GHH preferences are a specific utility function used in macroeconomic models to determine household consumption and labor supply.
Their primary feature is the elimination of the wealth effect on labor supply, simplifying analysis of substitution effects.
Introduced in 1988 by Greenwood, Hercowitz, and Huffman, they are foundational in real business cycle theory.
These preferences are particularly useful for examining the impact of technology or policy changes on work incentives without confounding wealth effects.
While offering analytical convenience, they can lead to large fiscal and monetary multipliers in certain New Keynesian models.

Formula and Calculation

GHH preferences typically take a functional form where utility is expressed as a transformation of the difference between consumption and a disutility of labor. A general form is:

U(c, l) = \frac{1}{1-\gamma} \left(c - \psi \frac{l^{1+\theta}}{1+\theta}\right)^{1-\gamma}

Where:

(U) = Total utility
(c) = Consumption
(l) = Labor supply (e.g., hours worked)
(\gamma) = Parameter related to the coefficient of relative risk aversion or intertemporal elasticity of substitution for the composite term ((c - G(l)))
(\psi) = Parameter scaling the disutility of labor
(\theta) = Parameter governing the elasticity of the disutility of labor

In this structure, the marginal rate of substitution between consumption and leisure becomes independent of consumption, depending only on the real wage. This mathematical property is what eliminates the wealth effect on labor supply.

##³² Interpreting the GHH Preferences

The core interpretation of GHH preferences revolves around the idea that labor supply decisions are purely driven by the relative price of leisure (the wage), and not by how wealthy an individual feels. In models employing GHH preferences, if a household receives an increase in non-labor income, their desired labor supply does not change. Instead, they would only alter their labor effort if the real wage rate changes, incentivizing a shift between work and leisure. This characteristic helps economists isolate the substitution effect from the income effect when analyzing labor market dynamics. This analytical convenience makes GHH preferences widely adopted in quantitative macroeconomics for simulating the impact of various economic shocks, such as technology advancements affecting productivity.

##³⁰, ³¹ Hypothetical Example

Consider an economy modeled with GHH preferences. Imagine a temporary positive technology shock occurs, leading to an immediate increase in the marginal productivity of labor, which translates into higher real wages. In this scenario, individuals modeled with GHH preferences will increase their labor supply. The higher wage makes leisure more expensive in terms of foregone consumption, leading to a strong substitution effect towards work. Crucially, because GHH preferences neutralize the wealth effect, the increased income from the technology shock does not lead individuals to demand more leisure (and thus reduce work hours), as might happen with other utility specifications. Therefore, the model predicts a clear, positive response of labor supply to the productivity shock. This streamlined response simplifies the analysis of economic fluctuations and policy implications.

Practical Applications

GHH preferences are extensively utilized in modern macroeconomic models, particularly in Dynamic Stochastic General Equilibrium (DSGE) frameworks, which are used by central banks and international organizations like the International Monetary Fund (IMF) for policy analysis and forecasting. The²⁸, ²⁹ir application allows economists to analyze how changes in fiscal policy, such as tax cuts or government spending, or monetary policy measures, affect aggregate labor supply and economic output without the confounding influence of income effects on labor decisions. Thi²⁶, ²⁷s provides clearer insights into the pure incentive effects of economic policies on work effort. For instance, models incorporating GHH preferences have been used to study business cycles and equity premia in emerging economies, offering explanations for observed co-movements among consumption, labor effort, and labor productivity.

##²⁵ Limitations and Criticisms

Despite their analytical convenience, GHH preferences face certain limitations and criticisms. A primary critique is their inherent assumption that there is no wealth effect on labor supply. While this simplifies modeling, in reality, individuals may choose to work less as their wealth increases, a phenomenon observed in some contexts. Thi²³, ²⁴s abstraction can limit the empirical realism and applicability of models using GHH preferences, especially in situations where income effects are significant determinants of labor decisions.

Fu²²rthermore, in some New Keynesian models, the specification of GHH preferences can generate very large fiscal policy and monetary policy multipliers due to a feedback from consumption-labor complementarity. Thi²¹s can lead to counterintuitive or unrealistic policy implications, with output responses to government spending shocks, for example, becoming excessively large or even infinite in an undistorted economy. Cri²⁰tics suggest that alternatives to GHH preferences may be necessary for certain models, especially those merging nominal price rigidities and incomplete markets, to avoid these potentially problematic outcomes.

##¹⁹ Greenwood Hercowitz Huffman (GHH) Preferences vs. Separable Preferences

The key distinction between GHH preferences and separable preferences lies in how they treat the relationship between consumption and leisure in determining an individual's utility and, consequently, their labor supply decisions.

Feature	Greenwood Hercowitz Huffman (GHH) Preferences	Separable Preferences
Utility Form	Non-separable: Utility from consumption is affected by labor/leisure choice.	Additively separable: Utility from consumption is independent of labor/leisure choice.
Wealth Effect on Labor Supply	Eliminated: Labor supply is independent of wealth. ¹⁸	Present: Changes in wealth can directly affect labor supply decisions.
¹⁶, ¹⁷ Labor Supply Determinants	Primarily the real wage (substitution effect dominates). ¹⁴, ¹⁵	Real wage (substitution effect) and income/wealth (income effect).
¹³ Analytical Convenience	Often more convenient for isolating substitution effects and generating specific macroeconomic dynamics.	C¹²an be simpler to calibrate but may lead to more complex interactions between consumption and labor.
Implication for Balanced Growth	Generally not consistent with a balanced growth path where hours worked remain constant, unless certain conditions are met or generalized.	C¹⁰, ¹¹an be consistent with constant hours worked along a balanced growth path.

⁹In separable preferences, the utility derived from consumption and the disutility from labor (or utility from leisure) are treated as independent components that are simply added together. This means a change in wealth would directly influence the desire for leisure, leading to an "income effect" on labor supply. In contrast, GHH preferences are structured such that the amount an agent works affects the utility received from consumption, making them non-separable. This specific structure mathematically ensures that the marginal rate of substitution between consumption and leisure is independent of the level of consumption, effectively neutralizing the wealth effect on labor supply.

##⁸ FAQs

What problem do GHH preferences solve in macroeconomic modeling?

GHH preferences address the challenge of modeling labor supply responses to economic changes without the complication of the wealth effect. By eliminating this effect, economists can more cleanly analyze how incentives from wages, rather than changes in perceived wealth, influence how much people work.

##⁶, ⁷# Are GHH preferences always used in Dynamic Stochastic General Equilibrium (DSGE) models?
While GHH preferences are widely used in macroeconomic models, particularly DSGE models, they are not universally adopted. Other utility specifications exist, and the choice depends on the specific research question and the empirical phenomena the model aims to explain.

##⁴, ⁵# Do GHH preferences imply that people work more when they get richer?
No, GHH preferences are designed to eliminate the wealth effect on labor supply. This means that under GHH preferences, individuals' decisions about how much to work are not influenced by their overall wealth or income level. They would only work more if the real wage increases, making leisure relatively more expensive.

##², ³# What is the "substitution effect" in the context of GHH preferences?
The substitution effect refers to how individuals adjust their labor supply in response to changes in the real wage. If wages increase, the "price" of leisure (the income forgone by not working) goes up, incentivizing individuals to substitute leisure for work. GHH preferences emphasize and isolate this effect.¹