Aggregate Returns to Scale: Why Measurement Is Imprecise

Abstract

The extent to which there are aggregate returns to scale at the level of aggregate production has important implications both for the types of shocks generating business cycles and for optimal policy. However, prior attempts to measure the extent of these returns using instrumental variable techniques have yielded quite imprecise estimates. In this article, we show that the production shocks implied by a range of returns to scale that encompasses both large increasing returns and large decreasing returns are almost identical. This makes clear that there is a fundamental reason for the imprecision of prior estimates and casts doubt on our ability to generate more precise estimates. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. The value of aggregate returns to scale—the percentage change in output from a given percentage change in factor inputs—has important implications for the sources of shocks that lead to business cycle fluctuations. With constant

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