Federal Reserve Bank of Minneapolis Research Department Staa Report # 236 Capital-skill Complementarity and Inequality: a Macroeconomic Analysis

There have been striking postwar changes in the supply and price of skilled labor relative to unskilled labor. The relative quantity of skilled labor has increased substantially, and the skill premium, which is the wage of skilled labor relative to unskilled labor, has grown signiicantly since 1980. Many studies have found that it is diicult to account for the increase in the skill premium on the basis of observable variables and have concluded that latent \skill-biased technological change" is the main factor responsible for the increase. This paper develops a framework that provides a simple, explicit economic mechanism for understanding skill-biased technological change in terms of observable variables and uses the framework to evaluate the fraction of variation in the skill premium that can be accounted for by changes in observed factor quantities. We use a version of the neoclassical growth model in which the key feature of the aggregate technology is capital-skill complementarity, which means that the elasticity of substitution between capital equipment and unskilled labor is higher than that between equipment and skilled labor. We nd that with capital-skill complementarity, changes in observed inputs alone can account for nearly all of the variation in the skill premium over the last 30 years. Our ndings suggest that increased wage inequality is a consequence of economic growth driven by the introduction of new, eecient technologies that are embodied in capital equipment. Krusell, Ohanian and R os-Rull thank the National Science Foundation. 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.