Productive Demand, Sectoral Comovement, and Total Capacity Utilization

We estimate the contribution of demand shocks to the Solow residual and business cycle fluctuations in a three-sector model using Bayesian techniques. In addition to standard discount-factor demand shocks, we also allow for shocks to shopping effort. Our novel identification strategy leverages capacity utilization data from both nondurable and durable goods sectors to identify key parameters of goods market frictions. First, search demand shocks account for the majority of forecast error variance in the Solow residual, output, and utilization. Second, key novel parameters related to goods market frictions are well-identified. Third, search demand shocks and sector-specific wage markup shocks prove essential for matching observed sectoral dynamics including the volatility, contemporaneous correlation, and autocorrelation of utilization rates. In addition, impulse response functions show that search demand shocks uniquely generate three-way comovement of the utilization rates and the Solow residual, highlighting a productive role for demand shocks.