Demand Shocks as Productivity Shocks

Abstract

We provide a macroeconomic model where demand for goods has a productive role. A search friction prevents perfect matching between potential customers and producers, and larger demand induces more search, which in turn increases output in the economy. Consequently, when viewed through the lens of a standard neoclassical aggregate production function, an increase in demand will appear as an increase in the Solow residual. We estimate the model using standard Bayesian techniques, allowing for business cycles being driven by both preference shocks – which we interpret as shocks to demand – and true technology shocks. Technology shocks account for less than 18% of the fluctuations in output and the measured Solow residual. Our model also provides a novel theory for important macroeconomic variables such as the relative price of consumption and investment, Tobin’s Q, and capacity utilization.

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