Excess Capacity and Demand Driven Business Cycles

I build a macroeconomic model that features chronic excess capacity. Firms can use their capacity to compete for buyers who are not fully attentive to prices. If one firm expands capacity while other firms do not, it “steals” or attracts profitable demand from others. Theoretically, I show that this capacity competition can cause an over-accumulation of capacity. In the presence of chronic excess capacity, capital resources can be slack, and demand shocks can have large effects on output. The model is consistent with stylized facts about capacity utilization and survey evidence from Switzerland. Quantitatively, when the model is estimated to match the U.S. macro data, demand shocks turn out to be the main driving forces of business cycles.