The Relative Importance of Aggregate and Sectoral Shocks and the Changing Nature of Economic Fluctuations

A principal components decomposition of sectoral IP data reveals that the contribution of aggregate shocks to the variance of aggregate output declined from about 70 percent in the period 1967-1983 to about 30 percent after 1983. We develop an islands model with two sectors and costly labor reallocation to investigate how this change in the relative importance of shocks alters business cycle moments. A version of the model with relatively more important sectoral shocks results in a sizeable decline in the cyclicality of labor productivity and is consistent with changes in several other business cycle moments observed in the data.