A Theory of the Capacity Utilization/Inflation Relationship

T he relationship between capacity utilization and inflation is quite variable. Figure 1 shows the time paths of utilization and inflation for the United States over the period 1953:1 to 1995:4. Two features characterize this relationship. First, inflation and utilization often move in opposite directions. The most dramatic episodes of negative comovement coincided with the 1973/1974 and 1979 periods of sharp energy price rises. Then, utilization plummeted while inflation soared. Second, inflation and utilization also frequently move together. In fact, the instances of positive comovement slightly dominate those of negative covariation—the average historical correlation between utilization and inflation is 0.09. The question is, why do inflation and utilization behave in this way? Macroeconomics provides many theories of the relations between real economic activity and inflation. But there is no single theory explaining the foregoing features of the utilization/inflation relationship.1 Thus to address the question posed above, this article develops a new theory. The new theory is based on the standard neoclassical theory advanced by Kydland and Prescott (1982) and Prescott (1986), which emphasizes the importance of technology shocks for the behavior of real variables such as output, consumption, investment, and employment. Building on the standard theory, the new theory blends together ingredients from various other neoclassical theories. The extensions include endogenous capacity utilization (following Greenwood, Hercowitz, and Huffman [1988]), a role for money and inflation (as in Greenwood and