RDP 9411: Demand Shocks, Inflation and the Business Cycle 1. Introduction

The links between demand growth, capacity utilisation and inflationary pressures are at the heart of macroeconomics. One of the most basic issues facing macro-economists is what factors determine how an increase in nominal demand is “split” between an increase in prices and an increase in output. The predominant view is that in the long run, expansionary demand policies simply increase the price level, but in the short run, they can lead to both output growth and increases in prices. These short-run linkages are the focus of this paper. By using survey data, rather than macroeconomic data, we examine the relationships between changes in demand and costs, and changes in output and prices. We pay particular attention to the role that capacity utilisation plays in affecting these relationships.

One of the stylised facts underlying much of the New Keynesian economics is that changes in demand often have much larger effects on output than they do on prices, at least in the short run. This “fact” has generated considerable theoretical work aimed at explaining the relatively muted price changes. Underlying this work is the notion that the economy's short-run supply curve is relatively flat, so that changes in demand generate relatively large changes in output. Models which attempt to explain this flat supply curve focus on menu costs, co-ordination failures and the existence of monopolistically competitive markets.

While these models have been useful in explaining developments in some individual markets, they have not been widely adopted by macroeconomic policy-makers who typically rely on some concept of the output gap (that is, the difference between potential output and current output) when assessing demand-induced inflationary pressures. The idea is that an increase in demand when output is high (relative to potential output) will increase prices more, and output less, compared to the situation in which output is low. This idea has received some empirical support, with measures of the output gap helping to predict inflation in a number of different countries.^[1]

There are two important channels which might explain this relationship between inflation and changes in demand relative to potential output. The first of these is that increases in demand put pressure on firms' costs. The second channel is that increased demand leads to higher prices as firms increase their margins. There may also be some feedback from increased margins to costs, if higher margins lead workers to demand higher nominal wages to maintain their real wage.

By using data from the Australian Chamber of Commerce and Industry (ACCI)/Westpac Survey of Industrial Trends, we attempt to discriminate between these two channels for firms in the manufacturing industry. We do this by examining the impact that changes in demand have on manufacturing firms' costs and margins, and thus on their prices, and how this impact varies with the level of capacity utilisation. In the survey, firms are asked about the actual outcomes for a range of variables over the previous quarter, and their expectations for these variables over the following quarter. Amongst others, these variables include new orders (which we interpret as demand), output, prices and costs. Firms are also asked whether they are operating above or below “normal” capacity. By explicitly distinguishing between demand and output on the one hand, and prices and costs on the other, the data set allows us to trace through the effects of changes in demand on costs, output and prices.

In addition, since data exist on both actual and expected outcomes, we can explore the impact of unexpected changes in costs and demand on prices and output. Directly observing these shocks allows us to overcome some of the pitfalls that arise when the shocks are estimated with the aid of an econometric model. This helps in identifying the way in which demand shocks are transmitted to the output and pricing decisions of firms in the manufacturing sector.

The central results in our paper are as follows. Increased capacity utilisation does lead to inflationary pressures. These pressures occur primarily through increased costs. However, margins also appear to be pro-cyclical – that is, margins are higher in booms than in recessions. However, the movement in margins appears to be larger in recessions than in booms – as the economy goes into recession, margins fall and are then rebuilt as the economy enters the recovery phase. This rebuilding of margins does not lead to higher inflation immediately as downward pressure on cost increases is still being exerted by the high levels of excess capacity. Once margins have been restored, the additional demand associated with a boom generates relatively small additional increases in margins. Thus, in boom times, the pressures on prices come predominantly through increased costs. Our results also suggest that when capacity utilisation is high, changes in demand have a smaller effect on output (and a larger effect on prices) than when capacity utilisation is low.

The remainder of the paper is organised as follows. In Section 2 we provide some background to the general issues. Section 3 follows with our discussion of the survey, and the benefits and limitations of using the survey data. Section 4 then begins with an overview of the methodology we use in the empirical investigation and then presents and discusses our estimation results. Finally, we offer some concluding remarks in Section 5.

Footnote

See Blundell-Wignall et al (1992), McElhattan (1985), Bauer (1990), and Chadha and Prasad (1994) for examples. [1]