RDP 9411: Demand Shocks, Inflation and the Business Cycle 5. Summary and Conclusions

In the long run, inflation is a monetary phenomena. Few economists, however, believe that monetary expansion (or low real interest rates) generates instantaneously higher prices. The standard view is that stronger demand growth as the result of expansionary macro-economic policies causes output to increase faster than capacity and, in response, prices rise in order to choke-off the excess demand. There are lags at both stages; that is, it takes time for the initiation of easier policies to affect demand and it takes time for the increase in demand to affect prices.

In the paper we examine the short-run relationship between demand growth, capacity utilisation and price increases using data from surveys of manufacturing firms. The results are broadly supportive of the idea that the breaching of capacity constraints generates inflationary pressures. Predominantly, these pressures come through increased input costs. As capacity utilisation increases, demand for various factors of production rises and input prices increase. In addition, firms may face declining marginal productivity. The important point is that faced with higher costs, firms' output prices rise.

In recessions, the deflationary forces exerted by falling input costs are amplified by falling margins. While margins appear to be pro-cyclical (being larger in booms than in recessions) they do not appear to behave symmetrically over the course of the business cycle. Margins appear to be squeezed when demand is falling and the manufacturing sector is already in recession. Rebuilding of the margins appears to take place relatively early in the recovery. Once the recovery is well under way, the movements in margins tend to be smaller and price increases are predominantly driven by changes in costs.

There is some evidence that capacity constraints do limit increases in output. When demand rises, and firms are already above capacity, the output response is smaller than when firms are operating below normal capacity. This smaller output response is not driven solely by the fact that costs are higher, making production more expensive. To some degree, it reflects the difficulty of working the capital stock harder and the difficulty of obtaining important inputs. Given these difficulties, it is not surprising that when manufacturing firms are operating at high levels relative to capacity, a given increase in demand is reflected more in an increase in prices than an increase in output.

The rise in costs associated with an increase in capacity utilisation occurs with some lag. This suggests that the increase in costs is driven by higher input prices, rather than the existence of fixed factors of production and falling marginal productivity. Increased demand for inputs takes some time to be reflected in factor prices, as renegotiation of contracts needs to take place. However, once cost increases have occurred, they appear to translate into price increases relatively quickly.

While the results in the paper suggest some interesting conclusions they are not without qualification. For the survey data to accurately summarise the underlying macro-economic variables requires that firms answer the questions accurately, and that a number of restrictive assumptions hold regarding the across-firm distribution of changes in the relevant variables. While it is not possible to test these restrictions, they are unlikely to hold exactly. The nature of the survey data also makes it difficult to determine a relationship between the size of the estimated coefficients and the underlying macroeconomic variables of interest. In addition, the response of the manufacturing sector to changes in demand may not be representative of the economy as a whole.

Nevertheless, the basic qualitative results seem quite strong. Demand growth, without expansion in underlying capacity, generates inflationary pressures. These pressures come primarily through increases in firms' costs and occur with some lag. This suggests that changes in firms' input prices (including the cost of labour) are a key ingredient to understanding short-run inflation dynamics. This strong link between costs and prices also suggests that higher costs, due to factors unrelated to capacity utilisation, will generate higher inflation, at least in the short run.