Long-run and Short-run Dynamic Linkages Among Capacity Utilization, Inflation and Per Capita Income: Theoretical and Empirical Enquiries for Panel of Countries

Abstract

Traditional macroeconomic theory explains inflation as the result of excess demand surpassing the full employment level of supply. However, achieving full employment doesn’t necessarily mean that the production system is operating at its maximum capacity. When production falls short of its potential, this underutilization is commonly observed in imperfect markets, and it can be one of the factors contributing to inflation. Additionally, excess capacity can have adverse effects on the overall economic system, potentially leading to lower income generation. In light of these considerations, this study develops a theoretical model that incorporates capacity utilization, inflation and per capita GDP (PCGDP) as the key indicators. It empirically investigates whether there are long-term associations and short-term dynamics among these variables in a panel of 28 countries (14 from developed and 14 from developing regions) over the period 2003–2019. The findings reveal that there are clear long-term relationships among the variables. In the short term, capacity utilization and PCGDP are found to influence inflation in the developed countries, but this relationship is not observed in developing countries. Conversely, PCGDP is influenced by capacity utilization and inflation rates in developing economies. Interestingly, there are no causal relationships observed in the panel of all the countries.