The Cyclical and Distributional Effects of Capacity Utilization

Capacity utilization, and its role in inflation and inequality, has been at the center of the policy discussion in recent times. We study cyclical and distributional dynamics in an economy where capacity utilization choices are explicitly introduced and modeled. In the model, firms face idiosyncratic demand uncertainty, and choose input factors (including labor) prior to observing their individual demand. When demand is realized, output is produced by varying labor effort of workers, subject to the capacity limit implied by the firm's chosen input levels. A key feature in our setup is that productivity and capacity utilization are both procyclical in response to demand shocks. Our framework admits three scenarios that are consistent with the empirical evidence, but not possible in a standard new Keynesian model. First, markups can be procyclical as firms internalize the increased probability of being capacity constrained in response to expansionary demand shocks. Second, the labor share can be countercyclical for the ``right reasons", i.e., when labor productivity is more procyclical than wages. Finally, inflation exhibits a hump-shaped response as procyclical productivity mitigates upward pressure on prices, even though pricing is purely forward-looking. We investigate the conditions under which these outcomes are obtained, and shed light on the distributional role played by nominal price and wage rigidities