Revisiting neoclassical growth theory: A primary role for inflation and capacity utilization

This paper extends the neoclassical growth framework and provides an econometric estimation of output growth for twenty-one countries in a panel setting using annual data spanning nearly four decades. Building on the model where economic growth depends on returns to human and physical capital, we specify a baseline econometric model that includes variables most directly affecting these returns. The empirical findings highlight inflation and the rate of capacity utilization of physical capital as the two main statistically significant variables, with opposite signs consistent with theoretical predictions. We employ advanced panel-data techniques, including Common Correlated Effects estimation, error-correction models, and cointegration analysis, to ensure robustness. Interpreting the results through the lens of tax-smoothing principles suggests that policymakers should limit reliance on inflation surges during crisis-induced Treasury debt expansions. Instead, greater crisis financing through the private sector, while reducing inflationary pressures, can entail higher real interest rates that depress capital utilization and, consequently, economic growth.