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Demand Shocks, Inflation and the Business Cycle

  • Richard De Abreu Lourenco

    (Reserve Bank of Australia)

  • Philip Lowe

    (Reserve Bank of Australia)

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    This paper examines how firms adjust output and prices in response to changes in demand and costs, paying particular attention to the role that capacity utilisation plays in affecting these relationships. It primarily uses qualitative survey data on manufacturing firms’ actual and expected outcomes for these variables, and traces through the short-term effects of changes in demand on costs, output and prices. The survey data also enables an analysis of how firms respond to unexpected shocks to costs and demand. The paper finds that strong demand growth leads to increases in both output and prices, and there is some evidence that capacity constraints do affect this relationship. 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 paper distinguishes between the direct effect that changes in demand have on prices, through changes in margins, and the indirect effect, through demand-induced changes in firms’ costs. It finds that inflationary pressures are predominantly driven by increases in input costs. While margins appear to move pro-cyclically, there is a degree of asymmetry in their behaviour. Movements in margins appear to be largest in recessionary periods with margins falling as the economy goes into recession and then being rebuilt relatively early in the recovery. In boom times pressures on prices come largely through increases in costs, with little additional contribution from changes in margins.

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    File URL: http://www.rba.gov.au/publications/rdp/1994/pdf/rdp9411.pdf
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    Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9411.

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    Date of creation: Dec 1994
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    Handle: RePEc:rba:rbardp:rdp9411
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    1. Caplin, A. & Leahy, J., 1989. "State-Dependent Pricing And The Dynamics Of Money And Output," Discussion Papers 1989_32, Columbia University, Department of Economics.
    2. Pesaran, M Hashem, 1985. "Formation of Inflation Expectations in British Manufacturing Industries," Economic Journal, Royal Economic Society, vol. 95(380), pages 948-75, December.
    3. James J. Heckman, 1977. "Dummy Endogenous Variables in a Simultaneous Equation System," NBER Working Papers 0177, National Bureau of Economic Research, Inc.
    4. Paul W. Bauer, 1990. "A reexamination of the relationship between capacity utilization and inflation," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 2-12.
    5. Benabou, Roland, 1992. "Inflation and markups : Theories and evidence from the retail trade sector," European Economic Review, Elsevier, vol. 36(2-3), pages 566-574, April.
    6. Matthew D. Shapiro, 1989. "Assessing the Federal Reserve's Measures of Capacity and Utilization," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 20(1), pages 181-242.
    7. Sheshinski, Eytan & Weiss, Yoram, 1983. "Optimum Pricing Policy under Stochastic Inflation," Review of Economic Studies, Wiley Blackwell, vol. 50(3), pages 513-29, July.
    8. Eswar Prasad & Bankim Chadha, 1994. "Are Prices Countercyclical? Evidence From the G-7," IMF Working Papers 94/91, International Monetary Fund.
    9. Bruce C. Greenwald & Joseph E. Stiglitz, 1988. "Financial Market Imperfections and Business Cycles," NBER Working Papers 2494, National Bureau of Economic Research, Inc.
    10. Barro, Robert J, 1972. "A Theory of Monopolistic Price Adjustment," Review of Economic Studies, Wiley Blackwell, vol. 39(1), pages 17-26, January.
    11. Flaig, Gebhard & Steiner, Viktor, 1989. "Stability and Dynamic Properties of Labour Demand in West German Manufacturing," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 51(4), pages 395-412, November.
    12. Carlson, John A & Parkin, J Michael, 1975. "Inflation Expectations," Economica, London School of Economics and Political Science, vol. 42(166), pages 123-38, May.
    13. Bils, Mark, 1987. "The Cyclical Behavior of Marginal Cost and Price," American Economic Review, American Economic Association, vol. 77(5), pages 838-55, December.
    14. Hausman, Jerry A & Wise, David A, 1978. "A Conditional Probit Model for Qualitative Choice: Discrete Decisions Recognizing Interdependence and Heterogeneous Preferences," Econometrica, Econometric Society, vol. 46(2), pages 403-26, March.
    15. Catherine J. Morrison, 1989. "Markups in U.S. and Japanese Manufacturing: A Short Run Econometric Analysis," NBER Working Papers 2799, National Bureau of Economic Research, Inc.
    16. Buckle, Robert A & Meads, Chris S, 1991. "How Do Firms React to Surprising Changes to Demand? A Vector Autoregressive Analysis Using Business Survey Data," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 53(4), pages 451-66, November.
    17. Olivier Jean Blanchard & Stanley Fischer, 1989. "Lectures on Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262022834, June.
    18. Darren Flood & Philip Lowe, 1993. "Inventories and the Business Cycle," RBA Research Discussion Papers rdp9306, Reserve Bank of Australia.
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