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Economic Quarterly

Summer 1996

A Theory of the Capacity Utilization/Inflation Relationship

Mary G. Finn

A neoclassical theory presented here explains the relationship between capacity utilization and inflation. The theory shows how technology shocks, when accommodated by money growth, are an important source of positive comovement between inflation and utilization. By contrast, energy price shocks and exogenous changes in money growth cause opposite movements in inflation and utilization. The theory is successful in capturing the average correlation between utilization and inflation manifested in the U.S. data.

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