Demand Shocks, Inflation and the Business Cycle

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.