Marginalist economic theory tells us that when there is unemployment of capital resources prices should fall. Some marginalists like the New Keynesians and the neo-Keynesians will supplement this by saying that prices can tend to be ‘sticky’. Let us ignore these for a moment and come back to them in a moment. Let us first take the idea that prices should fall when there is unemployed plant and equipment.
First of all, some theory. The argument is extremely simple: if plant and equipment are unemployed then there is inadequate demand for the goods and services being produced. In marginalist theory firms should respond to this shortfall of demand by cutting prices. This will generate more demand at the lower price and the market should clear; i.e. the plant and equipment will be brought online once more.
If this argument is true then we should see prices fall when capacity utilisation falls. We should clear here: we are not saying that we should see inflation slow down when capacity utilisation falls. Rather we should see prices fall — i.e. we should not see inflation slow but rather we should see deflation.
During the extreme events of 2009-2010 we actually saw this relationship for a very brief moment in time. You can see how this relationship looks on the two graphs below. On the left is a scatter-plot diagram that maps the relationship between CPI inflation and capacity utilisation while on the right is a simple line graph depicting the same relationship. (The blue line is CPI and the red line is capacity utilisation).
Without getting into the debate as to how far prices should theoretically fall for a given fall in capacity utilisation we can at least visualise how such a relationship should look. (In actual fact we should see far larger amount of price deflation to clear markets where capacity utilisation has fallen below 68% as we see above, but regardless…).
Now, when we turn the the larger aggregates of data we see something rather different altogether. Here is the data for the inflationary period between 1967-1981.
