Research Discussion Paper – RDP 7502 The Role of Capacity Utilisation in the RBA1/74 Model


In a complete system of interrelated factor demands an increase in the pressure of demand will initiate a complex hierarchy of price, quantity and balance sheet responses. This paper attempts to illustrate the way in which the markets for goods and labour adjust to changes in the pressure of demand in RBA1/74 represents an intermediate stage in the integration of such a system into a structural model of the Australian economy.

Demand factors alone may not generate inherently regular cycles in response to exogenous shocks. This approach introduces a capacity ceiling to represent the supply constraints which, when combined with demand factors in the full model, generate stable responses. The pressure of demand is represented by a series for capacity utilisation which measures the gap between real activity and this non-linear ceiling. In RBA1/74, the capacity measure is explicitly represented in equations for prices and imports in the goods market and in the labour market equations for vacancies and unemployment. Changes in capacity utilisation also have indirect effects on the other variables in the model but these effects can only be analysed by simulation experiments.

Section 1 examines the reasons for choosing a particular measure of capacity utilisation as an indicator of the pressure of demand, and explains the derivation and construction of the capacity ceiling. Sections 2 and 3 outline the role of capacity utilisation in the markets for labour and goods respectively. The final section presents the results of simulation exercises, which illustrate the role of capacity utilisation in the full model.