Capacity Utilization

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Capacity Utilization

Postby Anup V » Fri Jul 13, 2012 12:53 am

Capacity utilization is the extent to which the productive capacity (how much can possibly be produced with the given resources) of a country is being used in the production of goods and services. Thus, it refers to the relationship between actual output that is produced with the installed equipment and the potential output that could be produced with the installed equipment. It is calculated by dividing the total capacity with the portion actually being utilized. If aggregate demand grows, capacity utilization will rise. If aggregate demand weakens, capacity utilization will decrease. Therefore, a decrease in this percentage signals an economic slowdown, while an increase signals economic expansion. This is displayed on the graph, where each of the three major recessions also show a large decline in capacity utilization.

Currently, about 78.5% of US capacity is being utilized. This signifies that over 20% of our capacity is not being utilized. Because full employment is represented by 100% capacity utilization, our economy is experiencing high unemployment according to this statistic. This suggests that we are still in a recession and that our output gap is negative. More optimistically, however, the large increase in capacity utilization since 2008 implies that we are in a recovery period.

As suggested previously, to combat high unemployment levels and allow the US to reach a maximum level of output, it is necessary for the Fed to employ an easy money policy. The purchase of open market securities will inject more money into the economy, increasing the money supply. This will cause the interest rate to fall, investment spending to rise, and unemployment to subsequently fall.

--The Bureau of Labor Statistics releases information about the Consumer Price Index each month. CPI calculates the cost to purchase a fixed basket of goods in order to determine how much inflation is occurring in the economy. A base year is used to compare current year prices to the base year's values. In this case, the base year is 1984. Unlike core CPI, headline CPI is not adjusted for the fluctuating food and energy prices.

--The output gap, which measures the difference between potential GDP and actual GDP, is currently negative in the US. This means that actual output is less than full-capacity output. This is a recessionary gap. According to the Phillip's curve, when unemployment is high, inflation is low. This can be shown by the sharp decline of the curve in the year 2008, when the US was in the brink of a major recession. While unemployment was very high, inflation was at its lowest point in decades.

--Currently, the headline inflation rate is declining. According to the above statements, this would mean that the unemployment rate is rising, and, therefore, the output gap is becoming more and more negative.

--The Fed should make stabilizing unemployment levels their number one priority. This can be accomplished through an easy monetary policy, in which the purchase of open market securities injects more money into the economy. This will cause the interest rate to fall, investment spending to rise, and unemployment to subsequently fall.

--Personal consumption expenditures, also featured on the graph, consists of the spending by households on durable and nondurable goods and services. It follows the trends of the consumer price index since it takes into account consumers' changing consumption due to prices.

Inflation is a great threat to long term investors because it lessens the value of their potential profits. Inflation can suppress economic growth and cause a rise in interest rates.
Anup V
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