Is there a natural level of capacity utilization?

Abstract

Previous studies of the Phillips Curve using capacity, utilization have estimated NAIRCU to be in the neighborhood of 82%. These studies estimate NAIRCU by imposing the restriction that there is no stable long run relationship between capacity utilization and the rate of inflation. The authors of these studies test the validity of this restricted model by estimating a model of the Phillips Curve, which has no supply-side variables. However, the actual estimates of NAIRCU are derived from restricted models, which include supply side variables. This article replicates these findings and then tests the validity of the restriction using a correctly specified model. An important finding is that the restriction is not valid and therefore the models used to produce estimates of NAIRCU are misspecified. Our findings call into question the existence of a vertical long run Phillips Curve. The implications of our findings are that the FED was overly cautious in raising interest rates to slow the economy and that the policy of pursuing “full employment” is still viable.