ENDOGENOUS CAPACITY UTILIZATION AND THE
ASYMMETRIC EFFECTS OF MONETARY POLICY
PEDRO PABLO ÂLVAREZ LOIS
Abstract. This paper investigates the role of variable capacity utilization
as a source of asymmetries in the relationship between monetary policy and
economic activity within a dynamic stochastic general equilibrium framework.
The source of the asymmetry is directly linked to the bottlenecks and stock-
outs that emerge from the existence of capacity constraints in the real side of
the economy. Money has real effects due to the presence of rigidities in house-
holds’ portfolio decisions in the form of a Lucas-Fuerst ‘limited participation’
constraint. The model features variable capacity utilization rates across firms
due to demand uncertainty. A monopolistic competitive structure provides
additional effects through optimal mark-up changes. The overall message of
this paper for monetary policy is that the same actions may have different
effects depending on the capacity utilization rate of the economy. Given the
empirically plausible link between inflation and utilization, the present anal-
ysis establishes a basis for studying the implications of asymmetric monetary
policy rules based on the capacity gap.
1. Introduction
What are the effects of central bank policy? Do they depend on the state of
the economy? How should monetary policy be conducted in the short run? For
many years, macroeconomists have grappled with these questions, but have not yet
reached a consensus. Achieving a thorough notion of the mechanics that constitute
the monetary transmission mechanism requires a deep exploration of the nontrivial
structure of the complete economy. This is not a straightforward task for either the-
orists and applied economists. From a theoretical point of view, the main difficulty
has been to develop models that can generate the salient features of aggregate time
series, which is the first step towards reliable policy analysis. Models of the trans-
mission mechanism should generate a response of economic variables to a monetary
policy shock consistent with those found in the data in, at least, three dimensions:
sign, timing and magnitude.
The literature has provided us with models that are able to replicate reasonably
well the sign and timing of the transmission mechanism. However, models that can
adequately account for the magnitude of the responses to monetary policy remain
Date: November 2000.
Key words and phrases. Capacity Constraints, Limited Participation, Idiosyncratic Demand
Uncertainty, Endogenous Mark-Up.
Special thanks are due to Hugo Rodriguez for his guidance and support. I also wish to thank
Jim Costain, Jordi Caballé, Jesus Ruiz, Gabriel Pérez-Quirôs and participants at the 7th ENTER
Meeting at Unwersity-College London, Macroeconomics Workshop U.A.B., Society of Economic
Dynamics Annual Meeting in Costa Rica and Soutomaior Vth Workshop on Macroeconomic
Dynamics, for their thoughtful comments and valuable suggestions. Financial support from the
Ministerio de Educacion y Cultura is gratefully acknowledged.