Aggregate Supply, Investment in Capacity, and Potential Output

The New-Keynesian aggregate supply derives from micro-foundations, an inflation-dynamics model very much like the tradition in the monetary literature. Inflation is primarily affected by: (1) economic slack, (2) expectations, (3) supply shocks, and (4) the persistence of inflation. This paper extends the New-Keynesian aggregate supply relationship to include also investment in capacity. Potential output, defined as the flexible-price equilibrium output depends endogenously on investment in capacity, on the pricing policy of firms. New-Keynesian theory stresses the notion that the pricing decisions are based on expected movements in marginal costs. In the absence of investment in capacity, inflation is related to movements in real marginal costs, and the latter is uniquely associated with movements in the output gap. In the presence of investment in capacity, the unique link between fluctuations in marginal costs and fluctuations in output gaps breaks down. Implications for central bank targeting of potential output and for the estimation of the Phillips curve are pointed out.