Capacity utilization under increasing returns to scale

This paper overcomes an important objection against the empirical relevance of the Benhabib-Farmer model as a potential account of actual business cycle fluctuations. This is attributable to an elasticity effect and a returns-to-scale effect of capacity utilization. These effects are closely related to the empirical puzzles that capital appears to play an insignificant role in explaining cyclical movements in output and that the estimated labor elasticity appears to be larger than labor's share. Due to these effects, multiple equilibria and persistent fluctuations can easily occur in a growth model for externalities mild enough so that the aggregate-labor demand curve is downward sloping. Analyses show that the propagation mechanism generated by capacity utilization under mild increasing returns is capable of explaining the periodic patterns of U.S. business cycles documented by Watson. (C) 1998 Academic Press.