What is the relationship between inflation and spare capacity in the U.S."?

Answer 1

First of all, we usually call it EXCESS CAPACITY, rather than spare capacity. (Some instructors are picky on this point.) Excess capacity represents production facilities that have already been built but are not being used because of a lack of AGGREGATE DEMAND.

INFLATION, on the other hand, can have two causes. First, and most common, is the case in which Aggregate Demand (probably labeled as AD or DD in your textbook) is gobbling up inventories and giving producers a chance to increase both prices and profits. The generalized price increases are called INFLATION. When this is the cause of inflation (and it usually is) then inflation gets worse as excess capacity comes down and BOTTLENECKS develop in industries as they run out of excess capacity.

For Inflation the other possible cause is a cost increase, or SHOCK, caused by something like a sudden increase in the price of energy or a stupid government policy change. In this case, prices go up as producers try to hand off their cost increases to their customers and customers buy less as their costs go up, so we get more excess capacity as inflation gets worse.

Most economists believe that this second case is only a SHORT-RUN phenomenon because the market will eventually sort out all of the relative prices. If that is true, as long as the government does not increase aggregate demand, by increasing the money supply for example, both the inflation and the excess capacity will melt away over time, over what they call the LONG-RUN. Just remember, John Keynes said, "In the long-run we are all dead." He meant that sometimes the government needs to step in and do something. It is a debatable point.

Answer 2

Excess capacity can be created if the cost of production exceeds the price consumers are willing to pay.