Journal of Economic Theory 0 (0): CCCC, 2008 ISSN: 1994-8212 © Medwell Journals, 2008 Corresponding Author: E.O. Ogunleye, Department of Economics, University of Ado Ekiti, Nigeria 1 The Relationship Between Output Gap and Capacity Utilization in the Nigerian Manufacturing Sector E.O. Ogunleye and Rogers Akinsokeji 1 2 Department of Economics, University of Ado Ekiti, Nigeria 1 Department of Economics, Adeyemi College of Education, Ondo, Nigeria 2 Abstract: The issue of diversifying the Nigeria economy through dynamic and sustainable measure to raise manufacturing performance motivated this study. The study thus, analyses the long-run relationship between output gap and capacity utilization in the manufacturing sector. Using a time series data of rate of capacity utilization and output gap in the manufacturing sector in Nigeria for the 1970-2000 period, the study employed the co-integration technique to analyze the long-run equilibrium relationship between them and the direction of causality was analyzed using the Granger causality test. The analysis revealed that significant output gaps and capacity underutilization exist the Nigerian manufacturing. An increase in output gap reduces capacity utilization that is a negative relationship exists between output gap and full capacity utilization. Also a unidirectional causality running from capacity utilization to output gap was confirmed. The study therefore recommends measures that will remove the low-capacity utilization and improve on productivity in the manufacturing sector. Key words: Capacity utilization, output gap, potential output, actual output, manufacturing, productivity INTRODUCTION that the ratio: actual/potential output equals unity, no A major focus of macroeconomics is the level of between the two especially when actual output falls short resource utilization. Usually, emphasis is on two issues. of potential output, then output gap exists. By definition, One, what determines the growth rates of resources and output gap is the difference between potential and actual potential output and the level of capacity utilization at any output. given period of time. Two, what determines the level of The level of output that an industry is capable of actual output relative to potential output, at any given producing at any one time depends upon its available period of time, (Branso, 1979; Abiola, 2002). stock of productive facilities. Thus in the aggregate, the More specifically, the subject of capacity utilization, desired productive facilities should be proportional to the especially in industry is a major debate and has attracted potential output. attention in recent years. This is as a result of the A ratio substantially less than the desired proportion realization that there exits a positive correlation between will suggest capacity underutilization. An industry capacity utilization on the one hand and output growth: operating below its optimum capacity level will surely The level of capacity utilization does not only determine experience low output, low employment generation and how much more output can be obtained by fuller will consequently suffer low profitability. utilization of existing capacity, but also defines the The manufacturing industry plays a pivotal role in required expansion of capacity for a targeted output any economy because it is not only an engine of growth, and employment via shift work operation, price stability but also a catalyst for technological, economic and and industrial growth, on the other hand (Fabayo, financial transformation (MAN News, 1998). In the last 1981). few years, travails and difficulties have been besetting the The potential output in an industry is defined as the manufacturing industry. At the heart of the problem is output, which an industry is capable of producing during flagging consumer demand, which has taken a more a given period of time, usually a year (Baur and Delly, ominous dimension in recent years as consumer 1988). If potential output equals the actual output, such fundamentals have weakened badly. output gap exists. However, if there is disequilibrium