This paper extends the classic Abel (1981) paper to introduce capacity utilisation into a
dynamic model with adjustment costs describing investment and hiring decisions of the
firm. We provide an analytical solution for the theoretical model and then use survey data
form the CBI Industrial Trends Survey to test the model empirically. The results show that
firms adjust their capital stock around a long-run equilibrium determined by sales over time.
However, the speed of this adjustment depends on whether the model accounts for a
capacity error correction term. Specifically, models which do not include a capacity error
correction term overestimate the error correcting behaviour of firms, and imply a quicker
adjustment speed of capital to its long-run equilibrium value. In other words, excluding
capacity dynamics from an accelerator model of investment underestimates the time it
takes capital to return to its long-run equilibrium value – providing an explanation for
sluggish investment following recessionary periods.
