The previous post presented a model for applying Effective Demand in the economy. We saw how Effective demand imposes a limit upon the increase of capacity utilization once real GDP comes close to Effective demand.

In the previous model, we held real GDP constant and watched changes in potential real GDP. In this post, I simply want to switch that. Now we will hold potential real GDP constant and watch changes in real GDP as capacity utilization changes. Here is the graph...

## Effective Demand Model Based on Real GDP

Let's identify the parts of the graph first. We once again see the horizontal lines that mark the current real GDP and potential real GDP. They are used to be able to reference intersection points better. The green line sloping up and to the right is real GDP as capacity utilization changes. (Capacity utilization is the independent variable on x-axis.) The brown-orange line sloping down and to the right is the Effective demand curve. Here are the equations of the two sloping lines.

Real GDP = potential real GDP + $3000 * (cu - els)/els

Effective Demand = real GDP * els/(cu*(1-u))

cu = capacity utilization, independent variable (currently 78.6%)... els = effective labor share, 74.5%... u = unemployment rate, 7.7%... real GDP is an independent variable in the Effective demand equation using the sloping real GDP line... $3000 billions is a constant to measure amplitude of the business cycle in real 2005 dollars, $$.

The vertical green line marks the current position of the economy. All 3 green lines cross at the current position of the economy (real GDP=$13.665 trillion, capacity utilization=78.6%)

Now, according to the principle of Effective demand, real GDP will not easily grow beyond Effective demand in terms of utilization rates of capital and labor. Thus, the vertical red line marks the intersection where Effective demand equals the rising real GDP line. This is the limit imposed by Effective demand, which is marked by a capacity utilization of almost 81%... The same value as calculated in the previous post.

The value of real GDP at that intersection is around $13.75 trillion. However, this number is just an approximation because potential real GDP is increasing too. So the eventual limit of real GDP depends on the difference in the rates of change between the growth of potential real GDP and the increase of the inflationary gap as based on capacity utilization and effective labor share, (cu-els)/els. In other words, real GDP increases with an increasing capacity utilization, but when capacity utilization reaches between 80% and 81%, the breaks will effectively be put on any further increase in the inflationary gap (keeping effective labor share constant at 74.5%). At this point, businesses have little incentive, macroeconomically speaking, to raise utilization rates of capital and by association labor.

(note: Inflationary gap is seen where sloping real GDP line rises above horizontal potential real GDP line. Inflationary gap increases to the right. Recessionary gap is seen where sloping real GDP line falls below horizontal potential real GDP line. Recessionary gap increases to the left.)

Real GDP in the economy has at times gone passed the red vertical line for brief periods. But real GDP has never gone passed the yellow vertical line, which is the intersection where Effective demand = potential real GDP. The economy came within $25 billion (2005 dollars) of that limit in 3Q-1997 at the height of the bubble of "irrational exuberance".

(note: This model of Effective demand is giving potential real GDP new and special dynamics.)

To close, this graph is just another look at the graphs in the previous post. Here we watch real GDP rise, whereas in the previous post we watched potential real GDP fall with an increasing capacity utilization. Just two sides of the same business cycle coin.

(note: I will use the model based on potential real GDP in the previous post to construct a growth model in later posts. Real GDP is in the moment, but potential real GDP has more profound dynamics, which allow us to construct a broader growth model.)

Update: Additional graph to show Inflationary gap and Recessionary gap according to the principles of Effective demand.