So as this theory of Effective Demand goes, the equation for effective labor share marks the center of the cyclical movement of capacity utilization. Thus if we take the difference between effective labor share and capacity utilization divided by effective labor share, we get the % movement of capacity utilization in a business cycle.
% over/under center of business cycle = (capacity utilization - effective labor share) / effective labor share
Let's graph this...
Now. let's multiply the above % movements by a fixed $ amount. The amount will be $3 trillion. Let's graph this.
So now we see the exact same graph but with $billions on the left axis. The graph is basically saying that a value in terms of money $ is rising above and below zero in a cyclical movement. The key thing to note here is the amplitude of the movement. The value normally moves within $300 billion over and below the center line. We would expect this since $300 billion is 10% of $3 trillion.
Now we add into this same graph another line. We will compare it to the output gap between real GDP and potential real GDP. We take the official real GDP data and subtract the official potential real GDP data. (real GDP - potential real GDP). This will give us the amount of value in terms of money $ that the real GDP rises and falls around potential real GDP (since 1967).
Right away we notice that the amplitudes of the two lines are fairly consistent until the recent crisis. We also see that the lines followed each other very well from 1967 to 1991. Then the lines separated completely. Eventually they came back together in 2003 and resumed their movement together. Then the crisis of 2008 hit and the lines separated again.
So why do the lines all of a sudden separate? Well, there was some sort of change in the data. It looks to be a problem in how potential real GDP is established. There are two ways to view potential real GDP. 1) As the potential that the economy should be able to reach with full utilization of its resources (labor and capital). or 2) As the center of the business cycle.
As to point #1, the theory of Effective Demand would say that the utilization of labor and capital is constrained by Effective Demand. Thus, if potential real GDP is put so high that it is beyond the constraints of Effective Demand, the economy will never reach it, and the output gap will always be considered to be in a recessionary gap. This scenario is currently being played out by the CBO and most economists.
As to point #2, we can see in the 3rd graph that we are currently in an inflationary gap according to the relationship between capacity utilization and effective labor share. While the official government numbers from the CBO say we are still in a large recessionary gap. Effective labor share is effective, in theory, because it determines the limits on output in terms of utilization of labor and capital. Effective labor share behaves as potential real GDP should behave. It is a reliable number for the business cycle in this regard.My view is that the government views potential real GDP according to point #1 and is setting itself up to be embarrassed.
We can see in the 3rd graph that effective labor share worked well for many years as a point of reference for the business cycle. Utilization rates of capital (and also labor) rise above and below it under the limits of Effective Demand. According to the equation for effective demand, we are now reaching the peak of an inflationary gap, while according to the government we are still deep in a recessionary gap. There is a big difference here. and of course I would like to be right because having a solid and true equation for effective demand would revolutionize economics in a good way... at a time when many are calling for a new model.
One constructive use of this model for the business cycle based on effective labor share and capital utilization is that it can be used to double-check the potential real GDP numbers of the government and vice versa.
note: Some of you might be left with a question. Why does $3 trillion work as a constant for the business cycle? Basically we are working with real numbers and not nominal numbers. So $3 trillion in real dollars is the same in 1967 as in 2012.