In the previous post, I talked about monetary policy around the limit that effective demand imposes on utilization rates of capital and labor. In this post, I want to show how the Fed funds rate behaves around the effective demand limit. Let's start with a graph...

The blue line is real Gross Domestic Income. The red line is effective demand. The green line is the Fed funds rate.

When effective demand come down close to real GDI, the economy is at the effective demand limit. This is when the red line is near the blue line. Now we look at what the Fed funds rate did at those times. We notice that the Fed funds rate rose as the effective demand limit approached real GDI, and then peaked or stayed high when the lines touched. Then when the lines started to separate, the Fed funds rate went back down. This is no coincidence.

Some people will look at this and jump wild... For they will understand what this means. We are watching a special dynamic that determines the Fed funds rate. This graph should open up many doors of research. For one, we the Fed funds rate is not only a function of the relationship between real GDP and potential real GDP, but it is also a function of real GDP and effective demand. It is actually a function of all 3 and how they move together.

Here is a graph plotting the Fed funds rate against the difference between effective demand and real GDI. The limit of effective demand is when the difference is zero. We see that the Fed funds rate rises as the economy approaches the limit of effective demand.

I have drawn in a polynomial trend line to show the tendency to rise. We can still see that the Fed funds rate will peak near the effective demand limit. The Fed could actually use this graph as a guide when raising the Fed funds rate.

When we look at the present data (down at the zero lower bound), we see that real GDI is once again nearing the effective demand limit, the Fed funds rate is not rising. Well we are in a liquidity trap situation. and normally at this point the Fed funds rate would be rising. So far there no indications that it will start to rise either, basically because inflation is subdued.

One thing we can take away from this graph is that from now on it could public knowledge when the Fed funds rate will peak. We just look at how close real GDI is to effective demand. We can instantly get an idea of the potential limit of the Fed funds rate as it is rising just by looking at the slope of its rise.

The Fed could actually use this graph as anther tool to control the Fed rate through the business cycle. Speaking of which, let me prepare another graph of the effective demand business cycle plotted with the Fed funds rate...

We can see here the same tendency of a rising Fed funds rate as the economy goes into an inflationary gap. Even though the zero lower bound pulls down the linear trend line. The center of the business cycle is where capacity utilization equals effective labor share (0%).

These graphs would help the Fed and anybody else know what was going on with the Fed funds rate.

We simply have to ask ourselves... What will happen with this zero lower bound situation? How long will it last? How can we get out of it?

To me the easy answer is raising effective labor share, but if we assume that is not going to happen, what then? There is no other answer. The longer we keep effective labor share low, the more damage we do to our workforce through marginalized unemployment.

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