In the previous post, I began to present how the Solow-Swan growth model can be extended with the equation for effective demand.
The Solow-Swan growth model and for that matter, the Cobb-Douglas production function, are focused on production, investment and supply. They don't explain the demand that can determine production one way or the other. As Adair Turner stated in his presentation at the INET conference in Hong Kong recently, many countries start growing and then most seem to reach a certain point and the growth stops. Why is this? The answer is found in demand.
All economists will say that labor income is rising in emerging markets. They say that people are better off. But then why does the economic growth stop?
The equation of effective demand that I am presenting also says that labor income will grow, but the limiting factor on production and growth becomes the percentage "SHARE" of income, not the $$ amount of labor income. The percentage share determines the percentage utilization rates of labor and capital. I began to present this idea in my post on the growth model using effective demand. Then I followed up by presenting two posts, here and here, of how the model explains "non-inclusive" growth, where growth is affected when labor does not receive an increasing share of the national income, whatever country it might be.
The model I present explains how a non-increasing labor share of income in the face of a rising real GDP over the years, leads to a higher natural rate of unemployment, while capital utilization increases instead. For example, if an economy is running at 80% capacity utilization, but the labor share of income is 55%, undoubtedly there will be over 25% true unemployment. The effective demand equation explains this effect. The result is large unproductive "informal" markets among the population.
Many emerging countries focus on exporting natural resources, like Nigeria, Chile, Ecuador... They have great wealth as a nation, but then you see a struggling poor domestic market. The countries develop their capital resources for export, and they may also build infrastructure for the people. But if the share of labor income stays low, the infrastructure does not lead to internal economic growth. Of course, many economists point to the fact that labor income is rising; Chinese economists say this about China. But if a country doesn't raise labor share of income over the years, their growth will stop.
The dynamics of Effective demand must be included in the Solow-Swan growth model in order to really understand how stable and sustainable growth occurs.
Keynes explained all this in Chapter 3 of The General Theory of Employment, Interest and Money.
"Thus the volume of employment is not determined by the marginal disutility of labour measured in terms of real wages, except in so far as the supply of labour available at a given real wage sets a maximum level to employment. The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages — not the other way round. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment.
This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment."
The concept of effective demand as Keynes describes it is not included in the Solow-Swan growth model. Their model does not describe the dynamics of how effective demand will inhibit the process of production as Keynes puts it.
So I have extended the Solow-Swan growth model with an equation that describes the dynamics of effective demand to inhibit full-employment. The model now has a supply perspective and a demand perspective. The two sides need to be balanced for growth to be sustainable to higher levels of real GDP per capita. (This is in terms of the internal domestic market of a country. Eventually the research into effective demand will describe international effective demand.)
(note: A simple calculation could say that as China is growing at 8% per year, labor share of income would have to rise at 2.5% per year on average, for China to have sustainable, inclusive growth. If China is not able to reach this level, China's growth will stop at some point. It seems China recognizes this, because their minimum wage is now rising at 13% for the next 5 years.)