In a previous post, I presented the basic model of Effective demand. Now I want to apply that model to the growth of an economy. But I am going to show the dynamics of a specific kind of growth... Non-inclusive growth. In this type of growth, labor's share of income does not rise as real GDP rises.
Of course, labor income will rise because real GDP is rising, but the % share of national income will not rise for labor. With this distinction we can proceed.
Let's start with a graph showing an economy with a real GDP of $2 trillion, a business cycle amplitude of $3 trillion, a capacity utilization rate of 62%, an effective labor share rate of 60% and an unemployment rate of 6%. (money in real $ terms). Here is what it looks like...
I realize there is a lot going on in this graph. Let's take it slow... The vertical blue line marks effective labor share. This line will stay constant throughout all the following graphs, since we are looking at a scenario of growth where effective labor does not change. .... The vertical green line marks capacity utilization. The actual position of the economy is where the vertical and horizontal green lines cross. ... The vertical red line is the limit imposed on capacity utilization by effective demand, which is determined by the crossing point of effective demand and the horizontal green real GDP line. ... The upsloping dark blue line is the Super macroeconomic potential real GDP. Where this line crosses potential real GDP is the optimal point of capital utilization for the economy.
We can see that the economy is doing well. The actual position of the economy is close to the optimal point, around 62% capacity utilization. Also, the limit imposed by effective demand is near the optimal point.
Now we are simply going to raise real GDP from $3 trillion to $5.5 trillion. What does it look like?
Again, effective labor share does not change. As well, capacity utilization rate and the Effective demand limit both don't change. However, the optimal point of capital utilization has shifted from 64% to 72% approximately. Yet, the economy cannot increase capacity utilization to 72% because effective demand imposes a limit at 64%. Consequently, a Dead-weight Loss develops. Real GDP has risen, but the utilization of capital could be much better. Thus, the dead-weight loss.
But now let's remember that unemployment is still at 6%. We have not changed it. What happens if we raise unemployment to 15%? Well, let's look...
Effective demand increases when unemployment increases according to its equation...
Effective demand = real GDP * els/(cu*(1-u))
Now, the only changes we see in the graph come from the Effective demand curve shifting right, which allows the Effective demand limit to shift right too. This limit imposed by effective demand is now sitting at the optimal point of capital utilization. Therefore, we have no more Dead-weight loss. The economy is not being restricted from the optimal point of growth.
So now, how can the economy move toward the optimal point? The answer is simple... it simply raises the capacity utilization rate. Here is what it looks like...
The vertical green line marking capacity utilization can now increase to 70%. The economy is using its capital resources at a higher rate. Real GDP is higher at $5.5 trillion.
Yet, what is happening here? Basically, labor has been marginalized. Unemployment increased so that the economy could continue growing without a dead-weight loss. But increasing unemployment was a choice made to allow the increase of capital utilization. The other choice would have been to share more of the national income with labor. This would have allowed unemployment to stay low during growth of real GDP.
Yes, labor income rose, because labor is still receiving 60% of a higher real GDP. But the cost to labor has been an increase in unemployment from 6% to 15%. The problem now is that unemployment cannot go back down, because the economy is up against the Effective demand limit. Lowering unemployment would decrease Effective demand, but the other side of the Effective demand limit is that it cannot go lower than the prevailing capacity utilization rate. The result is that this economy is now stuck with a high percentage of marginalized workers.
This scenario is extremely common throughout Latin America. but the strangest thing is that now, this scenario is being played out in the United States. When utilization of capital is increased to the effective demand limit, you have locked in your natural rate of unemployment. And I have calculated that the natural rate of unemployment in the US has risen to over 7% according to this dynamic.
When an economy favors capital utilization over labor utilization, we see an economy that would like to export natural resources. For example, oil in Nigeria, copper in Chile. In these countries, one sees a large portion of the population marginalized from work. There are no jobs for many people. And wages go down. It is a growth path that rewards capital, and hurts labor. The result is a class society with more intense income stratification between the rich and the poor.
It is not a wise growth path for a society.