The Effective demand research is developing models to understand the economy in a new way and to predict recessions. So we continue to develop the model. In this post I want to identify the points of various GDP levels in the Aggregate supply - Effective demand model. Let's start by looking at the model using data from 1stQ-2013...

I realize there is a lot going on in this one graph. Yet, it is nice to have it all in one graph. First find the Effective demand limit curve and the Aggregate supply curve. Their crossing point is the LRAS curve. But the story is not that simple.

Let's look at the red dots. These represent the different points of GDP in the model. The first obvious one will be the real GDP point. We currently have a real GDP of $13.750 trillion and an inflation rate of 1.6%.

Above real GDP is the Effective demand price point. The space between these two points measures the spare capacity in the economy in terms of labor and capital. If we slide that space down the effective demand limit curve until it reaches the x-axis, we get the point of nominal GDP. This point is obtained by multiplying real GDP by (1 + the current year inflation rate). We get a GDP value of around $13.950 trillion. The price level on the effective demand limit curce will equal the space between the inflation rate and the price level of the effective demand limit curve at the current real GDP.

The red dot to the far right is the real GDP limit if aggregate supply is increased by increasing utilization of labor and capital keeping unit labor costs constant. This means that unemployment is falling and capacity utilization is rising without inflation. So if the inflation rate stays the same and unit labor costs stay the same, eventually real GDP will grow to $14.100 trillion and then run into the effective demand limit.

If there is inflation as output increases, real GDP will hit the effective demand limit earlier than $14.100 trillion. For example, if inflation rises to 2.6% with increases to labor and capital utilization rates, the economy will hit the effective demand limit at the "nominal" GDP point, $13.950 trillion... (holding effective demand constant.)

If the economy is under the influence of the LRAS curve (inflation with no growth in output), real GDP will tend to rise up the aggregate supply curve. Inflation develops more rapidly as labor and capital are employed. You would tend to see unit labor costs rise too. In the graph above, real GDP would reach the effective demand limit at around $13.820 trillion. We are not far from there now. The economy is not yet showing signs of being under the influence of the LRAS curve.

The LRAS curve (long-run aggregate supply) has an effective range from where the AS & ED lines cross, all the way too the far right red dot. If effective demand stays constant (and it has been constant for the last 4 quarters), real GDP will hit the LRAS curve (effective demand limit) anywhere between those two points. An increase in the inflation rate will move the aggregate supply curve up closer to the effective demand curve and narrow the effective range of the LRAS dynamic.

The last point is to the far left. This is potential real GDP as calculated in the effective demand model. The calculation of this price level is easy. Here is the equation...

Price level of potential real GDP = inflation rate - (capacity utilization - effective labor share)/effective labor share

Effective labor share is (Labor share: business sector, 2005=100) * 0.78.

Also, here is the equation for the Effective demand limit curve.

Effective demand = real GDP * effective labor share/(capacity utilization * (1 - unemployment rate))

This graph gives us much more information than the traditional aggregate supply-aggregate demand model. It will hopefully be useful in detecting the next recession.