In the previous post, I laid out a basic formula for determining the natural rate of interest. I want to adjust that formula using the optimal effective labor share. In the growth model of effective demand, there is an optimal balance between labor share and capital share of income for the growth of the economy.

The equation for the optimal effective labor share is...

cu* is optimal capacity utilization for a given real GDP (Y), effective labor share (els) and the amplitude constant of the business cycle in real 2005 $$ ($3 trillion).

Optimal effective labor share is equal to optimal capacity utilization from the growth model.

Here is a graph of actual effective labor share to optimal effective labor share...

Graph #1

In the 60's and 70's, labor share was excessive in relation to the optimal level. This created an environment that could more readily produce inflation. A higher labor share implied that labor had more money to chase fewer goods. Why fewer goods? Lower than optimal capital share of income meant a suppression of the capital needed to maintain the means of production in relation to the liquidity strength of labor income.

Why then was inflation low in the 1950's? Eisenhower was running a balanced budget and the Fed was very concerned about inflationary pressures and was taking steps to control inflation.

"The Board (Fed) has been criticized for their policies and actions during this time, but it is reasonably accepted that the price rises would have been significantly larger had they not intervened." (source)

Since 1989, effective labor share has been below optimal. Capital share has been above optimal. This created an environment of low inflation. Labor has fewer relative dollars on balance with the capacity of capital to increase the means of production. And we know that inflation has trended low since the 80's. We can see in graph #1 that effective labor share is now far below its optimal level. We now face a problem of persistent and stubborn low inflation.

The natural rate of interest should adjust in relation to the difference between optimal and actual effective labor share. There should be an adjustment due to the implication that inflation is harder or easier to control depending on this difference. So here is a graph of the natural rate of interest with no adjustment for optimal effective labor share...

Graph #2

We can see that many of the peaks and troughs of the Fed rate (gold line) matched with the predicted rate from effective demand (purple line). We can also see that the Fed rate (gold line) has been trending lower since 1990, but the natural rate of interest has not. So now we will adjust the natural rate of interest for optimal effective labor share.

Natural rate adjustment = o * (actual els - optimal els)/optimal els

o = coefficient of conversion to adjust natural rate... els is effective labor share.

I will use an o coefficient of 22%, which means 22% of the percentage difference between actual and optimal labor share. So if the percentage difference is 10%, the natural rate of interest will adjust by 2.2%.

Graph #3

We can see that the natural rate of interest is declining at a similar rate to the Fed rate since the late 80's. This adjustment would actually lower the prescribed effective demand rate for the current Fed rate. But the main point in making this adjustment is to show how optimal effective labor share could affect the natural rate of interest.

Sources cited...

Cullip, Jermie. 1950's Economics, 6/9/2013, http://homepages.gac.edu/~jcullip/workexamples/mea.html#http://www.gac.edu/~jcullip/workexamples/mea.html#3

## Comments

You can follow this conversation by subscribing to the comment feed for this post.