Another change to the effective demand limit equation. The most recent post presented this equation.
Effective Demand Limit function, L = 0.650*LSI+35*NX/rGDP+35*G/rGDP+35*I/rGDP-122*CPIall+80*(ED-FF)-80*(yoyC,10year-FF)
A new variable has been added for the yearly growth in real GDP. Now the equation has been refined to this...
Effective demand limit function, L = (1-a)*LSI/100 + a*NX/rGDP + a*G/rGDP + a*I/rGDP - b*yearly change of rGDP - (1+b)*CPIall + c*(ED-FF) - c*(10year-FF, yoychange)
LSI = labor share index (non-farm business sector), 2009 base year
NX = real net exports
rGDP = real GDP
G = real Government consumption expenditures and gross investment
I = real Gross private domestic investment
CPIall = year over year % change of CPI for all items. (Headline inflation)
ED = policy rate prescribed by Effective Demand Monetary rule after non-monetary variables have been set.
FF = Fed Funds rate
10year = 10-year Treasury Constant maturity rate
yoychange = year over year change for (10year-FF)
a = 0.31
b = 0.35
c = 0.80
The peaks of the business cycle have been smoothed out more in relation to effective demand... especially the peak in 1984, which did not lead to a recession, but still led to an economic contraction. They all fall within the -1% to -2% range, with the exception of the peak in 1973, which surpassed the range, but led to a quick and deep recession. (The red dots are the starts of recessions.)
How does the growth in real output affect effective demand?
When output increases, there are more options for the consumer to purchase goods & services. Demand becomes weaker for any one firm in the aggregate. With more production, prices would have to drop in order to keep effective demand steady. For example, I did a simple test of the equation by increasing yearly real output growth from 0% to 2%. In order for effective demand to stay the same, headline inflation would have to drop by 2%, from a 3% inflation target to 1%. Core inflation would also have to drop just 1% from 3% to 2% keeping the central bank base nominal rate unchanged.