Many think that effective demand is simply aggregate demand. But that is not true. They are different concepts. It is very important in the current economic sickness to understand the role of effective demand. So I will define effective demand in this post as Keynes saw it.
1. Effective Demand is not Aggregate Demand
Don’t confuse the AS-AD model with effective demand. The common AS-AD model puts AS = AD at any point in time. The lines always cross. What is consumed equals what is supplied. That is in agreement with Say's law.
When Keynes defined the concept of effective demand, he did not describe the AS-AD model where you have price level on the y-axis and real output on the x-axis. (see Chapter 3 of Keynes' General Theory) Keynes' model put demand above aggregate supply at any point in time. Demand above aggregate supply gives entrepreneurs incentive to employ more labor and capital. The difference between demand and aggregate supply gets smaller as more labor and capital are utilized. So imagine two lines that meet at some distant point. One line is demand above the other line of aggregate supply. But the demand line is not aggregate, but rather effective demand. The point at which these two lines meet is the effective demand limit upon full employment.
Here is the model I use for how Keynes described effective demand.
I put price value on the y-axis to show what is supplied and demanded. But on the x-axis I put the utilization of labor and capital. The x-axis represents how the economy grows by utilizing more labor and capital. As you move right on the x-axis, you utilize more labor and capital with the demand line higher than the supply line. Eventually you reach the equilibrium point between supply and demand. The equilibrium point is where Keynes defined effective demand. It is where you will find your full employment level for utilization of labor and capital. Therefore, the point where the two lines cross is the natural level of real output. That is the effective demand point that Keynes describes….
If we see the crossing point as stationary, then as you employ more labor and capital beyond the point, effective demand will go below what entrepreneurs will supply. Then entrepreneurs will un-employ labor and capital because they see their profit rates maximize.
So the normal model has AS and AD moving together. In Keynes model, the economy is moving toward a “fixed” long run equilibrium state between supply and demand.
(note: The difference between the aggregate supply and effective demand lines measures the spare capacity in the economy in terms of both labor and capital.)
2. Effective Demand is based on Labor's Share of National Income
For me, the line of effective demand is determined by labor’s share of national income in relation to the utilization of labor and capital on the x-axis… Not by labor’s total income, but by labor’s % share. You can actually change labor's total income without changing its share.
3. Shifts of the Effective Demand line
The effective demand line can shift when labor's share changes. An increase in labor share will shift the effective demand line upward. The equilibrium point shifts up and right along the aggregate supply line allowing more utilization of labor and capital at a higher natural level of real output.
4. Shifts of the Aggregate Supply line... Productivity Increases
The aggregate supply line will shift up and down too. If productivity increases, output per utilization rate of labor and capital rises, and we see the AS line shift upward. Yet the result is to shift the equilibrium point of effective demand to the left, thus lowering the natural level of output in terms of utilizing labor and capital. Thus productivity increases are not possible when the economy is near the equilibrium point. Entrepreneurs would want to un-employ labor and capital.
That is why the data shows that productivity will stabilize when the economy is near the effective demand limit. So the productivity conundrum is no mystery, when effective demand is properly understood.
This graph shows productivity stalls against the effective demand limit. When the line in the graph moves away from the ED limit, we see productivity increases. That is when the utilization of labor and capital is to the left of the equilibrium point in the model given above.
5. Vertical Shift of Equilibrium Point
Look at the graph of productivity. Find the points for 1994 through 1997. Productivity did not move for 4 years against the ED limit. But then look at how the plot moved up along the limit for a couple years before the 2001 recession (0.73 to 0.80 range). So I ask... How was productivity able to increase at the ED limit? Wouldn't the equilibrium point move to the left and shut down utilization of labor and capital?
The answer is that the equilibrium point in the model shifted up vertically.
As productivity increased, effective demand had to increase at the same time. How did this happen? Well, labor share rose during that period of time, which shifted the effective demand line upwards.
(Note: The utilization rates of labor and capital had to stay steady in order for the equilibrium point to rise vertically. So as unemployment fell during that time, we saw capacity utilization fall too. As more labor was employed, less capacity had to be employed in order to not go beyond the profit maximization point of the ED equilibrium point.)
6. Drop in Potential GDP after the Crisis
After the crisis we saw labor share fall.
The effective demand line in the model shifted downward thus moving the equilibrium point of the natural output level down along the aggregate supply line. The y-axis then tells us that potential GDP declined. The x-axis then explains the higher unemployment rate and the lower capacity utilization rate that we see. Once you understand effective demand as Keynes saw it, the drop in potential GDP and the rise in the natural rate of unemployment is no mystery. But the CBO is slow to understand this.
7. Looking at Current Effective Demand
This chart has the most recent data on effective demand. (1Q-2014)
Productivity is stalled. Profit rates have peaked. There is very little spare capacity left as the lines are very close. We are at the effective demand limit. Full employment now sits at a lower level. Even the Fed may be realizing this.
Keynes defines effective demand as a distinct equilibrium point and not an infinite range of values along the aggregate supply curve...
"For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of the proceeds over the factor cost."
"The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.
"The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. ... The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.
"If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment.... Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile."
I am helping to write that vitally important chapter. Economists must understand effective demand as Keynes saw it. There are a lot of futile discussions abounding out there.
UPDATE: What stops productivity from just rising up the "slope of 1" line in part 4. This graph shows the answer. Increased productivity shifts the aggregate supply curve up. As the equilibrium point moves left, profit rate maximization moves left too. Thus firms trying to maximize profits would be forced to un-employ labor and capital if they tried to raise productivity against the effective demand limit.
Janet Yellen gave a speech where she posed 4 questions to economists in general seeking answers... The first question she asked was this...
"The Influence of Demand on Aggregate Supply The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?
"Prior to the Great Recession, most economists would probably have answered this question with a qualified "no." They would have broadly agreed with Robert Solow that economic output over the longer term is primarily driven by supply--the amount of output of goods and services the economy is capable of producing, given its labor and capital resources and existing technologies. Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the mostly exogenous supply-determined longer-run trend."
Janet Yellen is really asking for research into effective demand. She sees a weakness in aggregate demand affecting aggregate supply... or potential output. That is effective demand, but she cannot even use the term effective demand because economists do not understand it.
I have been researching effective demand for 4 years. I have seen really a complete lack of understanding of what effective demand is among economists. It surprises me that Janet Yellen would be calling for research on its dynamics.
She does not really understand effective demand yet though. She goes on in her speech about hysteresis which is a short-term shock which produces a long-run affect. Effective demand is not a short-run shock. It is based on the relative strength of labor share to profit share. A lower labor share sets a lower limit upon potential output. And the drop in labor share is not short-term. It has been constant for years since the crisis.
I have models that can be built on by other researchers. It truly is important for economics to finally understand and define effective demand.
Many top economists use the IS-LM model to support low interest rates. The LM curve of the IS-LM model is built upon a model of financial markets.
In the graph above, money supply has been pushed far to the right to keep interest rates low. The model implies that the money supply would eventually have to be reduced in order to raise interest rates, but the Fed has other ways to raise interest rates.
But there is a glitch to pushing the money supply so far to the right. Low interest rates help unproductive firms stay in business. And we have had low interest rates for years now.
What is the glitch?
There are more unproductive firms doing business... and the economy has become dependent upon them. Not good...
The Wall Street Journal had an article showing how inequality is growing between identical workers, because productivity differences between firms even in the same industry have widened. (link) So there is evidence that low productive firms have become more prevalent.
Creative destruction is an important part of a proper interest rate cycle. Proper interest rates keep low productive firms at lower levels. These low productive firms drag on productivity, wage growth, investment and potential growth. A higher prevalence of unproductive firms supports the case for low interest rates. But the purpose of low interest rates was not to increase unproductive firms but to keep them from crashing too fast. Now they are not being allowed to crash at all. Thus, the glitch.
An efficient economy where resources are allocated to maximize net social benefits must have a proper interest rate cycle for creative destruction.
The Fed missed the interest rate cycle this business cycle, so the prevalence of low productive firms has increased. It will be very difficult to raise interest rates because the economy now depends on these low productive firms.
A rise in interest rates will push many unproductive firms over the edge and start a cascading downward of the economy. The economy has become more sensitive to interest rate hikes due to an increased prevalence of unproductive firms.
Interest rates will have to go through a properly disciplined cycle to get the benefits of creative destruction. Or the unproductive firms will be pushed out anyway as profit rates decrease at the end of this business cycle. Either way, there will be pain for some.
Data as of 4thQ-2016
Effective Demand = $17.587 trillion
Real GDP = $16.805 trillion
Productive Capacity is rising to next business cycle =
UT index is rising = +3.9%
demand limit = 75.9%
TFUR = 72.0%
ED Fed rate rule (down from a peak of 3.8% in 2014) = 1.6%
Estimated Natural Real Interest rate = 2.2%
Short-term real interest rate (fallen from 2.8% peak in 2014) = -0.5%
There is no recession for 4thQ-2016. I am expecting a recession by the middle of 2017.
(UT index is rising which implies a recession is on the way.
Click on Graphs below to see updated data at FRED.
UT Index (measure of slack):
Recession Alert (developed at recessionalert.com):
z derivatives in terms of labor & capital:
Effective Demand, real GDP & Potential GDP:
ED Output Gap:
Corporate profit rate over real cost of money:
Exponential decay of Inflation:
Measures of Inflation:
YoY Employment change:
Speed of consuming slack: yoy monthly:
Speed of consuming slack: quarterly:
Real consumption per Employee:
Will real wages ever rise faster than productivity?:
Real Wage Index:
Productivity against Effective Demand limit:
Bottom of Initial Claims?:
Tracking inflation expectations:
M2 velocity still falling:
All in one:
Double checking labor share with unit labor costs & inflation: