This post will build a model step by step that will begin to explain the dynamics of Effective demand and how it imposes a constraint on the utilization of labor and capital. Let's establish the baseline of the model.

## Foundation of Real GDP & Utilization of Capital

We make capacity utilization the independent variable and make the real $ output, income and the size of the economy dependent upon utilization of capital. Utilization of labor is associated with the utilization of capital and is implied in the independent variable. I have placed the current available data for real GDP (4Q-2012) as a constant in the graph. All calculations that follow are based on the current real size of the economy, $13.665 trillion. If only real GDP rises holding all other variables constant, all the following lines simply rise with no distortion.

## Potential Real GDP

Now we add in potential real GDP as calculated by the principles of Effective Demand.

When the line for real GDP is above the line for potential real GDP, there is an inflationary gap. When the line for real GDP is below the line for potential real GDP, there is a recessionary gap.The economy is currently in an inflationary gap according to the principles of Effective demand.

## Potential Real GDP with Changes in the Utilization of Capital

The pink line added here gives how potential real GDP would change with changes in the utilization of capital. It is based on the equation...

Potential real GDP = real GDP - $3000 billion * (cu - els)/els

els = effective labor share, 74.5% ... cu = capacity utilization, independent variable ... $3000 billion is a constant for the amplitude of the business cycle around potential GDP in terms of real $billions of dollars (2005). The values given here are used throughout the equations for the graphs in this post.

As the rate of capital utilization increases, potential real GDP falls according to the equation. The basic understanding is that a higher capacity utilization implies a larger inflationary gap. The result is to push down potential real GDP relative to the constant of real GDP in the graph.

## Distinguishing Effective Labor Share & Capacity Utilization

This graph simply shows that...

- the intersection of potential real GDP and real GDP points to the value of effective labor share in the economy. (74.5%).
- The intersection of potential real GDP and the current constant of potential real GDP points to the value of capacity utilization in the economy. (78.6%)

These intersections can always be used to determine the values of effective labor share and capacity utilization. They can also be used to determine the size of the inflationary gap or recessionary gap as the case may be.

## Seeing the Position of the Actual Economy

The green vertical line added is placed over the intersection of potential real GDP and the constant line of potential real GDP. This line marks current capacity utilization. And where this line intersects real GDP is the current position of the economy. (capacity utilization = 78.6%, real GDP $13.665 trillion)

## Super Macroeconomic Potential Real GDP

The dark blue line added has the equation...

Super macroeconomic potential real GDP = 3000*(els*cu - 0.5*cu^{2})/els + real GDP*cu

Where did this equation come from? The equation before for potential real GDP (pink line) is the derivative of this equation. Therefore, at each point along this dark blue line, the rate of change is equal to the potential real GDP of the economy. As the super macro level of the economy gets bigger, potential real GDP decreases at a constant rate until it intersects the super macro line. Where the two lines intersect, potential real GDP is equal to the rate of change of economic growth. The intersection is a special place and marks the optimization of utilizing capital and labor in the economy. In the 1960's, the economy moved to the right of this optimal intersection. The economy moved around this intersection in the 1980's. Since the 1990's, the economy has moved to the left of optimal utilization of capital for economic output. This eventually led to the dead-weight loss we are experiencing now. More on the dead-weight loss later.

## Effective Demand

The brown-orange line added in that slants down and to the right is the line for Effective Demand. The equation for the line is...

Effective Demand = real GDP * els/(cu * (1-u))

u = unemployment rate, 7.7%... els = effective labor share, 74.5% ... cu = capacity utilization, independent variable... real GDP = $13.665 trillion.

The Effective demand curve is the only line in the model affected by the unemployment rate. As unemployment falls, the Effective demand curve shifts left. (Note: the lines related to potential real GDP are based on a theoretical point of 100% employment. But I will explain that in a future post.)

According to the principle of Effective Demand, real GDP will not want to go to the right of Effective demand in the graph. At which point macroeconomic real output would be more than demand and overall profit rates would stop increasing. We can see that the economy is currently very close to effective demand. There are dynamics close to that line that inhibit increased utilization of capital and labor.

(Note: The economy can still grow when up against the effective demand barrier by employing new capital and labor. However, the utilization rates of capital and labor will not increase.)

I have added a vertical red line that marks the barrier beyond which real GDP will not want to go, because macroeconomically businesses don't have profit incentives to go there. What is the consequence of that barrier?

## The DEAD-WEIGHT LOSS in the Modern Economy

The blue triangle in this graph represents the economic potential that is lost in the current economy. Effective demand is a barrier that keeps the economy from using that potential utilization of labor and capital. The result is that real GDP rises to the pink potential real GDP line. The higher real GDP with lower utilization of capital and labor manifests as high corporate profits in an atmosphere of high unemployment. It is a type of monopoly scenario on a macroeconomic scale.

Essentially, the dead-weight loss shown in the graph reflects the high and consistent unemployment rate since the crisis of 2008. Labor is being locked out of the economy by low Effective demand due to low effective labor share of income.

## The Super Macroeconomic Perspective of the Economy

We now pull back into space and look down on the US economy. Actually, I am just showing where all the lines go. The economy can only exist to the left of 100% capacity utilization.

The super macroeconomic potential real GDP goes up and eventually falls back to zero in the far reaches of fantasy land. The Effective demand curve swoops down to where people would be very little interested in most of the output available. Beyond 100% capacity utilization lies extreme economic inefficiency in terms of incentive to produce and consume.

The beautiful thing about the graph is that all the lines move in a tight dynamic just to the left of 100% capacity utilization. (shown by blue circle) It is as if there is a divine plan managing the little world we live in. A little world where the lines cross. In fact, you can change any variable in the equations, and the lines simply keep crossing where they should in order to describe the real economy. It is a joy to play with the model and watch how the lines move in relation to one another.

This is the basic model for Effective Demand.

(Note: I will use this model to produce a growth model in later posts.)