Effective Demand Research

Limit of Inflationary Gap Determined by the Unemployment Rate

The previous post talked about the Inflationary gap and the Recessionary gap with respect to how Effectve Demand calculates potential real GDP. Here is the graph...

The main thing to point out here is that the inflationary gap increases to the right, but eventually hits the limit imposed by Effective demand. The vertical red line is the first limit, where Effective demand equals real GDP. The economy usually does not pass this limit. The vertical yellow line is a harsher limit, where Effective demand equals potential real GDP. The economy has never passed this limit since 1967. Thus,... and this is an important clarification...

Effective demand limits the inflationary gap.

Here is the math...

Inflationary gap = real GDP - potential real GDP

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

Inflationary gap = $3000 billion * (cu - els)/els)

Now, the Inflationary gap hits its limit when Effective demand = real GDP

Since, Effective demand = real GDP * els/(cu * (1-u)), we have...

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

Thus...

els/(cu * (1-u)) = 1

cu = els/(1-u)

Now, to find the limit of the Inflationary gap at Effective demand, we have...

Inflationary gap at limit = $3000 billion * (cu - els)/els) * els/(cu * (1-u))

Inflationary gap at limit = $3000 billion * (els/(1-u) - els)/els) * els/(els/(1-u) * (1-u))

Simplify...

Inflationary gap at limit when equal to = $3000 billion * u/(1-u)

Thus, the Inflationary gap limit can be solely determined by the unemployment rate. When the left side of the equation equals the right side, the Inflationary gap has reached its limit. The current Inflationary gap is $165 billion. The current unemployment rate is 7.7%. So we ask the question... are we at the limit of the Inflationary gap? No...

$165 billion is not equal to $3000 billion * 7.7%/(1-7.7%) = $250 billion.

If the inflationary gap was at its limit right now, the unemployment rate would have to be 5.2%. So, we can conclude that the inflationary gap has not reached its limit yet.

Building a Model for Effective Demand (cont.)

The previous post presented a model for applying Effective Demand in the economy. We saw how Effective demand imposes a limit upon the increase of capacity utilization once real GDP comes close to Effective demand.

In the previous model, we held real GDP constant and watched changes in potential real GDP. In this post, I simply want to switch that. Now we will hold potential real GDP constant and watch changes in real GDP as capacity utilization changes. Here is the graph...

Effective Demand Model Based on Real GDP

Let's identify the parts of the graph first. We once again see the horizontal lines that mark the current real GDP and potential real GDP. They are used to be able to reference intersection points better. The green line sloping up and to the right is real GDP as capacity utilization changes. (Capacity utilization is the independent variable on x-axis.) The brown-orange line sloping down and to the right is the Effective demand curve. Here are the equations of the two sloping lines.

Real GDP = potential real GDP + $3000 * (cu - els)/els

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

cu = capacity utilization, independent variable (currently 78.6%)... els = effective labor share, 74.5%... u = unemployment rate, 7.7%... real GDP is an independent variable in the Effective demand equation using the sloping real GDP line... $3000 billions is a constant to measure amplitude of the business cycle in real 2005 dollars, $$.

The vertical green line marks the current position of the economy. All 3 green lines cross at the current position of the economy (real GDP=$13.665 trillion, capacity utilization=78.6%)

Now, according to the principle of Effective demand, real GDP will not easily grow beyond Effective demand in terms of utilization rates of capital and labor. Thus, the vertical red line marks the intersection where Effective demand equals the rising real GDP line. This is the limit imposed by Effective demand, which is marked by a capacity utilization of almost 81%... The same value as calculated in the previous post.

The value of real GDP at that intersection is around $13.75 trillion. However, this number is just an approximation because potential real GDP is increasing too. So the eventual limit of real GDP depends on the difference in the rates of change between the growth of potential real GDP and the increase of the inflationary gap as based on capacity utilization and effective labor share, (cu-els)/els. In other words, real GDP increases with an increasing capacity utilization, but when capacity utilization reaches between 80% and 81%, the breaks will effectively be put on any further increase in the inflationary gap (keeping effective labor share constant at 74.5%). At this point, businesses have little incentive, macroeconomically speaking, to raise utilization rates of capital and by association labor.

(note: Inflationary gap is seen where sloping real GDP line rises above horizontal potential real GDP line. Inflationary gap increases to the right. Recessionary gap is seen where sloping real GDP line falls below horizontal potential real GDP line. Recessionary gap increases to the left.)

Real GDP in the economy has at times gone passed the red vertical line for brief periods. But real GDP has never gone passed the yellow vertical line, which is the intersection where Effective demand = potential real GDP. The economy came within $25 billion (2005 dollars) of that limit in 3Q-1997 at the height of the bubble of "irrational exuberance".

(note: This model of Effective demand is giving potential real GDP new and special dynamics.)

To close, this graph is just another look at the graphs in the previous post. Here we watch real GDP rise, whereas in the previous post we watched potential real GDP fall with an increasing capacity utilization. Just two sides of the same business cycle coin.

(note: I will use the model based on potential real GDP in the previous post to construct a growth model in later posts. Real GDP is in the moment, but potential real GDP has more profound dynamics, which allow us to construct a broader growth model.)

Update: Additional graph to show Inflationary gap and Recessionary gap according to the principles of Effective demand.

Building a Model for Effective Demand

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...

1. the intersection of potential real GDP and real GDP points to the value of effective labor share in the economy. (74.5%).
2. 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*cu²)/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.)

Comment on "The Price is Wrong" by Paul Krugman

Paul Krugman wrote, "So what’s with this apparent massive and persistent excess supply of labor?" He criticized those who call for lower wages and then went on to recommend a reduction in the real interest rate by raising expected inflation.

What would the study of Effective demand say? Let me just show a chart...

My next post will explain...

ED Potential real GDP and the Recession of 1982

I want to compare Effective demand ED potential real GDO in the recessions of 1982 and the current one of 2009. The emphasis will be on how effective labor share changed in relation to capacity utilization. First, let's look at the current one. (Effective labor share and capacity utilization use the right axis.)

I want to direct your attention to the point towards the end of the crisis where capacity utilization rises to equal effective labor share. Do you see how capacity utilization takes a different path from that point? You will see it in the next graph too. It is a critical point in the recovery and marks the point from which real GDP will rise at normal rates. More in depth study is needed to understand the mechanism.

We can also see in the above graph that effective labor share eventually fell to a lower level as did capacity utilization. But we also see the same thing back in the recession of 1982. Here is what happened back in 1982.

So why did ED potential real GDP keep rising through the 1982 recession, but fell during the current one? One factor was that effective labor share fell more in the current crisis, which is now keeping the actual real GDP low. But that is not the only reason. You have to look at real GDP. There is a factor connected to real GDP (output) that has made it collapse just recently. Effective demand is weaker, yes, but there is something more happening within output. 

The Effective demand equation does not explain the collapse internally of real GDP (output). The Effective demand equation only determines effective aggregate demand in relation to real GDP.

In short, something happened within real GDP to marginalize a good portion of it out of the economy. And now Effective demand is coming into balance with the new lower level of real GDP locking in the lower factor utilization rates.

I have an explanation for what is happening to real GDP based on the equations of Effective demand. Basically, a dead-weight loss has just occurred in the economy, which didn't happen back in 1982. And there are deep reasons for that. I will start posting the explanation of this soon, which will lead us into the economic growth model of Effective demand.

Potential real GDP based on Effective Demand

In the preceding posts, I talked about the potential real GDP based on Effective Demand. I want to show the equation for it and some graphs too. First the equation...

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

els = effective labor share ... cu = capacity utilization ... $3000 billion is a constant for the amplitude of the business cycle around potential GDP in terms of real $billions of dollars (2005).

The equation simply says that the business cycle is determined by the rise and fall of capacity utilization around effective labor share. The center of the business cycle is when capacity utilization is equal to effective labor share. There we see (cu - els) = zero, and ED potential real GDP = real GDP.  When capacity utilization is above effective labor share, ED potential real GDP will be below real GDP. When capacity utilization is below effective labor share, ED potential real GDP will be above real GDP.

Here is the graph of data since 1967.

In the graph we compare Effective Demand (ED) potential real GDP to actual real GDP and to the official potential real GDP released by the Congressional Budget Office (since 1967). For most of the years, there is really no surprise. The blue line and the pink line of the different potential real GDPs follow each other fairly closely. But then we get to the crisis of 2008 and the lines make a big divergence. Here is a graph focusing on that divergence...

The yellow line of real GDP falls and begins to follow a parrelel path to the official potential real GDP from the CBO. We are familiar with that scenario. But the potential real GDP calculated upon effective labor share fell with real GDP and then moved straight right for 2 to 3 years before settling into a new parellel path to the official real GDP line. Real GDP has moved from below the ED potential real GDP line to above it as capacity utilization rose above effective labor share. (note: During that period of time, effective labor share fell a few percentage points.)

Now, if the ED potential real GDP line stays steady, it is only reasonable to assume that the eventual contraction of the economy will cause capacity utilization to fall below effective labor share again. The consequence is shown by the additional brown line where real GDP will turn to cross the center of the business cycle. 

It's interesting to note that the ED potential real GDP started to diverge from the official potential real GDP in 1Q-2008 before it fell hard in the 4Q-2008. The economy was falling apart months before the crisis became public knowledge.

What does it mean that potential real GDP could fall so harshly? Many economists can't fathom a fall in potential real GDP. They think that it represents the natural potential of the economy using its full resources of labor and capital. They think that the economy will simply return to that level as labor and capital are re-utilized. But this is where the principles of Effective Demand come in and explain the situation. A lower effective labor share has locked the utilization rates of labor and capital into lower levels. The economy won't be able to utilize labor and capital to the extent that it needs to in order to return to the historic potential trend.

Real GDP moves within a range governed by the dynamics of the business cycle. Potential real GDP is meant to describe the center point of that range. Effective demand has the ability to put constraints on real GDP. The basic mechanism for doing that is the effect that effective labor share has on the utilization rates of labor and capital. The dynamics of Effective demand can box the economy into new levels.

Let's look at the equation for Effective Demand...

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

The principle of Effective Demand says that real GDP will not want to rise above Effective Demand. Therefore, as effective labor share (els) goes down, the constraint on real GDP goes down too. Before the crisis, effective labor share was roughly 78% and the combined utilization rates of labor and capital, (cu*(1-u)), were roughly 76.5%, just a little below effective labor share. Since then, effective labor share has fallen to 4 % points to 74%. The combined rate for labor and capital has fallen 5 points to 71.5% as of 4Q-2012. In essence, they have both fallen close to the same amount, meaning that the economy is almost back to the pre-crisis ratio between els and cu*(1-u).

Before the crisis, the combined utilization rates of labor and capital stayed just below effective labor share for 3 years! Even during the bubble, the principle of Effective Demand limited the utilization of labor and capital. The implication is that the combined utilization rates of labor and capital will not now return to 76.5%, because it must stay below the current effective labor share of 74%. The low level of the ED potential real GDP reflects the constraint.

More on the Interesting Graph for the Low Limit of the Unemployment Rate in a Business Cycle

In the previous post, I gave some graphs plotting (effective demand - potential real GDP) against the UT index since 1967. Now I want to focus in on some of the dynamics of those graphs. Let's start by looking atdata from 4Q-2003 to 1Q-2008. It was the period of an expansion before the crisis.

The plot is the blue line. The orange dashed line is the trendline of the plot. The y-intercept is pointing toward a value of $145 billion when the UT index hits zero. The calculated unemployment rate at the y-intercept would be 4.6%. However, the unemployment rate bottomed out at 4.4% before the plot could reach a UT index of 0%.  The UT index was only 0.7%.

The hypothesis now is that the trendline points to the lower limit of the unemployment rate in an expansion. I checked the other past expansions and this hypothesis was consistent with all of them. Even when the UT index went to -2%, the ultimate low of the unemployment rate equaled the calculated unemployment from the y-intercept where the UT index = 0%. Thus, the y-intercept determines the bottom limit of the unemployment rate in a particular business cycle.

Now let's apply the hypothesis to current data.

The current data is pointing straight toward a lower limit of 6.9% for the unemployment rate. This agrees with a previous analysis I made. Now, according to the above hypothesis, unemployment will have a lower limit around 6.9% to mark the end of the expansion, irregardless of whether the UT index is positive or negative. In other words, if we reach 6.9% unemployment and the UT index reads -2.3%, we have hit the end of the expansion. Also, if we reach 6.9% unemployment and the Ut index reads +1.5%, again we have hit the end of the expansion. Therefore, 6.9% marks the end of the expansion anyway you look at it. (see math in preceding post on how to calculate the unemployment rate at the UT zero lower bound, where the UT index = 0%.

I have been targeting 7.0% in my prediction. and I will stand by that. But there is something very promising about this graph. We might be able to pinpoint the end of an expansion using the unemployment rate. If we could do that, this takes economic analysis to a new level.

 

An Interesting Graph to Determine the Natural Rate of Unemployment

In the preceding post, I showed a line calculated by subtracting potential real GDP from effective demand. It is a measure of how far effective demand is over the center line of the business cycle. I am now going to plot this value against the UT index since 1967. Here is the graph...

The lines fan out from a y-intercept. Actually the earliest contractions are down low and then with each succeeding contraction, the slopes increase. The most recent contraction, the crisis, is over the others. The most recent data, 4Q-2012, is at a UT index of 2.82% and a value of $669 billions for effective demand over potential real GDP.

I want to start zooming in on the y-intercept.

You can see the lines don't cross the y-intercept cleanly, but there is a tight pattern there. Above you can see the most recent line coming at a high angle. Let's look even closer...

There is a lot of action going on around the y-intercept. Let's see if we can make sense of it. First of all, let's recall the equation for effective demand, ED...

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

els = effective labor share ... cu = capacity utilization ... u = unemployment rate.

Now, when UT is equal to zero, (els/cu(1-u)) = 1.

Next, we look at the equation for potential real GDP, Y*...

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

In the graph above, when UT = 0, effective demand - potential real GDP = $150 to $190 billion. Or approximately $170 billion..

Therefore at UT = 0, ED - Y* = real GDP - (real GDP - $3000 billion * (cu - els)/els) = $170 billion

Simplify, $3000 billion * (cu - els)/els) = $170 billion

cu = (1 + 170/3000)els = 1.0567 * els

Recall from above, (els/cu(1-u)) = 1 and also, 1.0567 * els/cu = 1,

therefore when UT = 0, (els/cu(1-u)) = 1.0567 * els/cu

Simplify for unemployment, u =0.0567/1.0567 = 5.4% 

5.4% is the natural rate of unemployment at $170 billion. When the line crossed the y-intercept around $110 billion in the 60's, the natural rate of unemployment was 0.0367/1.0367 = 3.5%. (110/3000 = 0.0367).

In order for the natural rate of unemployment to have risen to 7.0%, the line must now cross at $225 billion. It looks to be close to that trajectory in the first 2 graphs above. We will see.

More on the Business Cycle and Effective Demand

In the preceding post, I showed the business cycle based on capacity utilization over effective labor share. Then I compared this to the relationship between real GDP and potential real GDP.

Now I want to show another graph that shows a deeper story of the business cycle.

The red line is the center of the business cycle determined when capacity utilization is equal to effective labor share. (The red line represents a theoretical point of 100% full employment but I won't go into that here.)  The green line is the difference between capacity utilization and effective labor share multiplied by $3 trillion (the constant in real $ terms). The green line shows the movement of output over and below the center line of the business cycle.

The orange line is effective demand minus the official potential real GDP provided by the CBO, Congressional budget Office. (The equation for effective demand is in the title of this blog.) When the orange line comes down to touch the green line, effective demand is equal to aggregate output (real GDP). The economy has reached its limit of expanding the business cycle according to the theory of Effective Demand.

What does it mean when the orange line goes far below the green line? Basically the government is mistaken about the true level of potential real GDP. I can only hope they will see my research and get a different perspective.

Moving on... According to the principles of Effective Demand, potential real GDP is determined by the following equation.

Potential real GDP = real GDP - $3 trillion * (cu - els)/els

cu = capacity utilization .... els = effective labor share ... This equation is based on labor share: Business sector, 2005=100.

When we take this calculation of potential real GDP and subtract it from Effective Demand, we get the purple line in the graph above. The purple line follows the orange line fairly well and also comes to touch the green line. Yet the purple line follows the principles of effective demand by not going far below the green line as the orange line does.

Economists say that the economy is still improving and showing growth. The purple line being still above the green line supports this claim. Yet a limit is looming as the purple line continues its descent. On the other hand, the orange line based on official CBO projections is signaling an impossibility in that effective demand cannot go below aggregate output to such a large extent.

The purple line, ultimately based on effective labor share, is a better guide for potential real GDP and for projections of the economy.

Constructing the Business Cycle of Capacity Utilization using Effective Labor Share

So as this theory of Effective Demand goes, the equation for effective labor share marks the center of the cyclical movement of capacity utilization. Thus if we take the difference between effective labor share and capacity utilization divided by effective labor share, we get the % movement of capacity utilization in a business cycle.

% over/under center of business cycle = (capacity utilization - effective labor share) / effective labor share

Let's graph this...

Normally capacity utilization goes above and below effective labor share by +- 10%. Albeit, two contractions have fallen below 10%. So, we see a fairly consistent range for a business cycle.

Now. let's multiply the above % movements by a fixed $ amount. The amount will be $3 trillion. Let's graph this.

So now we see the exact same graph but with $billions on the left axis. The graph is basically saying that a value in terms of money $ is rising above and below zero in a cyclical movement. The key thing to note here is the amplitude of the movement. The value normally moves within $300 billion over and below the center line. We would expect this since $300 billion is 10% of $3 trillion.

Now we add into this same graph another line. We will compare it to the output gap between real GDP and potential real GDP. We take the official real GDP data and subtract the official potential real GDP data.  (real GDP - potential real GDP). This will give us the amount of value in terms of money $ that the real GDP rises and falls around potential real GDP (since 1967).

Right away we notice that the amplitudes of the two lines are fairly consistent until the recent crisis. We also see that the lines followed each other very well from 1967 to 1991. Then the lines separated completely. Eventually they came back together in 2003 and resumed their movement together. Then the crisis of 2008 hit and the lines separated again.

So why do the lines all of a sudden separate? Well, there was some sort of change in the data. It looks to be a problem in how potential real GDP is established. There are two ways to view potential real GDP. 1)  As the potential that the economy should be able to reach with full utilization of its resources (labor and capital). or 2) As the center of the business cycle.

As to point #1, the theory of Effective Demand would say that the utilization of labor and capital is constrained by Effective Demand. Thus, if potential real GDP is put so high that it is beyond the constraints of Effective Demand, the economy will never reach it, and the output gap will always be considered to be in a recessionary gap. This scenario is currently being played out by the CBO and most economists.

As to point #2, we can see in the 3rd graph that we are currently in an inflationary gap according to the relationship between capacity utilization and effective labor share. While the official government numbers from the CBO say we are still in a large recessionary gap. Effective labor share is effective, in theory, because it determines the limits on output in terms of utilization of labor and capital. Effective labor share behaves as potential real GDP should behave. It is a reliable number for the business cycle in this regard.

My view is that the government views potential real GDP according to point #1 and is setting itself up to be embarrassed. 

We can see in the 3rd graph that effective labor share worked well for many years as a point of reference for the business cycle. Utilization rates of capital (and also labor) rise above and below it under the limits of Effective Demand. According to the equation for effective demand, we are now reaching the peak of an inflationary gap, while according to the government we are still deep in a recessionary gap. There is a big difference here. and of course I would like to be right because having a solid and true equation for effective demand would revolutionize economics in a good way... at a time when many are calling for a new model.

One constructive use of this model for the business cycle based on effective labor share and capital utilization is that it can be used to double-check the potential real GDP numbers of the government and vice versa.

note: Some of you might be left with a question. Why does $3 trillion work as a constant for the business cycle? Basically we are working with real numbers and not nominal numbers. So $3 trillion in real dollars is the same in 1967 as in 2012.