I hear people talking about wanting to raise real GDP. Well, when you look at the equation for real GDP...

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

you have three options to raise real GDP.

- Raise potential real GDP. This option is not on the minds of most economics.
- Raise capacity utilization. This is difficult because capacity utilization is reaching the limit imposed by Effective demand at the moment.
- Lower effective labor share. This is what has been happening, but the consequence is that Effective demand shuts down faster upon utilization of capital, thus putting a limit on real GDP growth. Thus, effective labor share now cannot decrease much further without completely stopping and then contracting the growth in real GDP.

The only real option is to increase potential real GDP.

But how do you do that? We are now in a situation where real GDP is reaching the limit imposed by Effective Demand. (See this post for explanation.) At this limit, capacity utilization will not increase and effective labor share will not decrease.

Suppose we raise labor share of income... what happens? Well, we would suppose from the equation above that real GDP would decrease. Seems like a natural neo-classical prediction. Well, let's look at what happens to the Effective Demand equation...

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

If you raise els, effective labor share, you essentially raise Effective demand. And once you raise Effective demand, you push away the limit being imposed on real GDP. Once you push away the Effective demand limit, capacity utilization can rise again. It is a give and take process where effective labor share rises, then capacity utilization rises, and they go back and forth.

What happens to potential real GDP in this back and forth process?

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

The numerator (cu - els) does not change. because cu and els are rising in unison. But the denominator (els) rises, which has the effect of raising potential real GDP in relation to real GDP. You have now raised potential real GDP. You go back to option #1 above and see that real GDP can now rise due to a higher potential real GDP and a higher Effective Demand.

The ultimate solution is to raise labor share of income. Unfortunately, it has been declining.

If you watch this video, you will eventually hear it said (between the 58 and 63 minutes point) first, that labor income needs to rise and, secondly, that there is no scientific way to determine potential real GDP.

In the video, Scott Sumner says potential real GDP is basically a "judgment call". But now with my equations of Effective demand, we have a scientific way to determine potential real GDP. And lo and behold, potential real GDP appears to be low, much lower than the prevailing "judgment call".

Keynes had an idea... a concept for Effective demand. The explanation above honors his idea of how Effective demand operates in the economy. At first glance, it appears that raising labor share of income would lower real GDP, but eventually it raises real GDP due to raising Effective demand and potential real GDP in the economy.

The key is to raise labor share of income to an equilibrium point, where utilization of labor and capital is optmized for society as a whole. Soon I will show how to calculate that equilibrium point in another post.