In my post about Adair Turner and his idea of OMF, Overt Monetary Finance, I said that when the economy is up against the effective demand limit, increases in the money supply will show up as increases in the aggregate price level and not as increases in real GDP. I want to graphically show this now.
I will use the 3-stage aggregate supply curve to show this. David Latzko has a wonderful graph of this that allows me to explain.
We see three stages shown by the colors red, green and blue. The red stage represents a deep slump where utilization of available labor and capital is at a low level. As real GDP increases, there is little inflationary pressure. An increase in money velocity or money supply will tend to show up in increased real output and not higher prices.
The green stage shows that utilization of labor and capital is increasing and beginning to reach full capacity. In this 2nd stage, the increase in real GDP is accompanied by an increase in the aggregate price level. I won't go into the dynamics of why the aggregate price level rises here.
Then the economy reaches the blue stage, where utilization of labor and capital reaches full available capacity. At this stage, real GDP stops increases and all increases in the money supply or velocity of money get translated into increases in the aggregate price level. This level of real GDP is called the Natural Level of real GDP. (Some economists falsely equate this stage with potential real GDP.)
The Natural level of real GDP is also associated with the natural rate of unemployment. Now I have already shown, here and here, that the effective demand limit determines the natural rate of unemployment. It then follows that the effective demand limit determines the natural level of real GDP too. And we see the logic of this in the graph above. As long as there are unutilized resources of labor and capital, real GDP will increase. But when those resources get closer to being utilized at full capacity, the aggregate price level increases. This is what Adair Turner is seeing in Great Britain. Thus, Great Britain has already reached the effective demand limit.
We can place effective demand into the graph like this...
According to the principle of effective demand, output is limited when real GDP equals effective demand. At this point shown by the intersection of the two lines, if you have no other changes (no shifts in the aggregate supply curve, nor the effective demand curve), any increase in the money supply or velocity of money will show up as an increase in the aggregate price level and not in real GDP.
I can make this a little simpler by using a Kinked aggregate supply curve. The kink shows exactly where the natural level of real GDP is. Effective demand crosses the kink. Here is the graph...
I have drawn in the extra curved line for Effective demand, which will cross where the Short-run aggregate supply curve and the Long-run aggregate supply curve cross.
The US economy is still to the left of the effective demand point on the Short-run supply curve as of today, but it is nearing the crossing point. When the economy reaches the effective demand point (when the UT index goes close to zero), we should start to see some inflation pressure appearing. However, we are already close with inflation actually falling. So maybe the effective demand curve has shifted to the left of the Long-run aggregate supply curve. This will be something to watch.
Real GDP can still increase when it is up against the effective demand limit. When it does increase though, the product of the utilization rates of labor and capital does not increase. Real GDP must increase for another reason, like increased productivity or increased investment. When investment picks up around the effective demand limit (or the natural level of real GDP), this is a signal of a bubble forming. Let me show a graph of this...
The green line is private domestic investment. The red line is effective demand. The blue line is real GDI. When real GDI was at the effective demand limit in the mid 1990's, you can see how investment began to increase. The bubble was forming. Up until the 90's, investment and effective demand moved like mirror images to some extent. All the increased investment from 1996 to the crisis of 2008 was a bubble lifting real GDP artificially higher, but the utilization rates of labor and capital stayed under the effective demand limit. It appears from the graph that investment is back into an equilibrium with effective demand. No cause to think that a bubble was forming as of the end of 2012.
To close, in looking at this last graph, I just want to state that whenever effective demand was near real GDP, the economy was at the natural level of real GDP.
Sources cited:
Lecture 14: Aggregate Demand and Aggregate Supply, David Latzko's Web page, Pennsylvania State University, 4/18/2013, http://www2.yk.psu.edu/~dxl31/econ14/lecture14.html
Dynamics of Short Run Model, Department of Economics, Illinois State University, 4/18/2013, http://economics.illinoisstate.edu/ntskaggs/images/SRAS1.gif
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