I have been writing a lot about a new way to calculate potential real GDP using the factor of effective labor in relation to capacity utilization. (potential real GDP = real GDP - $3000 billion * (cu - els)/els).

Let's put this new potential real GDP to a test using the Taylor rule. We can do this because the Taylor rule uses potential real GDP as one of the variables.

The equation used for the Taylor rule in this post is...

Fed funds rate = inflation + real interest rate + 0.5*(inflation - inflation target) + 0.5*(log(real GDP) - log(potential real GDP))

The potential real GDP calculated from the point of view of Effective demand is...

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

cu = capacity utilization... els = effective labor share (0.78*labor share: business sector, 2005=100)... $3000 billion is a real $ constant in 2005 dollars for the amplitude of the business cycle... inflation target used throughout graph is 2.5%... real interest rate is based on daily effective rate, not target rate.

Now let's graph these equations and compare them to the actual Fed funds rate over the years...

The actual rate set by the Fed is the pink line. We can see it hitting the zero lower bound since 2008. The yellow line is the Taylor rule using the potential real GDP from the CBO, Congressional Budget Office. The blue line is the Fed funds rate using the potential real GDP from Effective Demand.

For years the blue line and the yellow line were very close. There was some difference between 1991 and 2001, but one can make their own judgement call if higher rates earlier on in the 90's would have calmed down the eventual bubble. In which case, the Effective demand blue line would have been better. Be that as it may, we have to focus on the separating between the lines since 2008.

Since 2008, the standard Taylor rule has gone much lower because there is such a big difference between the CBO potential real GDP and the potential real GDP calculated upon effective labor share. If you followed the equations of Effective demand, you would have raised the Fed rate to 0.8% in the 3Q-2011. If you follow the standard line, you kept the rate low.

Some were calling for a higher Fed rate in 2011. There was reported disagreement among Fed board members in 2011 as to whether the Fed rate should be raised. There were thoughts of risk of another recession, but the economy was actually not close to recession.

Be that as it may, the Taylor rule of Effective demand is now saying that with an inflation target of 2.5%, the Fed funds rate should be... -0.08%. It is back to being just barely in negative territory.