The Fed funds rate and Fed policy are basically designed to provide the economy with a proper amount of money (liquidity) so that aggregate demand can allow aggregate supply to reach full capacity with price stability at a fairly low inflation rate.
I am presenting a new equation that can establish a proper and stable path for the Fed funds rate. The Taylor rule has been used in the past, but it uses a potential real GDP that is debatable. The Effective demand rule that I am presenting uses more solid numbers, like labor and capital utilization rates, labor share income and unit labor costs.
I will now develop some of the model for how the Effective demand rule works and apply it to fed policy before the crisis.
The Model of the Effective Demand Rule
There is a lot going on in this graph. The black lines are the bounds of the Fed rate. The vertical black line is the Natural level of real GDP (LRAS curve). The economy would move upwards on both sides of this line. The area below the black lines shaded in red are areas that the Fed rate does not go.
The curves sloping down to the left are the various paths of the Fed rate at different rates of effective labor share.
Let's assume that the effective labor share is 78% (green line) and doesn't change. As the economy goes into a recession, the TFUR (total factor utilization rate of labor and capital) falls. Let's say the recession is severe, and the TFUR falls below 69%. The Fed rate must then move along the 0% line in a liquidity trap situation. Then as the economy recovers, the TFUR rises. We follow the red arrows to show the path of the Fed rate as the economy recovers.
Once the TFUR reaches 69%, the Fed rate begins to get some traction to stabilize prices and production. The Fed rate stops moving along the 0% bound and ideally starts rising up the 78% effective labor share curve. The Fed rate keeps rising steadily with the TFUR until it reaches another bound. In the graph above, the Fed rate reaches the effective demand limit and the LRAS curve (long-run aggregate supply) at the same time. At the LRAS curve, the Fed rate will have to rise sharply to control the inflation that develops with little increase in output.
Leading up to the Crisis
Let's apply the Effective demand model by looking at what happened before the crisis of 2008. Let's start with a graph...
The violet line is actual Fed funds rate data. In 2005 to 2007, the LRAS stood in a zone around 78%. So as the fed rate moved up the lower bound close to the Fed rate path of 78% (see lower red arrow), the economy suddenly contracted at a TFUR of 76%. We can see that the TFUR fell a bit. But the Fed rate kept on rising as if the economy was still rising along the lower bound.
Why didn't the Fed rate drop with the contraction? The Fed saw that inflation was rising from 3% to 4%. The economy was somewhat close to the LRAS curve, where inflation can rise with little increase in output. The TFUR began to rise a bit again. The vertical rise in the Fed rate looked like the economy was on the LRAS curve. The Fed rate reached its maximum around 5%, and inflation was back down to 2%. At this point, the Fed must have been thinking that the inflation of the LRAS curve was under control.
(note: I am assuming that the Fed kept an inflation target of 2.0% throughout this analysis. But it is also possible that the Fed lowered their target toward 1% as inflation rose. The path for the Fed rate would have shifted up 1%.)
There was still a little spare capacity. The Fed rate was about 2% above the green line. (The green line is the Fed rate path for 78% effective labor share.) The result was that Fed policy looked to be tighter than it needed to be. Still the Fed rate held steady for four quarters and then dropped a little in the 3rd quarter of 2007, one quarter before the official start of the recession. In the 4th quarter of 2007, the Fed rate dropped further. In the 1st quarter of 2008, real GDP fell and the TFUR was falling. In the 2nd quarter of 2008, the TFUR contracted more and the Fed rate declined all the way to a lower bound. The Fed rate kept declining, even while the inflation rate rose to over 5% in the 3rd quarter of 2008. Inflation was no longer the problem, the economy was falling apart. The TFUR went into a free-fall in the 3rd quarter, and eventually fell to 61%. And Inflation fell to -1.6% by 3rd quarter 2009.
The Fed did not have to raise the Fed rate as much as it did. The TFUR was still 76% and the LRAS curve at 78%. And unit labor costs were not rising yet. (My view is that the Fed rate should rise if unit labor costs are rising faster than inflation.) But the Fed puts a high priority on controlling inflation outright and did not want to get into an inflation spiral with the LRAS curve. If the Fed rate had stayed low, inflation would have risen naturally with unit labor costs. Once unit labor costs outpace inflation, the Fed can step in and control them. Actually during 2008 the effective labor share rose to 79%, which helped control inflation, but then it fell back to 78% and inflation jumped up.
If effective labor share had been able to stay above 79%, the zone of the LRAS curve would have shifted right and the Fed rate would have had room to expand production a little more avoiding a sudden collapse. And with the Fed and Treasury already alerted to the problems of the banks, they would have had some more time to resolve the situation without as much chaos.
The equations for the curves are very precise with the actual data. The Effective demand model is useful for analyzing behavior of the Fed rate. And could even be used to help determine Fed policy.
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