I am critical of the Federal reserve for their actions over the years. I am actually upset. Their actions have contributed to a lower labor share of income, which I see as the major problem holding back the economy.
The Fed has focused on low and stable inflation. What is the effect on labor share? Let's look at this equation...
Price level (inflation) = unit labor costs/labor share of income
With this equation, let's say that we have 2.0% inflation, and labor share is falling at 1%. What happens to unit labor costs? We need to solve for x in the following equation to know how unit labor costs will change.
Price level * 1.02 = ulc*x/labor share * 0.99
x = +1.0% approximately
So we see that with 2% inflation, labor share is falling behind inflation and unit labor costs are rising. So if unit labor costs are rising, this limits the incentive of businesses to hire more labor. It would seem that if unit labor costs are rising slower than inflation, that there would be some incentive to hire more labor. The cost would be lower over time. This is the scenario that we have seen since the crisis.
However, a declining labor share is the consequence of such a strategy. Over time, less national income is going to labor. This translates into less national income going to hire labor. The other side of this is that capital share of income has been rising. This translates into relatively more national income going to the utilization of capital. The result is relatively higher unemployment.
Now I want to focus directly on unemployment in the Effective demand rule for the Fed rate. First here is the equation for the Effective demand rule...
ED rule for Fed rate = 0.61*(TFUR2 + els2) - 0.438*(TFUR + els) - 2.0%
TFUR is total factor utilization rate (product of the utilization rates of labor and capital)... els is effective labor share (labor share: Business sector (2005=100) * 0.78)... 2.0% at the end of the equation is the inflation target.
Let's look at the variable TFUR, which is the product of capital utilization and labor utilization (capacity utilization*(1-unemployment rate)). Holding all else constant, as unemployment falls the Fed funds rate should rise. This is a basic fact of the equation. As the economy recovers from a recession, labor and capital are re-employed. The Fed rate will rise appropriately to adjust for this. This is good and normal. But we are not in normal times...
The variable els, effective labor share, has been falling since the crisis. This has put downward pressure on the Fed rate. When we look into the els variable, we see that inflation is rising faster than unit labor costs, but the result is downward pressure on the Fed rate.
Thus, there is an environment to maintain low inflation, but labor is receiving less national income, which keeps the unemployment rate relatively higher. Thus, the TFUR variable has depended more on capital utilization to get the Fed funds rate back into positive territory, which hasn't been enough. The TFUR variable is actually constrained by the els variable, and not knowing this has led to a very poor strategy by the Federal reserve. They must be thinking that capacity utilization will rise to over 80% and inflation will start to kick in. They would be simply wrong. It won't happen because of the effective labor share constraint.
From the above analysis, it is seen that the Federal Reserve has had a very poor strategy to lower unemployment.
It is important that Federal Reserve take into consideration the constraints that I write about in my blog here... the constraints of Effective Demand and effective labor share. Keynes tried to tell us about these limits. Now we have the equations to utilize his insights.
Edward:
I believe I have read you over at Economist's View. Maybe a different Lambert?. In any case you may a strong case for labor and its share of income. Relatively easy to read and understand also.
Posted by: run75441 | 05/10/2013 at 05:25 AM