Keep in mind that these posts are preliminary steps to forming a new model in economics.

In a previous post I presented the relationship between Inflation, labor share and unit labor costs. The equation is...

Inflation = unit labor costs/labor share

The equation that I use in the Effective demand model uses the "effective" form and gives the same result...

Inflation = unit labor costs*0.78/labor share*0.78

Inflation = effective unit labor costs/effective labor share

The 0.78 is just a conversion from 2005=100 to effective values in relation to capacity utilization.

Now to expand this equation to new heights. Let me just show you a graph to start, then explanations after...

Here we see the AS-ED model (aggregate supply-effective demand). There are simple equations to determine the various price levels in the graph. And you actually do not even need to know the real GDP on the x-axis.

The first equation is for inflation...

Inflation rate = (effective unit labor costs - effective labor share)/TFUR

TFUR is simply multiplying capacity utilization by the employment rate, (1 - unemployment rate).

This equation allows us to see the effect of labor and capital utilization on the inflation rate. A lower utilization rate will increase this inflation rate. This inflation rate is actually equal to the measured inflation rate * (1 + spare capacity). When spare capacity (see below) is high at the bottom of the business cycle, this inflation rate includes a premium potential. This inflation rate will converge with the measured inflation at the LRAS curve.)

The next 2 equations are used to measure the spare capacity to the effective demand limit. The equation labeled "spare capacity" in the graph measures the difference between the inflation rate and the effective demand price level. The effective demand price level gives the reference point for determining the spare capacity.

The two equations are...

Price level of ED = (effective unit labor costs - TFUR)/TFUR

Spare capacity = (effective labor share - TFUR)/TFUR

It is important to note here the difference between labor share and unit labor costs.

Unit labor costs = total nominal wages/real output

Labor share = total real wages/real output

The price level of Effective demand is looking at the nominal wage costs in relation to utilized capacity. Spare capacity is looking at real wage costs in relation to utilized capacity. So it should come as no surprise that the difference between the two is the inflation rate. We can obviously see from the graph the following relationship...

Inflation rate = Price level of ED - spare capacity

What do all these numbers means? What is inflation? What is spare capacity?

My way of looking at these numbers is to see them as the spaces of price around the economy. Inflation is the space below that shows how far away from deflation we are. The spare capacity and ED price level is the space above the economy that shows how far away from the effective demand limit we are. It is within this bounded space that the economy expresses itself.

If there is too much space below and too much above, the economy is in a mess. If there is too little space below and too little space above, well... The economy does not like to go into deflation territory. There is resistance at the 0% line. Likewise the economy does not like to cross the effective demand limit. So if there is low inflation and low spare capacity, the economy is stuck between a rock and a hard place... Wait a second, that is exactly where we are at this moment in history.

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