With the release of the labor share of income number (business sector), 94.7. We can update the graph for the aggregate supply-effective demand model (AS-ED).
This graph shows the last 6 quarters (from 4Q-2011 to 1Q-2013). The blue line below shows aggregate supply continuing to increase at a low inflation rate.
The effective demand curve is holding steady and not shifting much over the last year. However, as aggregate supply increases, effective demand is decreasing according to its natural slope downwards. The decrease of effective demand shows that people are less willing now to purchase aggregate output at higher inflation rates. Society is willing to buy output at lower and lower inflation rates.
Business also gets more competitive as the economy gets closer to the effective demand limit. There is less incentive to raise prices. Inflation is between a rock and hard place.
If you extrapolate out in the graph above, there is effective demand to purchase over $14 trillion of output at 1.5% inflation. But the aggregate supply curve would want a price level over 9% to produce that much right now. Usually unit labor costs would rise at this point in the recovery to push inflation rates up. But that is not going to happen this time. So the aggregate supply curve has to shift instead. That is a different process than just increasing production from higher prices.
The price level of effective demand has decreased from 8.3% to 4.2% over the last 6 quarters. This puts downward pressure on inflation. Society is more sensitive to inflation, so if businesses started to raise prices, people are less willing to buy the output. So an increase in inflation now would upset the shifting aggregate supply curve.
The price level of effective demand is based on the equation...
Price level of ED = (effective unit labor costs - TFUR)/TFUR
Effective unit labor costs is the unit labor cost index multiplied by 0.78, the conversion coefficient for effective labor share... TFUR is capacity utilization multiplied by the employment rate or (1 - the unemployment rate).
Over the last 4 quarters the TFUR has risen from 70.4% to 72.1%. This means that more labor and capital are being employed in the economy. And the effective unit labor costs have fallen from 76.8% to 75.1%. Relative labor costs are decreasing as the price level decreases. It is a scenario for disinflation.
What would it take to raise the price level of effective demand and thus raise effective demand? Unit labor costs must rise relative to the utilization of labor and capital (TFUR). Disinflation must be turned around. Businesses can only raise labor costs so much before they start losing profits. Yet on the other hand, labor has limits to how low their relative purchasing power can go. Yet, we know that labor is losing the battle as capital income is hitting record highs.
Now to the topic of... liquidity of demand. The question is... Does effective demand have more or less liquidity to buy output? It has less liquidity because it is less willing to buy output at a higher inflation cost. Therefore there is a demand for liquidity. Usually at this stage of a recovery, labor starts asking for higher wages. But we don't see that for many reasons. Also monetary policy is tight because the Fed funds rate wants to go negative, but can't.
Effective demand has been weakened over time by low labor share of income and low unit labor costs. Monetary policy cannot solve this. Not even nominal GDP targeting. The only way to increase effective demand at this point in time is to pay labor more. And business will fight it, because their aggregate profit rates are already peaking. They would see their profit rates go down and may then cut production triggering a contraction with little rebound potential.
I predict a contraction when real GDP is around $14.000 trillion to $14.100 trillion. That is when the downward trending effective demand curve would cross the aggregate supply curve. If aggregate supply continues to increase by an average $60 billion each quarter, the economy would go into a contraction in 4 quarters (1Q-2014). But the big problem would be the low inflation rate, which would want to push into negative territory.
It will be very difficult to raise inflation over the next year with effective demand so low. As effective demand pushes down on aggregate supply at low inflation rates, aggregate supply is basically backed up against the 0%-inflation wall with no room to maneuver downwards to adjust. Aggregate supply would have to adjust by contracting, shifting to the left. It would not have the option of lowering prices much, nor lowering unit labor costs.
Let's project out to when aggregate supply crosses the effective demand curve.
This is based on a real GDP of $14.050 trillion, an unemployment rate of 7.1%, a capacity utilization rate of 79%, an inflation rate of 1.5% and an effective labor share of 73.5%. Usually around the LRAS curve, there are inflationary pressures, but capacity utilization will still be below 80% and unemployment will still be above 7%. This means little pressure for hyper-inflation. The most likely scenario is a contraction of aggregate output, by either lower inflation or lower output. The chances of deflation would rise with useless monetary policy.
We are setting ourselves up for a huge problem.
Have you considered building this model out in Minsky?
Posted by: Steve Roth | 05/09/2013 at 01:56 PM
Happy to find this blog, I will have to read your posts and try to catch up.
Am I correct in thinking the past couple decades has been a process of shedding the ground-level worker/consumers from the main economy, pushing them to a sub-economy where most of what they do ends up supporting each other? A process I call "pancaking," it separates out a dense, unproductive foundation layer who do not accumulate capital or social leverage, but merely tread water.
More later, I'll be back,
Noni
Posted by: NoniMausa | 05/10/2013 at 12:13 PM