Effective Demand Research

Question about potential RGDP, inflationary gap, participation rate and unemployment

Here is a question sent to me by email,

Inflationary gap, are you saying the blue line is potential GDP provided Participation Rate is 66.7% (2001) or (?) and U3 at natural rate of unemployment?

The question refers to the role of potential real GDP to determine the inflationary gap and if the low labor participation rate or U3 unemployment has an effect.

Here is the answer.

Hi _____,

The potential real GDP does not depend on unemployment nor participation rate. It only depends on utilization of capital in relation to labor share of income.

 

I realize there are many ways to evaluate under-employment looking at part-time work and changes in labor participation. Underemployment will show up in the capital utilization number in the equation for potential real GDP.

 

pot real GDP = real GDP - $3 trillion * (capacity utilization/labor share - 1)

 

In the equation, real GDP will rise over potential RGDP as capacity utilization rises. We see an inflationary gap grow (real GDP - potential real GDP). But there is a limit to how far it can rise. Here is the equation that establishes the limit on the inflationary gap.

Effective inflationary gap = $3 trillion * u/(1-u)

u = the unemployment rate

When the right side equals the left side, the business cycle has reached its top limit.

 

So, unemployment does not determine potential RGDP, ... rather... unemployment determines the limit of real GDP over potential RGDP.

 

So then you ask, what is the true unemployment in this second equation? It is the U3. You just need to know how many people are working. You do not need to know how much they are working because that is reflected in capital utilization and also in the productivity number.

 

Now, as unemployment falls, there may be slippage in the U3 as some people re-join the labor force. That is ok... Eventually when U3 reaches the point where effective inflationary gap equals the right side of the equation above, the business cycle has topped out. Think of it this way... What if some people re-joined the labor force, would the unemployment rate rise? maybe, maybe not... It depends on if they rejoin because they found work. The unemployment rate may fall with an increase in labor participation. If 50,000 people rejoin, and they all find jobs, U3 will decline.

 

U3 is determined by just a small percentage of the total economy. U3 for the whole economy is extrapolated from that small percentage. 

 

If people were to rejoin the labor force, a certain percentage will find jobs, and a certain percentage will still be looking. The unemployment rate may tend to decline with an increase in labor participation if those people are being instantly employed. But then some will come back with hope, because they see some others finding jobs. On balance, the unemployment rate may not slip very much at all as the labor force participation changes.

 

The problem is that wages and hopes have fallen so much, that many people just went out of business, they left the labor market. And unless wages start to rise, they ain’t coming back. And that brings us back to the first equation above for potential RGDP. If wages and labor share actually rise, potential RGDP will rise too. The inflationary gap will decrease, which is just the difference between real GDP and potential RGDP. A smaller inflationary gap will then make the left side of the second equation be less. The result by raising labor share is you give more room between the left side and the right side of the second equation. This gives more room for unemployment to fall even more.

 

I realize my explanation is a little convoluted, jumping back and forth between the equations, but the essential answer to your question is there.

 

Edward

I just realized that some legitimate comments were going to spam. And I just saw that there are over 3600 spam comments... Whoa Nelly!

Productivity related to Real Wages

I was listening to an economics lecture from UC Berkeley on Youtube about productivity. It was lecture 23 from Economics 113, spring 2013. The professor was Martha Olney.

In the video she shows a chart of productivity from 1960 to 2012 about the 2:00 minute point. She mentions that productivity grew in the 60's at 2.8%, from the mid 70's to mid 90's 1.5% and from 1995 to 2004 3.3%. Her point is that there was a slowdown in productivity from the mid 70's to the mid 90's, but nobody has been able to figure why.

She showed that it was not caused by age, gender, oil, manufacturing/services, immigration, education, R&D, choice to work less, and more. None of these factors showed any correlation to the the changes in productivity.

I don't understand why this is a mystery. To me the answer seems simple. Let me start out by giving an equation for productivity.

Productivity = Wage rate/unit labor cost

Unit labor cost = labor share * price level

Thus,

Productivity = Wage rate/(labor share * price level)

Productivity = (real wage * price level)/(labor share * price level)

In real terms...

Productivity = real wage/labor share

From this equation, we would expect productivity to rise when real wages rise and when labor share falls.

Here is a graph of this equation from 1947 to 2013. (Business sector: real compensation per hour/Business sector: labor share/100)

Graph #1

We can see a slow down in productivity from the mid 70's to mid 90's. Now here is a graph of just Business sector: real compensation per hour/100)

Graph #2

The changes that she mentioned about productivity are now more obvious to see. So most of the story about how productivity changed over the decades is really the story about how real compensation changed. In other words, to understand the changes in productivity, one really just needs to understand why real compensation per hour changed.

One of the factors of a falling real wage was the minimum wage. Here is a graph of the minimum wage from Financial Ramblings.

Graph #3

We can see that the minimum wage peaked around the time that productivity started to slowdown. And the minimum wage stopped declining in real terms about when the slowdown in productivity ended. Of course, there were other factors, but there was an economic view from the 70's to the 90's that wanted to reduce real wages. This view of wages was in large part due to Milton Friedman's emphatic view during the 1960's that there was no positive objective that could be achieved by a minimum wage.

Well, Friedman was wrong. But his views took hold.

There was a general suppression of real wages in the US, even though productivity was rising. According to the equation above, labor share had to decline faster than real wages were suppressed in order for productivity to rise. It was thought before this time period that labor share was fairly constant. The fact that labor share had to decline to compensate for real wages supports the view that real wages were consciously and purposely suppressed.

Real wages do not perfectly and naturally follow productivity. It would be nice if they did. Real wages can be pushed away from a natural balance with productivity and this is what has happened since the 1970's.

However, the consequences of suppressed real wages and a declining labor share would eventually weaken demand in the economy and make room for bubbles and easy credit. Productivity itself was suppressed from the suppression of real wages, as a declining labor share could not fully compensate the effect.

In a previous post, I talked about the work of Bruce Kaufman who is a wise expert when it comes to the minimum wage. Bruce Kaufman writes that raising the minimum wage to a socially efficient level will actually increase productivity.

"The loss of jobs from a minimum wage (if such occurs) forces society to confront and solve a problem it otherwise prefers to ignore: that is... Why do (some) workers have such low productivity that they cannot earn at least a subsistence wage? Moreover, not only do some workers potentially lose their jobs, some firms also go out of business. But again this result has to be regarded as in the social interest, since it weeds out the least efficient and most backward firms and concentrates capital and managerial talent in the most efficient and advanced firms." - Bruce Kaufman, Institutional Economics of the Minimum Wage: Broadening the Theoretical and Policy Debate, page 447

The suppression of real wages allowed productivity to slow down by allowing inefficient firms to compete with efficient firms. The purposeful effort to lower real wages and labor share created a friction on productivity growth. Thus, on balance productivity slowed down.

Comment on Worthwhile Canadian Initiative blog today...

http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/06/we-should-not-teach-the-keynesian-cross-in-intro.html

A post by Nick Rowe over the Keynesian Cross.

"I incorporate the view of social capital to understand the KC.
Here is a link to a post by Michael Pettis with a graph of optimal investment against social capital in China...

http://www.mpettis.com/2013/06/10/how-much-investment-is-optimal/

The idea is that investment has an optimal level in relation to social capital. That if you tried to increase investment beyond its optimal level, social capital would not absorb it in the long-term. The consumption portion of the aggregate demand curve in the KC would be sticky in response to investment. Markets won't clear well over time. In effect the KC will not show that there is a bubble. Eventually the market will bring values of investment back in line with what social capital is truly able to absorb. The KC does not reveal what level of investment is optimal for society."

The Solution to the Economy: Raise Social Standards and Social Efficiency

Yes, the economy is a concern. There are problems to sort out. The problems run deep. What is the solution?

The solution to the problems of the economy will be found through "Social Efficiency" and raising the social standards that have been declining through the years. I will present 3 examples of lowered social efficiency, grade inflation in schools, the minimum wage and finally low interest rates. My purpose is to show that nominal interest rates need to rise, but that real wages must rise in unison too.

Grade inflation at Yale University

Let's go to Yale University and see an example. Yale is currently working on a solution to its grade inflation. Grade inflation is when more students get A's than before.

"...a full 62 percent — nearly two-thirds — of grades awarded in Yale College, the university's undergraduate school, are A or A-. (That wasn't case four decades ago, when just 1 out of 10 grades awarded fell in the A range.)"

This quote is taken from an article about the problem of grade inflation at Yale. There is a comment below that article by Adam Glover...

"What do they call the person who graduates first in their medical class? Doctor
What do they call the person who graduates last in their medical class? Doctor
Rather than worrying about grades, I'm more concerned that students are sacrificing real learning for a better GPA."

The problem is that standards, and more importantly, Social Standards of quality have been lowered. The issue of grade inflation at Yale is just one isolated example of declining Social Standards around the world. Just this week we see cheating in the schools of China is rampant, even as parents try to bribe teachers so their children get better grades.

Low social standards with low minimum wage

Let's now search for declining social standards in the economy. One example is the minimum wage, which has been declining in relative worth for decades. Many economists feel that a lower minimum wage makes it easier for businesses to compete and survive. However, the problem is that a lower minimum wage is a lower social standard, and as a result, many businesses that are not socially efficient are able to survive, just like an incompetent doctor who graduated because of grade inflation at his school.

When it comes to understanding the social efficiency of the minimum wage, I go to Bruce Kaufman, and in particular his paper entitled, Institutional Economics and the Minimum Wage: Broadening the Theoretical and Policy Debate. He writes about the social cost of labor, which is more than the private costs of each laborer combined. Social costs include education, health care and even more time for parents to spend with their families.

Think of the doctor who graduated last in his class, but still became a doctor. The school covered its own private costs by graduating the student and increasing its market share of alumni who can donate money in the future. The student covered his private cost by graduating. However, there will be a social cost to society by having a sub-par doctor. The school has a responsibility to cover that social cost by not graduating poor students. But since standards are lower, social costs rise.

I will present 2 points that Bruce Kaufman makes.

First, wages need to cover the social costs of labor. If wages do not cover the social costs, the quality of people's lives suffers, while business profits more. The market failure is corrected by raising the minimum wage.

"...the minimum wage reduces or eliminates the externality-like gap between the private and social cost of labor and thus improves economic efficiency. The effect is analogous to placing a tax on a paper mill that dumps pollutants into a river. The higher cost causes the firm to reduce production and cut employment, but economic welfare is improved—not hurt—because the tax corrects a market failure (a missing property right) that allows the firm to use a valuable social resource (the river) without paying the cost. A minimum wage is also, in effect, a tax on firms, but these firms—like the paper mill—are using a resource to make profit without paying the full social cost."

Second, Bruce Kaufman distinguishes between "high road" and "low road" firms. The basic difference is that high road firms invest in communities for the long-term. They are committed to meeting social costs in order to have a socially responsible business in that community. Society should appreciate these types of business.

On the other hand, low road firms seek to cut costs in order to raise profits. These firms pay their workers as little as possible with little concern for the social costs of their business upon society. We know these types of firms are growing in numbers, because more working people are receiving food stamps.

"Minimum wage laws may enhance efficiency in another way as well, by protecting not only workers but also “high road” employers who make long-term investments in human capital, physical capital, and R&D. Research shows that productivity is higher at firms using a high performance work system (HPWS) with self-managed work teams, job security provisions, extensive training, employee involvement methods, and formal dispute resolution programs (Appelbaum, Berg, Kalleberg, Bailey 2000). These kinds of organizational investments are crucial for long-run growth but may be seriously impeded by the instability and hyper short-term competition found in competitive markets. A minimum wage law can protect and encourage new forms of work organization, such as HPWS, by putting a floor under competition so “low road” firms are not able to undercut and drive out high road firms."

The point Kaufman is making is that a higher minimum wage protects the high road firms that are socially more efficient.  Lowering the minimum wage is like lowering the standards of social quality. The result is that we find more businesses surviving that are not socially desirable, because they do not pay the proper social costs.

Low social standards with low interest rates

Now we come to interest rates. We all know interest rates are low because the Federal Reserve keeps the Fed rate at the zero lower bound. It is assumed that the economy is depressed. Thus low interest rates make money cheaper so as to entice businesses to invest and create jobs. Nonetheless, low interest rates lower social efficiency, just like grade inflation at the schools and a lower minimum wage.

With low interest rates, low road firms find it easier to survive. Low interest rates encourage businesses with lower standards for social efficiency. Thus social costs continue to rise.

Bruce Bartlett today makes a case that low interest rates lower the cost of capital. He mentions two results... 1. capital is substituted for labor in production and 2. labor's share of income declines. His main point is that if you raise the cost of capital, labor will be more valuable and the declining labor share will reverse its downward trend. I agree. But for the reasons of social efficiency.

Bruce Bartlett says we need to raise the cost of capital. However, we must also raise the cost of labor, so that labor has more money to demand products. Thus, it is doubly true that we need to raise the cost of capital by raising interest rates or at least scaling back loose monetary policy. Why? If we were to raise the cost of labor (which must be done), while keeping capital cheap, labor is put at a further disadvantage. In essence, we will have to raise the cost of both... labor and capital. The result will be a balanced foundation for socially efficient economic growth.

We have seen in the past week that investors around the world reacted strongly to the idea that the cheap money from quantitative easing by the Fed may start to decline. Investors behaved just the like the students at Yale who recognize that grade inflation exists, but do not want to change the grading system. People depend upon socially inefficient standards for their own self-interest, while society suffers for it.

Raising interest would lead to a temporary hit of effective demand, but as wages improve and social efficiency improves, effective demand will begin to rebound in a socially better way. The Chinese are raising interest rates to clean out inefficient investing, which is accumulating and will hurt them in the future. The same logic applies to the West, where increasing "social" inefficiency of the economy is suppressing demand on a permanent basis due to accumulating social costs. Raising interest rates and wages will temporarily hurt demand but open the door to a long-term healthier demand. I think this is understood in China.

Michael Pettis, who has been warning of inefficient investing in China, talks about the ability of social capital to absorb capital investment. Social capital refers to the institutions of business and society, as well as the purchasing power of society. When social capital is well-developed, capital investment is supported. He puts forth an argument with the implication that expansionary monetary policy designed to bolster investment will be ineffective when social capital is weak.

"...if social capital is too low or, to put it another way, if capital stock exceeds the ability of an economy to absorb it efficiently, then the best way to achieve growth may be to focus not on increasing inputs, which may end up being wasted and so may actually reduce wealth, but in improving the ability of the economy to absorb the existing inputs."

In many ways social capital in the United States is weak. Labor income has fallen. Communities are more fragmented. The scope of small business start-ups is more limited. 

"I would argue, however, that economies are much better at absorbing and exploiting capital if they operate under an institutional framework that creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights), encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses..."

As Michael Pettis says, it is important to have institutions that transfer resources to businesses that increase social capital. Bruce Kaufman made this same point above in terms of how a higher minimum wage supports high road firms that are socially efficient.

Michael Pettis gives a basic argument implying that if monetary policy is ineffective, it would be better to improve social capital first, which includes supporting small business innovation, increasing wages and raising household income. He sums up his arguments...

"What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently."

Low labor share constrains demand for production

In the United States, labor income needs to rise in order for capital growth (investment) to be absorbed efficiently. In effect, expansionary monetary policy is made ineffective when there is weak social capital.

Ultimately, low real wages and low labor share of income mean less demand for finished products. Thus production is limited. Even if capital is cheap, there is less effective demand to warrant investment in capital. With cheap labor, business has limited its own production, even while raising profit margins. Cheap labor is limiting economic growth through less effective demand. The answer is to raise labor income.

Conclusion

The standards of social efficiency have fallen in the economy.

Real wages are stagnant, while businesses record record profits. Businesses defend a low minimum wage in the name of economic efficiency, so that firms can compete better. However, a low minimum wage creates an environment where socially undesirable firms can compete with socially desirable firms, who would be willing to pay the social costs of their production. The result is that high road firms lower their standards to compete causing social costs to grow and accumulate. Eventually economic growth is suffocated by the accumulated social costs.

Low interest rates are defended because they allow any and all firms to survive, even the socially undesirable ones, in the name of "economic recovery". I say that the true economic recovery is the recovery of higher standards of social efficiency. Until these higher standards are brought back, social costs will grow and accumulate putting a weight on economic growth. Low interest rates increase the accumulation of social costs.

There are socially unproductive standards rampant in society and the economy. And just like at most universities, where the grading curve goes lower and lower and lower, the economy too is lowering its standards. The result is a sub-par economy.

We need to start raising the curve, so that the chaff is separated from the wheat... so that socially inefficient wages are separated from the socially efficient ones... so that the low road firms are separated from the high road firms... so that flighty investors are separated from the  investors who want to commit to the long-term growth of a community.

We need to raise the social quality of the economy once again. The solution is to raise real wages and to unwind expansionary monetary policy... steadily and carefully.

 

Cited sources

Bartlett, Bruce. Labor's Declining Share is an International Problem. Economix blog, The New York Times, 6/25/2013, Web link

Kaufman, Bruce. Institutional Economics and the Minimum Wage: Broadening the Theoretical and Policy debate, Cornell University, ILR school, ILRReview  volume 63, article 4, number 3, 2010. Web link

Moore, Malcom. Riot after Chinese teachers try to stop pupils cheating, The Telegraph, 6/20/2013, Web link

Pettis, Michael. How much investment is optimal?, Michael Pettis' China Financial Markets, 6/10/2013, Web link

Trotter, J.K. Yale Averts Grading Curve Apcalypse, The Atlantic Wire, 6/25/2013, Web link

Potential reality for potential real GDP

Getting the US potential Real GDP correct is critically important for monetary policy and ultimately the stability of the global economy.

This blog is devoted to a new definition of Effective Demand at a macro-level. And there are new equations and new principles associated with this new definition. One important new equation is the one for potential real GDP.

Potential GDP = real GDP - a * (capacity utilization/effective labor share - 1)

a = business cycle amplitude constant in terms of real 2005 dollars. ($3 trillion)

Here is the graph for this view of potential real GDP.

Graph #1

Notice the difference between the official CBO potential real GDP (pink line) and the potential real GDP of Effective demand (dark blue line). Potential real GDP as calculated by the above equation is actually below real GDP, while the official CBO line is $1 trillion above.

Has the effective demand determination of potential real GDP always been so different from the official determination?... No... In fact, the two lines tracked each other very well for 30 of the last 46 years. Let me show this...

First, we graph real GDP minus the official CBO potential real GDP...

Graph #2

View the zero red line as potential real GDP and the blue line as real GDP rising above and below potential real GDP through the business cycles. Now these are official numbers that economists use and have used to make evaluations of the economy.

Now I add in a line for the potential real GDP of Effective demand...

Graph #3

The lines tracked each other very well from at least 1967 to 1991. Then they separated due to a change in how the CBO determined potential real GDP. The lines returned to each other in 2002 and stayed together until the crisis.

The equation for the Potential RGDP from Effective demand never changed. It still shows that the economy is moving through a normal business cycle, even though the trough was abnormally low, as was the trough in 1982-83.

Think about it this way... capacity utilization is back up to 78%. It is just 2% to 3% below its pre-crisis level. Thus capacity utilization has rebounded fairly well. We see this in the pink  line having risen back over the zero red line. However, for the pink line to have fallen to -$800 billion, like the dark blue line of the CBO, capacity utilization would now have to be 54%, instead of 78%. So if you accept that the past correlation between the two lines was good, the current CBO determination of potential real GDP is suspect.

Also, look at how both lines are leveling off. It makes more sense, based on past movement,  that the pink line is leveling off as it nears a maximum. It does not make as much sense that the CBO potential RGDP line would be leveling off at such a low level. Just another reason to suspect the CBO determination.

This issue is critically important. because expansionary monetary policy by the Fed and the ECB is based on the potential real GDP far above the current real GDP. Such that liquidity has to be pumped into the economy in order for spending and investment to increase. Yet, we are seeing that this excess liquidity is destabilizing the world economy. If in fact potential real GDP is where effective demand calculates it (and there is historical precedence as seen in graph #3), monetary policy is based on a huge delusion and is simply creating more problems, and serious problems at that.

The  understanding of why these lines have diverged so much since the crisis... is something economists have not realized yet and something they will have to realize as soon as possible.

My comment on Econbrowser.com today on the post "The end of low interest rates".

Apart from my views that unemployment has an effective demand constraint at 7% and that China is intelligently positioning itself ahead of the curve while the rest of the world continues to destabilize (high rates stabilize, low rates destabilize, the trick is to find the balance), I have another comment:

Capital is much less grounded in communities than it was in the past. My grandfather was president of Santa Fe railroad until 1966. He was conservative in his investing. He had the mind-set to invest in communities for long-term development.
Since the 70's capital is much less grounded in communities, and much more likely to jump for self-centered reasons, even when it means turning your back on the long-term development of your community. Even Japanese capital is leaving Japan.
Capital has become "flighty and capricious" and bubbly as noted in the article above. A talk of tapering QE back in the 50's would not have had such an over-reaction. Capital would have taken it more in stride and kept more to their long-term development goals. However, now capital is much more impersonal, more "self-centered & self-interested" as promoted by Friedman.
Investors act more like children now on average. It is more difficult to take candy away from a child than an adult. Barry Ritholtz even has a post called "Taper Tantrum reaction".

http://www.ritholtz.com/blog/2013/06/taper-tantrum-reaction/

The immature behavior of investors is a dynamic that will complicate unwinding of QE globally.

Tracking the Effective Inflationary Gap with Unemployment

What is the effective inflationary gap? Well, first let's recall what the inflationary gap is. It is when real GDP is more than potential real GDP. Now, the effective inflationary gap is a measure of how much upside the inflationary gap has based upon the unemployment rate. The effective inflationary gap will set the top limit of the inflationary gap, in effect setting the top of the business cycle.

I may have totally lost you by this point. Let me just show you the equation for the effective inflationary gap and then show you a graph of how it works....

Effective inflationary gap = a * u/(1-u)

a = business cycle amplitude constant in 2005 real $$. ($3 trillion)

u = the unemployment rate

Now the inflationary gap as measured by the principles of effective demand is...

Real GDP - Pot RGDP = a * (cu - els)/els

cu = capacity utilization

els = effective labor share

Here is a graph of the two equations from 1stQ-1967 to 1stQ-2013.

The important relationship is that the effective inflationary gap (blue line) sets a top limit on the inflationary gap (orange line). You can see that in most instances, the blue line caps the topside of the orange line. When the orange lines goes over the blue line, we are into NAIRU territory. You can see that the NAIRU was an issue back in the 60's and 70's, but not so much since.

Effective inflationary gap is based on the unemployment rate. The effective inflationary gap rises in a downturn and falls during the expansionary phase of the business cycle. The inflationary gap line (orange) also moves with the business cycle. The inflationary gap itself is a function of capacity utilization and labor share. The two lines meet at the topside of the business cycle.

The inflationary gap rises when capacity utilization rises or labor share falls relative to one another. The effective inflationary gap falls when unemployment falls. Unemployment tends to fall at a fairly steady rate. At least it has been that way since 1987. So, when will these lines meet?

Look at the most recent point in the graph. The inflationary gap is around $150 billion, which would equal an effective inflationary gap rate based on 4.8% unemployment. So if the inflationary gap stays at $150 billion, it will take unemployment about 4 to 5 years to reach 4.8% at the rate it is falling. This basically means that capacity utilization has to stay at 78% while unemployment falls to 4.8% over the next 4 years. Not a realistic proposition.

So, capacity utilization will rise as unemployment comes down. They will meet at some point. Let's say they meet at an inflationary gap of $200 billion. The corresponding unemployment rate of the effective inflationary gap would be... 6.3%. Thus, 6.3% unemployment would signal the end of the business cycle expansion.

However, the calculations using the equations of effective demand say that the lines will meet around an inflationary gap of $225 billion. At that point the effective inflationary gap would correspond to an unemployment rate of 7.0%.

So depending on how capacity utilization and unemployment improve in the coming months, the unemployment rate would bottom out between 6.7% and 7.2%. There is still a possibility of labor force participation increasing as unemployment falls, which would keep unemployment elevated as capacity utilization rose.

Capacity utilization would have to rise further to meet that $225 billion deadline. Of course, if labor share declines further, that would push the inflationary gap up closer to the effective inflationary gap due to less effective demand. Personally, I would not like to see labor share decline further.

IS-LM curves for Capital & Labor

I will start to build the model for the IS-LM model for Effective demand. This model incorporates the growth model of effective demand, the concept of an optimal labor share and the monetary policy framework of effective demand.

In the IS-LM model, interest rates are on the y-axis and Real output (GDP) is on the x-axis. Normally Real GDP is a function of consumer spending, investment, net government expenditures and net exports. But there is another way to define real GDP. It can be divided into Capital income and Labor income.

Real GDP = Capital income + Labor income

Here is the model which separates out capital income and labor income for an economy with a real output of $1000.

Graph #1

This graph gives 13% of real GDP to capital income and 87% to labor income. Real capital income is at equilibrium of $130. Real labor income is in equilibrium at $870. The IS curves of capital and labor together add up to the IS curve of the total economy. As well the LM curves of capital and labor add up to the LM curve of the total economy.

The capital and labor markets are in equilibrium for this particular level of Real GDP.  Both capital and labor have the same natural rate of interest at 3%. The corresponding IS & LM curves cross at 3%, which represents the natural rate of interest.

But now what would happen if labor share drops? Labor would then be receiving less of national income and capital would be receiving more. The equilibrium of the IS-LM graph above would be upset. When labor has less income than the optimal equilibrium, they have less liquidity. Would real GDP simply drop too because labor has less consumption power? Possibly, but the other possibility is that the natural rate of interest for labor would decrease encouraging labor to convert savings into cash for spending. Likewise, the natural rate of interest for capital would rise to soak up the excess liquidity of capital.

Thus, capital and labor would end up with different natural rates of interest. Capital's new natural rate would seek to reduce capital's excess liquidity. Labor's new natural rate would seek to increase labor's liquidity for spending.  Here is a graph simulating the change...

Graph #2

I lowered the labor share from 87% to 75%. The real income of capital has almost doubled from $130 to $250. The real income of labor has fallen from $870 to $750. The red dots show how the different natural rates might move as labor share fell from the optimal level.  The natural rate of capital rises to 5.21% . The natural rate of labor declines to 0.79%. The IS and LM curves of capital and labor still add up to the same curves of the total economy. What we have here is another equilibrium state of the economy at a real GDP of $1000.

How would we determine the natural rate of interest for the total economy? You might think it is where the IS & LM curves of the total economy cross, which in graph #2 is at 3%. But there is another option... where the difference in IS & LM curves of labor and capital balance to 0. For example in graph #2, at a 3% interest rate, capital's IS minus capital's LM is $44. Likewise, at a 3% interest rate, labor's IS minus labor's LM is -$44. The difference between capital and labor balances to zero at 3%.

But now let's change the slope of the lines. We will make capital very insensitive to interest rates (inelastic). A change in interest rates has less effect on capital's spending or hoarding of money. We will make labor more sensitive to interest rates. A change in interest rate will affect labor's demand for money and spending much more.

Graph #3

To the left we see that the slopes of capital's IS & LM curves are steep (inelastic). In the middle, we see that the slopes of labor's IS & LM curves are flatter (more elastic). The curves for the total economy now cross at 1.07% (see dashed green line). Just by changing the elasticities of the curves for labor and capital, the natural interest rate of the total economy changed. In this graph, the natural rate dropped from 3% to 1.07%. 

We can see a balanced natural interest rate for the total economy at 1.07%, and not at 3%. At 1.07% the difference between capital's curves is -$28. The difference for labor's curves is $28. Capital and labor balance to zero at 1.07%. Thus, at 1.07% the economy has an equilibrium to clear the markets. When we add up the IS curves for capital and labor at 1.07%, they add up to a real output of $1000. But when we add up the IS curves for capital and labor at an interest rate of 3%, they add up to only $897 of real output. Thus it is more efficient for the Fed rate in this instance to be set at 1.07% instead of 3%. The economy may appear to have a natural interest rate at 3%, but the rate is more optimal at 1.07%.

The natural rate of the total economy will always be between the natural rates of capital and labor, unless the sign of the slopes change. The natural rate of interest for the total economy will move toward the natural rate that is relatively more elastic, whether it be capital or labor.

Exchange rate between Capital & Labor - a wild idea

I have been posting about the natural rate of interest. The idea is that labor share is falling below an optimal level. We see food stamps rising. The other side of this coin it that capital share is rising above an optimal level. The result is that labor is losing liquidity, while capital is gaining liquidity. We see the effects in stock prices, bubble asset values and record-high corporate profits.

So if capital income has so much liquidity, and labor income has so much less, then in theory there should be a different natural rate of interest for each one in order to achieve balance. The following graph shows the natural rate of interest based on labor share falling below its optimal level.

Graph #1

The plot of the natural rate of interest declines over time reflecting labor's loss of liquidity power. Labor liquidity is important in the goods market. Labor purchases the finished goods that the means of production produce. Capital income maintains the means of production. So labor's liquidity is important to keep those means of production working.

Interests rates are low to encourage labor to hold cash and spend it in order to keep the capital equipment working. At the same time, capital income is enjoying the low interests that are designed for labor.

Well, the line of the natural rate of interest in graph #1 is designed so that labor can have more liquidity to spend. But the line has a flip side. If we adjust the natural rate down for low labor share, then we also need to adjust the line upwards for high capital share. This is what we would see...

Graph #2

The blue line is the adjusted natural rate of interest for labor to purchase goods and hopefully produce inflation. The blue line refers to the consumption market. The yellow line is the adjusted natural rate of interest for capital to develop the means of production. The yellow line is the means of production market.

In the 60's and 70's, capital was at a disadvantage by having to use the higher natural interest rate for the consumption market. However, there was labor demand for more production, so capital was able to profit with growth, but at a cost.

Now, capital has a huge advantage in having access to money at the lower natural rate of interest designed for consumption. Capital can have liquidity at low cost, but there is low labor income demand in the consumption market to attract capital's excess liquidity. No wonder that corporations have large cash reserves and look to invest overseas.

Inflation follows the Labor Natural Rate of Interest (consumption market)

Inflation is how the price of goods & services are influenced by consumption demand. When labor's income is weak, it is harder to increase prices. So we would expect that inflation follows the decline of labor's liquidity. In fact, this is what we see...

Graph #3

This graph shows that inflation (purple line) has been declining with labor's natural rate of interest since the 1980's. If we look back to the 70's, we see volatility in inflation, which is partly due to labor's excess liquidity in comparison to capital's costs to produce goods & services.

For some years after the Volcker recession of the early 80's we had balance between the natural cost of money for capital and labor. Yes, there were problems still, but inflation came under control as labor's excess share liquidity began to decrease. Capital found it less expensive to invest because capital used the lower natural interest rate of consumption, which was then lower than capital's natural rate of interest. Capital began its boom & bubble period, which lingers even stronger to this day.

Exchange rate between labor & capital - A wild idea

So how can this imbalance between liquidity of labor and capital be rectified? We could charge capital income the higher rate. I am trying not to laugh. That idea is far from reality.

How about?

We could institute an exchange rate between capital owners and labor. There would be one currency for capital owners and another for labor. A labor dollar would adjust to equal a capital dollar. Such that when labor is paid, there is a currency exchange. And when labor purchases goods & services from a business, there is a currency exchange. The exchange rate will maintain liquidity balance and purchasing power parity throughout the economy.

The extra transaction cost would be offset by economic efficiency.

If an exchange rate was instituted now, labor currency would increase in value at the expense of excess liquidity in capital currency. The result would be more demand for goods & services, more output and more inflation through the exchange rate mechanism.

But as it is now, a dollar in the hands of labor has less value than a dollar in the hands of a capital owner. I propose that this difference in value is due to their natural rates of interest.