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07/10/2014

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I read this once last night and several times today. It seems to be a model with only very thin ties to the real world.

I prefer Velocity as the underlying mechanism for Effective Demand Limit.

_______________Velocity = GDP / M2
Transposes to: GDP = Velocity x M2

If Velocity drops then GDP is going down. The problem is documenting a change in Velocity. All of this would be much easier to explain if we could measure Velocity. But Velocity is real anyway.

Consumer spending still makes up about 65% of GDP. Changes in consumer spending are obviously going to have a larger effect than any capital spending.

I see frequent recognition that there are a lot of investors holding cash, how does that increase velocity? Does anyone seriously believe that companies are actively growing their businesses, especially in the aggregate.

Your model for Effective Demand Limit documents a relationship between Labor Share and a limit on GDP. But something in the real world has to limit GDP, not a model.

My scenario is as Labor Share declines, so does Velocity, and as Velocity declines so does GDP.

The first part of that sentence is true because Labor Share get spent immediately into the consumer economy. The second part to that sentence is true because of the GDP formula above.

I understand that the typical economic mumbo jumbo has all money being spent and never sitting idle, but I can not bring myself to believe it.

What your model of Effective Demand Limit adds is a measure of where the GDP will be limited. Along with other insights.

The .76 constant for Effective Labor Share still bothers me. It must represent some unknown if it is not a correction factor for 2005(.78) or 2009 dollars.

Hi Jim,
Velocity is a symptom, not a cause. There must be a cause.
The model I gave has a simple analogy.
Take someone who has a kitchen that has a capacity to prepare 20 meals. Yet, there are only 16 possible customers. As long as the kitchen makes 16 or less meals, the profit rate is good. If it makes more than 16, the kitchen has to eat its profits.
Once you can see the limit of your customers, you know you have to maintain production within those limits. That way you can sell your production. And if you produce less than the limit of your customers you can raise the price and make more money.
When you produce more than the limit of your customers, you have a deadweight loss so to speak in your profit rate.
Research needs to be done to investigate that.

But the velocity idea still needs a model to show a lower limit.
Here is a graph plotting the UT index with velocity.
http://research.stlouisfed.org/fred2/graph/?g=FpM

At some times velocity peaks at the effective demand limit, and at other times it bottoms out, like now.
What is causing that difference?

Jim,
Velocity is a function of the M2 money supply as well as GDP. How do you connect the money supply to effective demand?

Resending revised comment. Delete previous 2.

Other things can raise GDP, or M2 could changed by the Fed. Velocity could also be changed by other things. The other things are operating outside of the equation GDP = Velocity x M2 but they are no less active.

Traditionally velocity is derived but it is a measure of something real. (The number of times M2 is turned over in the economy.)

If nothing else changed but the consumer was paid more money then velocity would go up. (Increase in Labor Share) If nothing else changed but the consumer was paid less money then velocity would go down. (lower Labor Share)

We just don't have a recognized way of measuring velocity directly. So we get use to accepting it as an effect and never a cause.

If I have been reading you correctly, Labor share is now very low. And FRED is showing velocity at record low levels.

Let's assume that that labor has a percentage of the money supply that corresponds to their labor share. Then as the money supply rises, labor has more money, but still the same percentage according to labor share.
So if velocity falls, it falls the same for labor and capital incomes.

It just seems that velocity is low now because M2 has increased and GDP has dropped to a lower trend level.
Yet I would say that GDP dropped due to lower labor share causing lower effective demand. M2 has increased because the Fed has tried to pump liquidity into the economy, but it is not going to labor.

It seems that low velocity of money at the effective demand limit is a weird sickness. Usually velocity is much higher at the limit.

FRED does show M2 going up much quicker than before 1990. (After all the borrowing began I guess.)

How can M2 keep going up this quickly. Is this QE1 to QE whatever?

If that is the case then when the Fed tightens, M2 will drop and velocity would go higher.

But somewhere in all this there must be a real mechanism to impose a limit on GDP when Labor Share drops too low. (Effective Demand Limit)

Your models do not exist in the real world, they are models.

Decreasing velocity seems to offer a possibility. Perhaps increasing M2 is only responsible for part of the decrease in velocity.

But then GDP numbers would have to be off too?

Perhaps something is distorting the reported GDP. I read a few years ago that some imports were leaking into the Gross Domestic Product stat.

I still see velocity as a symptom of deeper causes.
Think of the end of the business cycle. GDP slows down and the Fed tightens. Velocity will rise if M2 slows faster than GDP. But velocity simply reacts to how fast the Fed tightens.
But also, labor is spending more money at the end of the business cycle. Yet, velocity is simply the outcome of changes to spending, Fed tightening and real GDP hitting its natural limit.
I think the deeper causes behind velocity is where you find the keys to effective demand.

We may be dealing with something similar to the difference between 'aggregate demand' and your 'effective demand'.

Velocity is recognized as the entity returned by GDP divided by M2. Maybe what I am referring to is not that particular velocity, although something very similar. More like the turn over rate of dollars spent in (discretionary?) consumer goods in a quarter or year? (The final products of all the effort.) Haven't thought this out, so there must be a better characterization.

Otherwise the question becomes, what is the difference between a dollar spent by labor/consumer and a dollar spent out of capital? Besides representing 65 to 70% of GDP and being spend more rapidly than capital income, are there any other differences?

If your work with Effective Demand is correct then there must be some difference between Labor Share income and capital income? In the way it is spent or consumed, otherwise why would reducing labor share work to limit GDP?

I have characterized the problem as consumers can not spend what they do not have. Our economy is directly oriented towards sales to the consumer, so when consumers start to run out of discretionary income, the whole thing starts to bog down.

Your graphs of GDP and Effective Demand Limit over many prior recessions indicate that there must be some real mechanism.

Quite the puzzle, isn't it?

There is one difference between capital income and labor income that we can point to... labor income decreases profits for capital income. Capital income is spent from profits after paying labor income.
If capital is supplying production within the potential capacity of labor to purchase it, capital can generate profits by manipulating supply and demand.
When capital is supplying production beyond what labor could potentially purchase, they begin to lose leverage to manipulate the market to generate profits.
The labor income then becomes insufficient to generate an increasing profit rate.

There is one view that is clear... raising labor share will decrease profits. But there is another view. Labor share limits profit rate. And if you go beyond that limit, profits come down.
The two views are united in the same mechanisms.

It is quite the puzzle, but it is logical. And we watch as the economy shows signs of hitting the effective demand limit once again.

Jim,
The simple view I am putting forth in the post above is breaking the code business cycles, potential GDP and when recessions form.

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Data as of 3rdQ-2018
Effective Demand = $18.433 trillion
Real GDP = $18.671 trillion
Productive Capacity = $24.872 trillion
UT index is at effective demand limit = -0.92%
Effective demand limit = 74.1%
TFUR = 75.1%
ED Fed rate rule = 4.0%
Estimated Natural Real Interest rate = 2.3%
Short-term real interest rate = 2.8%

There is no recession for 3rdQ-2018. Chance of recession is growing as economy has now reached 2nd effective demand limit in this business cycle. I am forecasting that economic conditions will begin to contract in the second half of 2018.




Click on Graphs below to see updated data at FRED.

UT Index (measure of slack):

The UT Index

z-vertical:

z-vertical

z derivatives in terms of labor & capital:

z derivatives in terms of labor & capital

Effective Demand, real GDP & Potential GDP:

ED, real GDP & pot rGDP

ED Output Gap:

ED Output gap

Corporate profit rate over real cost of money:

Corp profit rate over real cost of money

Exponential decay of Inflation:

Corporate profits impact Inflation

Measures of Inflation:

Measures of Inflation

YoY Employment change:

YoY employment change

Speed of consuming slack: yoy monthly:

Speed of consuming slack

Speed of consuming slack: quarterly:

Speed of consuming slack quarterly

Real consumption per Employee:

real consumption per employee 2

Will real wages ever rise faster than productivity?:

Productivity & Real Wages

Productivity:

Productivity

Productivity against Effective Demand limit:

Prod & ED limit

Bottom of Initial Claims?:

Initial claims

Tracking inflation expectations:

Fisher effect?

M2 velocity still falling:

Measures of Inflation

All in one:

All in one

Double checking labor share with unit labor costs & inflation:

ULC LS CPI
My Photo
Edward Lambert: Independent Researcher on Effective Demand. Graduate of Atlantic International University where independent research was developed.
Some links for economic analysis
Fed Views - San Francisco Fed, around 10th of each month.
Well's Fargo monthly - around 10th of each month
Well's Fargo weekly
Well's Fargo Interest rate report
Well's Fargo Economic indicators
T. Rowe Price weekly market wrap-up
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