Update to Aggregate Supply - Effective Demand model

You can read about the AS-ED model at this link... as-ed model

Basically, AS is understood as a normal aggregate supply function. Holding all else constant, if inflation was to rise, GDP production would rise. However, the ED (effective demand) function differs from the normal AD (aggregate demand) function in that ED shows the effective demand limit upon production.

Let me show the updated graph and explain a bit further...

For the past  quarters, real GDP has been moving sideways at an inflation rate below 2%. The ED functions have been pointed to a real GDP limit between $16.1 and $16.2 trillion. That is where the ED functions were crossing the path of real GDP. Then towards the second half of 2014, real GDP reached $16.1 trillion. At that point, one of three things would have had to happen.

1. Real GDP would have blown right through the ED limit if the ED limit was not binding.
2. Effective demand would have risen to allow real GDP to keep expanding. ED balloons outward to the right. This is what we are seeing.
3. If the ED limit did not rise, real GDP would have stopped expanding and a recession would start to form. We did not see this happen.

The question now is whether a recession will form. and when? Some thoughts...

It is possible that a recession is starting. Effective demand has been rising, but I am expecting it to fall again to stimulate the next recession.

The truth of China is coming out. I do not see that as enough to put the US economy in a recession. Even a planned rate hike of 25bp by the Fed is not enough. The US economy does not have the troubles that China has. I sense that the US economy will find a way to bounce out of this moment of doubt. and even find a way to profit from it and continue to grow. More money is leaving China and some of it is heading to the US. The US dollar is up. I sense that investment will start to return to the US.

But the recession will still eventually come and it won't be pretty. I am keeping an open mind that a recession could be starting now, but my recession indicator has not hit that point yet. I will post the recession indicator in the next post.

Comments

[JimH]

Edward,

After Qtr2 2014, Effective Demand initially jumped up and out. But the Qtr2 2015 jumped out but down very slightly.

How do you explain ED jumping out? Is this reducing production and selling off inventory? Something we discussed here:
http://effectivedemand.typepad.com/ed/2015/02/new-ed-data-in-ased-model.html

[Edward Lambert]

Hey Jim,
I go back and take a look at this post...
http://effectivedemand.typepad.com/ed/2013/09/will-there-be-inflation-in-the-next-recession.html

Back in the 70s, when GDP hit the ED limit, the economy would start to rise along the AS curve leading to a rise in inflation. The dynamics are different now.
After 2Q15, inflation was weak with oil prices dropping. Labor share started to rise a bit. And capacity utilization fell quite a bit. So the ED curves rose and expanded outward allowing inflation to stay low as production increased. If the ED had not expanded to the right, GDP would have risen up the AS curve with inflation as it did in the 70s.

So production is not reducing. We see GDP rising in 2Q. But there is an effort to control inventories as capacity utilization drops. But at the same time, what is happening with China now? How much inventory are they dumping on the US market?