Approaching Effective Demand Limit Again

The famous economist John Maynard Keynes tried to put forth a theory of effective demand. Keynes even devoted chapter 3 of his General Theory book to it. However, nowadays you will not see the term effective demand in economic textbooks. What happened to it? Why is the term effective demand missing from common discourse?

Keynes laid down some basic ideas about effective demand but did not give specific equations. It is clear that Keynes distinguished effective demand from aggregate demand. Still modern economists equate effective demand with aggregate demand. This is a mistake. Now we only see the term aggregate demand in textbooks.

Consequently, there is a missing piece of economic theory that is still yet to be found. How then can we understand effective demand? Will we ever have a workable model for it?

Developing a model of effective demand was my doctoral work. This is the cornerstone equation of the model.

0% < labor share – (utilization rate of capacity * utilization rate of labor)

The equation basically says that the percentage of national income going to labor (labor share) sets a limit upon the multiple of the utilization rates of capital capacity and labor. The multiple cannot be greater than labor share.

The equation shows ‘demand’ through a relative amount of money given to labor (labor share) as opposed to money given to those who own capital. Capital income at a macro level depends on selling to those who do not have capital income. Certainly many economists would say there is no difference between money spent in the economy from capital and labor incomes. However, capital production is ultimately directed towards a final consumption by people who give their labor.

The equation shows the term ‘effective’ by saying that the income share of final consumers sets a limit upon how firms utilize their capital and employment. There is an effective demand limit upon production. Capital income measures its production according to the relative strength of labor income. Thus, if people are paid less, they demand less, and firms would have to produce less for them. On the other hand, if people are paid more, they can demand more, and firms would have to increase production.

So, there is a relationship of mutual dependence between labor income and capacity utilization. The equation I use above says the dependence has a limit. So, when the limit of labor share falls, it will push down capacity utilization.

Do we see this effective demand lmit in the data? Here is data for the United States since 1969 to the 2^nd quarter of 2017. (quarterly data)

Yes… the limit holds in the data. The blue line sees resistance at 0% shown by the horizontal red line. (data at FRED)

When I first presented this model to economists in 2013, the blue line had not yet reached the red line. The other economists were very skeptical that the line would stop at a zero lower bound. They did not think the equation was valid. Then in 2014, the blue line bounced off the effective demand limit of labor share, as my equation predicted. Since then it has risen and is once again heading down toward the limit.

In the last two business cycles, the blue line reached the limit two times before a recession hit. Is the same pattern setting up this time?

We should know within a year, if the blue line will hit resistance again on the lower red horizontal line. If we see resistance again, the evidence for the equation gets stronger.

What would happen at the effective demand limit? Basically labor share will rise in relation to capacity utilization. If unemployment starts to rise at that time, a recession would be spreading through the economy. 

The effective demand limit lines are concentrating toward a limit on real GDP of around $17.250 trillion.

Now, real GDP does not need to stop increasing at the limit, but if a recession is strong enough it will. Real GDP may continue rising, and we just see labor share rising in relation to capacity utilization.

Either way, the stock markets will react. Profits will stagante, as firms try to re-balance. When the economy is rising to the limit, profits in the macroeconomy rise and firms share in those profits. However, profits become a zero sum game at the effective demand limit. If one firm increases profits, then other firms lose an equal amount of profits. If the effect triggers problems, then the profit competition cascades into a recession.

 

Comments

[Gary D Anderson]

Hi, Edward. So, Prof, the chart from Mr Yglesias is almost an inversion of effective demand limit. http://www.talkmarkets.com/content/economics--politics-education/kashkari-reveals-dark-secret-fed-plan-for-wages?post=145383 This chart is interesting because it points to Fed procyclical behavior, the attempt to raise rates just when wages are starting to accelerate. Your study points to the inevitability of what happens when wages get too high. But Yglesias says it is the Fed that causes the pruning, implying that it is money supply rather than effective demand limit. I am wondering on some level if you are both right. The Fed must be looking at effective demand limit in secret all these years. And when capacity lags income they prune. What other sense can we make of all this?

[Edward Lambert]

Hi Gary,
Here is a graph of labor share with effective Fed funds rate.

https://fred.stlouisfed.org/graph/?g=fu2f

The relationship that you are describing is just not seen. In most cases, increases in Fed rate precede increases in labor share.
From my look into Fed data, it does seem though that they have a primitive view of the effective demand limit. Like at the end of this post...
http://effectivedemand.typepad.com/ed/2013/05/the-autopsy-of-the-fed-funds-rate.html

However, the Fed seems more to raise rates on the down side of the profit rate cycle...
https://fred.stlouisfed.org/graph/?g=fu2w

So the Fed seems to want to reach their medium-term goal when they sense the business cycle winding down. They see an opportunity to raise rates, but mostly they are behind the curve and have to raise quickly near the end of the business cycle.

These dynamics are separate from the effective demand limit, which has its own timing in the profit rate cycle.

Edward

[Gary D Anderson]

So, the first chart in your response is actually different than the chart supplied in my article regarding Yglesias. It appears that that FRED chart "share of gross domestic income" shows wages declining just prior to the recession hitting or just at the very beginning, while the chart you cited, "nonfarm business: labor share" shows wages not starting their declines until well into the recession periods. I don't understand the contradictory information coming from the two charts. But if your chart is more accurate, still, doesn't the rise in rates eventually cause the recession? Even if the rise in rates causes a short lived bump in wages, it still results in a decrease in wages after that. I don't think Kashkari is lying, meaning I think he sees people at the Fed wanting to get wages down. So, that fear of wage acceleration actually destroys the power of the Fed's fund rate, as you prove, as labor share continues to decline over time. One more thing, it is possible that because of interest on reserves, banks are kept from lending, and therefore inflation will be difficult to achieve. But if the Fed took away the excess reserves, how would it set rates if the Fed Fund rate is dead? Are they stuck with excess reserves until the end of time?

[Edward Lambert]

Hi Gary,
Yes, increases in the Fed rate can exacerbate the zero sum profit game around the effective demand limit. The higher Fed rate helps push the economy into recession.
The Fed wants to normalize rates to have some control over the economy into the next recession. But raising rates now is tricky I still see that there is room to raise rates without pushing a recession.
As far as Kashkari, I think you had a notion at the end of your post that maybe he was searching for reasons to not raise rates now. And using fairness of workers as an excuse. Yet the data does not really suit his story, so I don't think economists will follow the story.
As far as inflation, capacity utilization is low partly because of high profit rates. Low capacity utilization keeps inflation down.
Like in this post...
http://yourbusiness.azcentral.com/capacity-utilization-effects-product-profit-29150.html

So lending is optimized. Firms are actually more in debt now than around the crisis. They have locked in low rates for a while so they are good. And with profit rates high and capacity utilization low, there is less need to invest in the macro sense.
As for excess reserves, I look at this chart.
https://fred.stlouisfed.org/graph/?g=fuqS

Excess reserves have come down a bit as the Fed rate rises. So the future of excess reserves is linked to the future of the Fed rate. So if we get a recession in 6 months, the Fed rate goes back down to zero, and excess reserves are here to stay.

And inflation is not dependent on interest rates at the moment. It is much more a dynamic of high profit rates, low capacity utilization, increased inequality, weak labor power and weak effective demand from lower labor share.
This scenario applies to other countries like Japan and Europe.
Edward