# Nick Rowe explores interest rates & aggregate demand… What about profit rates, optimism & effective demand?

Nick Rowe at Worthwhile Canadian Initiative asks a question…

“What happened in 2008? Why didn’t the cut in interest rates prevent Aggregate Demand from falling? Was it just that the cut in interest rates wasn’t big enough? Or is the rate of interest the wrong thing to look at? Because it’s only a *relative* price, and relative prices only matter for *relative* demand?”

There is a lot to explore here, and I am going to go down the road of profit rates and effective demand. The issue involves the dynamics at the onset of a recession. But let’s start exploring with Keynes and go from there. Here is Keynes in Chapter 22 of *General Theory*…

“Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.”

The boom which is destined to end in a slump is caused, therefore, by the combination of a rate of interest, which in a correct state of expectation would be too high for full employment, with a misguided state of expectation which, so long as it lasts, prevents this rate of interest from being in fact deterrent. A boom is a situation in which over-optimism triumphs over a rate of interest which, in a cooler light, would be seen to be excessive.” (source)

Keynes says with an exclamation point that a lower rate of interest is the solution to a boom; just keep the boom going by lowering interest rates. Nick Rowe is then asking why a drop in interest rates during 2008 didn’t stop aggregate demand from crashing. The Fed rate did almost reach the zero lower bound by the end of 2008.

Back at the beginning of 2004, inflation started to appear. Soon after the Fed started to raise the Fed interest rate. The Fed rate kept rising until the Fed felt inflation was under control around a 2% target.

We can see that profit rates took a hit when the Fed rate started to rise back in 2004. But they soon got right back on track. Optimism overcame the Fed rate hike. (more on optimism below) The aggregate profit rate leveled out at the beginning of 2006 and then fell by the end of 2006.

Real GDP was growing and eventually hit the effective demand limit in the 3rd quarter of 2007. The recession officially started in December of 2007.

Link to graph #2. Real GDP stopped increasing after reaching effective demand limit. (note: area shaded red in LRAS zone, but area shaded red in graph #1 is recession.)

Once real GDP hit the effective demand limit, real GDP came to a stop. And we can see in graph #1 that the Fed then started to drop the Fed rate.

So the question is… Was the grinding to a halt of real GDP (and by association aggregate demand) due to high interest rates from 2004 to 2008 and then interest rates not going down fast enough in 2008? or Did real GDP grind to halt primarily because of the effective demand limit upon real GDP? In all recessions prior to 2007, except the Volcker induced recession, real GDP slowed down and stopped once reaching the effective demand limit.

What does Keynes say about the effective demand limit in Chapter 3 of *General Theory*?

“Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneursâ€™ expectation of profits will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called *the effective demand.” *(source)

We can see in graph #1 that aggregate profit rates started falling a year before real GDP reached the effective demand limit and kept falling for at least a year after. I would generally say that profit rates had been maximized before and after the effective demand limit.

If interest rates had dropped faster and farther in 2008 as the recession was starting, would the profit rate have started heading up? Would the expectation of more profit by entrepreneurs been resuscitated?*Â *

Or was the true problem having the Fed rate too high in 2006 and 2007?

As Keynes said in the first quote above from chapter 22, optimism can overcome a high interest rate. And when real GDP had room to grow in 2005 before hitting the effective demand limit, there was reason for optimism. Profit rates continued to increase. And in a certain light, the Fed rate was inconsequential to the growth of real GDP through 2005. But as profit rates began to maximize in 2006 approaching the “constraining dynamics” of the effective demand limit, the Fed rate became a problem. And when real GDP started grinding to a halt from the effective demand limit, the Fed quickly tried to bring down their interest rate.

Getting back to Nick Rowe’s question… “Why didn’t the cut in interest rates prevent Aggregate Demand from falling?”

In light of Keynes’ quote from chapter 22, the Fed rate should have dropped in mid-2006, when profit rates were declining and as real GDP was approaching the effective demand limit. The party of the boom would have been extended by optimism. The demotivating dynamic of the effective demand limit upon optimism would have been overcome. Unemployment and capital utilization would have stayed steady as real GDP kept growing from increasing productive capacity through optimistic investment. Profit rates would have stayed steady, but the sense of optimism to continue enjoying those profit rates would have continued. And the profit rates would not have started downward.

If one had wanted to avoid the crisis, one could say that the Fed kept their interest rate too high after 2005. But personally, I am glad the bubble burst. Eventually we will get back to a normal sustainable economy once economists realize that we need to fix where we are, and not try to return to the bubble years before the crisis.

Don’t economists realize how unsustainable the economy was back then? Like Keynes says in chapter 22, “The boom which is destined to end in a slump…”

We must avoid booms like the last one, and it appears that one is developing again but with labor in a much weaker position. The Fed decided yesterday to keep supporting the “quasi-boom” and the optimism behind it. But the pessimism is still waiting its moment to crash the party… the Fed cannot avoid the eventual pessimism that will develop once real GDP hits the effective demand limit sometime toward the end of 2014. The Fed rate will be somewhat inconsequential once the dynamics of the effective demand limit start to bite.