Real GDP… its center and natural limit in the business cycle

I posted yesterday about potential GDP being the center of the business cycle and how labor share reflects potential GDP. I want to go deeper into this using data.

P. Krugman wrote yesterday… “We don’t know how much capacity the economy has, but we do have strong reason to suspect that running the economy below potential is a very, very bad idea.” Well, I am going to show my view of how much capacity the economy has.

Start with the difference between potential GDP (the center of the business cycle) and Real GDP’s natural limit (the top end of the business cycle). Then the position of real GDP in relation to those will give us an idea of how much capacity there is.

This first graph shows the capacity utilization cycle in relation to labor share (blue line). Labor share represents the zero line. Capacity utilization rises and falls around its effective labor share center. Then the percentage difference between the two is amplified into the real GDP movements around potential GDP, which is the center of the real GDP cycle. OK… that summarizes the previous post.

Now I add a line for the natural limit of real GDP. This level of real GDP is calculated by putting the price level where the effective demand curve crosses the aggregate supply curve into the aggregate supply equation.

The line for the natural limit warps downward during contractions due to the aggregate supply curve sliding along the effective demand curve as it shifts through the business cycle. Eventually the natural limit firms back up when real GDP returns back to the crossing point.

 pot nat limit

The way to read this graph is to see real GDP moving through its business cycle. The zero line is the center of the business cycle (potential GDP). The yellow line and its 4 quarter running average (red line) are the top end of the business cycle. Real GDP expands up to the natural limit and then heads back down into a contraction.

The natural limit (LRAS curve) has been fairly stable around the +$200 billion point (2009 dollars). It has jumped up since the crisis though. The basic story is that real GDP is close to the top end of the business cycle showing that there isn’t a lot of capacity left.

Why am I different? I have studied labor share and its role in effective demand. I have developed models for labor share as a useful tool in understanding the economy. On the other hand, most economists don’t have models for labor share. P. Krugman never even mentions it. I have no idea whether he has a model for the declining labor share or not.

Here are the lines of the graph above for real GDP, potential GDP and the natural limit of real GDP since 4th quarter 1996.

pot nat limit 2

You can see how real GDP (red line) moves up to the natural limit (green line) and then pulls away below potential GDP (brown line) through a contraction.

Here is a close-up for the last 7 years.

pot nat limit 3

The red line is close to the green line. There is not much capacity remaining to raise the utilization rates of labor and capital.