# Potential insights

In a post titled Potential Misunderstandings, Paul Krugman makes a really good point about potential GDP… many people do not understand what it is. He is absolutely right to say that it is a supply-side concept. Yet, in order to know where your potential output is, one must consider demand potential. I use effective demand to determine that.

Menzie Chinn over at econbrowser.com had a post about potential output last week… and I made a comment under his post.

“I find it so interesting how potential GDP is determined upon supply potential without considering a demand potential. Because there looks to not be enough demand to reach potential output.

The theory says, more output means more income, which means “corresponding” demand. Yet, supply won’t surpass effective demand as Keynes said and even fall short of what is considered full-employment. Unless of course you follow Say’s law.

“Here is an excerpt from Chapter 3 of General Theory by Keynes…

“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.”

So yes, Paul Krugman is right about potential GDP being a supply-side concept, but Keynes says that if you allow supply to create its own demand, you may be a fool. Did he say that? Not in those exact words, because he was a gentleman. Yet, if one does not have a proper measure of effective demand, your determination of potential output for full employment may be folly.

My research into effective demand makes me determine a lower potential GDP than Mr. Krugman. I see potential GDP as the center of a cycle between capacity utilization and labor share. The top limit of that cycle is determined by effective demand. Thus, my view corresponds to Keynes’ words about demand. I use the following graph of past data for my determination of potential GDP.

Blue line is real GDP minus the official CBO potential GDP. When the blue line is above 0, there is an “inflationary” gap, below 0, there is a “recessionary” gap. The red line is the percentage difference between capacity utilization and effective labor times a business cycle amplitude constant (2005 $$ in this graph). You can see that the lines tracked very well from 1967 to 1991. Then they got off track, but came back together 5 years before the crisis. Now the CBO is projecting a large “recessionary” gap, whereas the relationship between capacity utilization and effective labor share (red line) shows an “inflationary” gap.

There is an obstacle to full employment. It’s called the top of the business cycle. Effective demand says we are closer to the top than economists like Mr. Krugman say.

After several times noticing that your posts usually say “Read More >” at the bottom even when there is no more, I feel compelled to mention it.

Arne,

Doesn’t that happen with all posts? I noticed that too. It seems like an automatic close to each post..

I was bothered by Krugman’s post today. He asserts that someone is wrong because someone is clearly not using his definition of something. Now that you have echoed it, I decided to see if the definition is universal. Google’s number 1 hit is Wikipedia, which says ” potential output (also referred to as “natural gross domestic product”) refers to the highest level of real Gross Domestic Product output that can be sustained over the long term.” It goes on to emplain that a high level may not be sustained because of inflation, but it does not say inflation is the only thing that could make it unsustainable.

If everyone is borrowing unsustainably, it would create an unsustainable GDP. By that defintion, is not Krugman simply wrong?

If there is a feedback effect in the economy causing the workforce participation to rise, but that effect is unstable, could that not create an unsustainable GDP without inflation ever becoming an issue? Of course, a sudden drop in workforce participation does reduce demand as well as limiting supply.

“Doesn’t that happen with all posts?”

i thought I saw some that were not that way. I guess I need to put this on the list of things I remember seeing that I never really saw?

Arne,

Unsustainability seems to normally be an afterthought.

There is a mild disagreement on when posts need a page break…should a post be shown in whole as a way to draw more readers, or be short on the front page to accommodate mobile readers and provide quicker access and choice to the range of posts for the day. There is a read more built into the template that is automatic but sometimes winds up at the end when a whole post is posted on the front/landing page.

Just look at domestic capacity utilization and tell me why there is such an output gap. If the notion that supply will create its own demand is true, (it’s not), why aren’t producers increasing production? Here’s the table: http://www.federalreserve.gov/releases/g17/revisions/current/revchart1.gif

“So yes, Paul Krugman is right about potential GDP being a supply-side concept, but Keynes says that if you allow supply to create its own demand, you may be a fool.”

Are you seriously claiming that Krugman believes in Say’s Law?

http://krugman.blogs.nytimes.com/2013/02/10/still-says-law-after-all-these-years/?_r=0

Nanute,

Of course there is plenty capacity for production, even more in China and other countries. The US can only demand so much, so production is limited by demand.

Mark,

Of course Krugman does not believe in Say’s Law. But he is not making a correction to potential output due to weak demand. So it is confusing. He keeps talking about the output gap to return to previous trend, but when he says that, he does not include an adjustment for demand which is weaker now.

He and Dean Baker seem to think that as the economy would return to full employment, demand would increase so as to bring us back to the previous trend of real GDP. That sounds a little like Say’s Law to me.

I am saying that there is a demand constraint that won’t allow that to happen.

I am implying that if one does not adjust potential output according to a measure of limited demand, they fall on the side of Say’s Law. I want to see a demand adjustment from Krugman. I haven’t seen it yet. but he must have one, right?

“That sounds a little like Say’s Law to me. I am saying that there is a demand constraint that won’t allow that to happen.”

That sounds a little like Says Law to *me*.

The whole idea of a structural constraint to output and employment has far more in common with Says Law than it does with anything Keynes said. Like Keynes, Krugman and Baker argue that the only constraint preventing output and employment from attaining potential is the willingness of policymakers to make it happen.

Mark,

A structural constraint is not what Keynes referred to in Chapter 3. He referred to a concept of effective demand.

I am saying that policy makers have no control over the effective demand limit on the utilization of labor and capital. A fiscal stimulus without an increase in labor share would be ineffective to raise the effective demand limit. Money would still multiply through the economy at the same labor share rate.

Mark, It will come down to this over the next year, if the utilization of labor and capital blow right past what I see as the effective demand limit, then you were right. But in 1978, the utilization of labor and capital grew fast right into the effective demand limit over 3 months, and stopped like hitting a wall. If my view of the effective demand limit puts brakes on the utilization of labor and capital like I have seen it do since the 1960’s, then you were not right.

I am developing a new view of effective demand and doing all I can to make sense of it. It is my responsibility to make the ideas available. There is no one else.

I greatly appreciate the freedom the managers of this blog give me.

In the end, if I am right, we will have all learned something. Even Krugman says that we need to learn more about the business cycle and the conditions that surround the start of a recession. I am offering a view that has worked in all previous recessions, even the Volcker induced recession.

So far the data keep coming in within the limits of the way I determine effective demand. The moment of truth will come.

“A structural constraint is not what Keynes referred to in Chapter 3. He referred to a concept of effective demand.”

“Effective demand” as Keynes defines the term in Chapter 3 of the General Theory is simply the intersection of aggregate demand and aggregate supply. Your concept is something else entirely.

“I am saying that policy makers have no control over the effective demand limit on the utilization of labor and capital.”

The direction of causality matters. Labor share is Granger caused by the unemployment rate and the inflation rate but not the other way around. This is an empirical fact.

Mark,

Keynes did not simply define effective demand as the intersection of aggregate demand and aggregate supply.

It is where Z = D (aggregate supply price, Z, is equal to proceeds expected, D). And Z cannot go higher than D.

Keynes said that the aggregate demand function is D=f(N)

Here is how to set the effective demand equation as a function of N, number employed.

ED = Z * labor share/(capacity utilization * N/N*)

Z = real output, aggregate supply price… N* is total labor available.

As N rises, ED will get closer to real output, until they are equal. The limiting factor becomes labor share which gives the relative proceeds expected by entrepreneurs… relative to factor utilization in production.

Keynes never found the formula for effective demand. Others have tried. This one is working so far.

“Keynes did not simply define effective demand as the intersection of aggregate demand and aggregate supply.”

Here is the direct quote of the section where Keynes defines Effective Demand in Chapter 3 of The General Theory:

“Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = (N), which can be called the aggregate supply function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called the aggregate demand function. Now if for a given value of N the expected proceeds are greater than the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to increase employment beyond N and, if necessary, to raise costs by competing with one another for the factors of production, up to the value of N for which Z has become equal to D. 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 entrepreneurs’ 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.”

http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch03.htm

In other words “Effective Demand” is simply the point where AD and AS intersect, nothing more, nothing less. To be excruciatingly clear, Effective Demand is the price level and real output level that correspond to the point where AD and AS intersect.

Mark,

Keep reading… From same source,…

“The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. For “Supply creates its own Demand” must mean that f(N) and φ(N) are equal for all values of N, i.e. for all levels of output and employment; and that when there is an increase in Z( = f(N)) corresponding to an increase in N, D( =f(N)) necessarily increases by the same amount as Z. The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.”

Then read the paragraph after that and it is clear… that Keynes’ concept of effective demand is not simply where aggregate demand and aggregate supply intersect.

Z does not always equal D. Also, Z does not go higher than D.

This is what Keynes said.

You are saying that Z is always equal to D, and that is where effective demand is. That is not what Keynes said.

“Then read the paragraph after that and it is clear… that Keynes’ concept of effective demand is not simply where aggregate demand and aggregate supply intersect.”

Of course it is. Otherwise you are claiming that Keynesian economists have been totally misinterpreting Keynes for nearly 80 years.

“Z does not always equal D. Also, Z does not go higher than D.”

That’s because Z (AS) is an increasing function of N (employment) and D (AD) is a decreasing function of N:

https://en.wikipedia.org/wiki/File:AS_%2B_AD_graph.svg

“This is what Keynes said. You are saying that Z is always equal to D, and that is where effective demand is. That is not what Keynes said.”

Don’t be ridiculous. I’m saying AD and AS intersect at a single point. The classical point of view is that AD and AS are essentially the same curve and hence have an infinite number of points of intersection.

And, more importantly, Keynes believed that AD could be moved by policymakers and consequently the point of intersection, effective demand, is a policy choice.

Mark,

Then we are left with this from Keynes…

“Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.[

I know what your response would be… policy can control demand. and supply and demand move together at a crossing point.

Supply is below demand and they eventually cross where output is purchased by demand.

However, the effective demand limit is a limit that caps off output as output rises to it. It is not the crossing point that we always see in the AS-AD model.

Look at figure 1 in this link…

http://economics.adelaide.edu.au/research/papers/doc/wp2008-04.pdf

The idea is that D is a cap upon Z as more N is employed. The paper gives a model that can explain why a negative real interest rate would be necessary to reach full employment.

“In Keynes’s opinion there is simply no market mechanism, as postulated by the classical theory, to generate the natural rate of interest such that the point of effective demand automatically coincides with full employment in the long run. A point of effective demand established by a ‘wrong’ rate of interest – a rate inconsistent with full employment – is inevitable in a laissez faire monetary economy.”

We will see if my view of effective demand will allow real output to pass its limit, even with a negative interest rate. We saw in 1979 that the real interest rate was very low, but the utilization of labor and capital stopped at the limit of my equation.

My conclusion is that even with a negative real interest rate, utilization of labor and capital will be stopped at a composite value of 73% to 74%.

We will know soon enough.

“The idea is that D is a cap upon Z as more N is employed.”

The reason why D (AD) is a cap on Z (AS) is because AD exceeds AS to the left of effective demand, but AS exceeds AD to the right of effective demand. Entrepreneurs have no incentive to increase employment when AD is below AS.Thus if effective demand is too low to attain full employment AD must be shifted to the right.

On page 14 the same paper notes:

“Keynes’s policy recommendations now follow from his theory. On the fiscal side, the ‘socialization of investment’ aims to stabilize aggregate demand and lift the rate of return on private sector investment. On the monetary side, public control of the central bank is necessary to lower the expected normal rate of interest. Monetary management cannot be

avoided and there is no alternative but to convince the public that the central bank can manage the monetary system so as to produce a lower expected ‘normal’ rate of interest.”

In other words the lack of a market mechanism means policymakers must provide AD stimulus through fiscal and monetary policy. Keynes believed effective demand was a policy choice, not a structural constraint.

Mark,

“Keynes believed effective demand was a policy choice, not a structural constraint..” Was he right? And could it be that Keynes saw the policy choice was necessary due to a structural constraint?