What is Effective Demand? Keynes made it a central concept of his great General Theory book. But what is it? Well, the idea is that there is only so much demand in the population for products. And that low demand can keep the economy from reaching full employment. How does that work? Keynes pointed to profits. Once firms see that profit rates stop rising, they stop increasing utilization of labor and capital. If profit rates stop increasing before full employment, well… we just won’t reach full employment now, will we?
Such is the thinking of Keynes on effective demand. But I want to show another part of the story related to the marginal consumption of employees. Here is the thinking. Employees will increase their real spending up until the effective demand limit, at which point employees simply maintain their spending and firms have no increasing demand profit motive to increase production.
Below is a graph. The orange line shows real personal consumption expenditures per employee (In FRED, DPCERX1A020NBEA/PAYEMS). In 2013, the orange line reads as around $77,000 of real consumption per employee. The blue line is the UT index which reflects the Effective Demand limit. (UT stands for “Unutilized Total” of potential labor and capital.) The equation for the UT index is…
UT index = effective labor share – (utilization of capacity * utilization of labor)
The effective demand limit is seen when the UT index (blue line) goes to zero. That’s when the real output of the economy reaches the effective demand limit. (graph has annual data to 2013) (Source of data from FRED.)
If you look close, real consumption per employee seems to decelerate as the economy reaches the effective demand limit. The orange line drops in relation to its exponential curve of growth. To see this better, the Year-over-Year difference of the orange line is plotted against the UT index in the following graph. (Note: A value of 0.002 on the right axis means that real consumption per employee rose $2000 from the previous year to the current year.)
Now we can see that the changes in real personal consumption per employee move similar to the changes in effective demand.
We are glimpsing some micro-foundations behind effective demand. It’s like this… As more labor and capital is employed, the UT index goes to zero at the effective demand limit. Yet, at the same time, the change in consumption per employee will tend to zero also. As the change in real consumption per employee goes to zero, growth of profit rates will reach their maximum. In the aggregate, Firms do not increase marginal consumption per employee. So, the marginal consumption benefits per employee maximize.
Firms may try to employ more employees, but to increase the profit rate, they will lower utilization of capital capacity. We saw this throughout the 90’s. We are now seeing once again that real consumption per employee is trending to zero growth. If unemployment continues to decline, I suspect we will see capacity utilization stall or fall.
Here is the most recent data for quarter to quarter change in real consumption per employee. (Note: In this graph, the FRED codes for real consumption per employee are PCEC96/PAYEMS.) These codes give recent quarterly data.
The lines continue to move together. The uptick in real consumption per employee in the first quarter 2014 is most likely due to the “winter freeze” on hiring, while people still had to spend money. The result is more spending per employed person. This uptick gave some incentive for businesses to hire in April. Yet, I expect growth in real consumption per employee to adjust back down. So, hiring will slow down through the summer.
Another factor to take into consideration is the consumption by the rich. They have been consuming a great deal. Yet, 2013 was a great year for stocks and housing. 2014 not so much. Consumption by the rich will decline in 2014, which will tend to lower consumption per employee and reinforce the effective demand limit.
In all, the marginal consumption rate per employee has fallen back down to near zero since the crisis. The economy is experiencing weak effective demand. I foresee the utilization of labor and capital will be moderate moving forward.