New Variable for Effective Demand Limit… part 2
For those nutty readers that follow the effective demand story that I present on Angry Bear, today, the first day of 2015, marks a breakthrough. I just posted yesterday a model to expand the variables for assessing the effective demand limit upon production. Today a new variable is added to the mix with interesting results…
Here is the graph that ended the previous post…
Graph #1
We see an effective demand limit (orange line) upon the production cycle of utilizing labor and capital (blue line). The problem remained that there were still gaps that had to be filled. Let me point them out.
Graph #2
If I increased the coefficient on the variable for monetary policy (ED-FF), I could close the gaps at 1981 and 2000, but a gap would then open up at 1979. Like this…
Graph #3
Would it be possible to close the gaps in graph #2 without opening up other gaps that have already closed? It almost seems impossible or super complicated?
Well, let’s go back and look at the stagflation of the late 70’s. What happened? The abrupt rise in commodity prices produced a price supply shock which affected demand to the extent that production had to be cut. As the effective demand model is designed to show the times when production is cut, it has to incorporate the effects of supply shocks too.
So I incorporate another variable into the limit function. Let me first place the new graph which incorporates this new variable.
Graph #4
Let’s analyze this graph first… You will see that the huge gap in 1981 closed while the gap in 1979 did not open. Closing that gap in 1981 is a big accomplishment in understanding the effective demand limit.
You will also see that the gap in 2000 closed. This also was an important gap to close in order to coincide effective demand with the beginning of the 2001 recession. You will also see that the gap from 1995 to 1998 was stable. Maintaining the stability of this gap in the model was important because the economy was riding the natural limit of real GDP in a stable way during those years. Production increases through 1997, but fell back to below effective demand.
We can also see that effective demand was biting into production in 1988 setting up the eventual recession which started in 1990.
So, what variable did I include? It is a variable for supply shocks that trigger stagflation… The variable is the Consumer Price Index of all items, yoy%. (link) Simply put, I incorporated inflation. The idea was to see how much a forced rise in prices to consumers would affect the effective demand limit.
Graph #5
Inflation had large jumps in the 70’s. Those jumps might close that gap that opened up in 1979 (see graph #3). The idea is that a quick jump in prices will take the consumer by surprise to the extent that they will lower their demand for production. If this jump happens close to the top of a business cycle, it can lower effective demand to where it falls upon expanding production and cuts short the business cycle expansion.
The equation of the limit function in graph #4 is…
Limit function, L = 0.765LS + 10NX/rGDP – 55CPIall + 80(ED-FF)
LS = labor share index, 2009 base year
NX = net exports
rGDP = real GDP
CPIall = year over year % change of CPI for all items.
ED = policy rate prescribed by Effective Demand Monetary rule
FF = Fed Funds rate
This limit function (L) is then entered in the effective demand equation…
Effective demand limit, EDL = rGDP*a*T/L (1 -(1 – 1/a)*T/L)
T = TFUR, capacity utilization * (1 – unemployment rate)
a = coefficient, set at 3.
How can you do this equation at home? You first set the coefficients for the variables LS, NX/rGDP and CPIall. This gives you a baseline for the limit function. Then you add this baseline into the Effective Demand monetary rule (ED) to evaluate the reaction function of monetary policy (FF) to the baseline economic conditions. Then you feed back (ED-FF) into your limit function and adjust the coefficient on (ED-FF).
So you have to use a monetary rule based on the limit function (L) and then compare it to the actual Fed rate. Since I am the only economist currently with a monetary rule based on a this type of limit function to the utilization of labor and capital (TFUR), an economist would have to use my Effective Demand Monetary rule to crunch the numbers. They would not work in the Taylor rule, unless it was modified.
Some Reflections
It seems the large overshoot of effective demand in 1973 reflects the extent to which the economy was taken by surprise with higher commodity prices, such as fertilizer from Peru and oil from OPEC. Inflation began to rise briskly due to that overshoot. Production was not cut in an attempt to hold down inflation apparently. And even though there was another supply shock later in the 70’s, we do not see an overshoot of effective demand due to a response that raised effective demand by combining a higher labor share with a much more accommodative monetary policy.
At this point, this new equation is saying that there is currently spare capacity still available to the economy and that the unemployment rate would go down to 5.5%. When we eventually see the top of this business cycle, we will have another data point to refine the coefficients in the limit function. Still, the equation is showing a zone where the utilization of labor and capital (TFUR) will hit a limit.
Going forward… the limit function tells us that there are various ways to extend the present business cycle.
- raise labor share
- keep the Fed rate as low as possible, ZLB
- increase net exports as a share of GDP
- keep inflation low
The equation does not tell us about the risks from pushing the business cycle beyond a balanced state. It only tells us how we can extend or cut short the business cycle. Everything is being done at the present moment to extend the business cycle, except for raising labor share. Is this good? Time will tell…
One final note… Look at how production overshot the effective demand limit between 2005 and 2007 in graph #4. It should not be that tight, otherwise a contraction in production would have occurred earlier. The reason is that long term interest rates did not rise at the same pace as the overnight Fed rate. The reason normally given points to the foreign funds flooding back into the US from countries like China. So monetary policy was not as tight as the limit function is assuming. So the variable (ED-FF) will have to incorporate a measure for the differential between short-term and long-term interest rates.
The equation is not perfect yet, but it is getting better.
How does this revision interact with your view on the Fisher Effect in terms of desirable Fed rate?
“abrupt rise in commodity prices produced a price supply shock which affected demand to the extent that production had to be cut.”
This terminology doesn’t make sense to me. There is a proper economic term for this – a terms of trade shock. Why don’t you look at the terms of trade explicitly (import price index / export price index)?
P.S. In general I see your point and think foreign trade leakages (perhaps due to reserve currency status), with some forward effects from import prices (or more accurately expected import prices). My big beef is with general equilibrium models which cannot really explain persistent trade imbalances (quite simply using a general equilibrium model when you are not anywhere near global equilibrium is in my view daft).
Your emphasis on distribution (i.e. labour share) is in my view displaced, mainly because I see labour share as a symptom not a cause, and not really accessible to direct policy intervention anyway (apart from a massive increase in government employment bidding up the price of labour, I suppose). I suppose you could also claim that falling labour share reflects a de-facto monetary policy target of low nominal wage growth, so perhaps nominal GDP growth should be your emphasis. But an undervalued dollar will also push down labour rewards relative to capital rewards because it makes the marginal relatively labour intensive industry less competitive internationally.
Oops
I said in my previous post “undervalued dollar” should have been “overvalued dollar”. Apologies for any confusion.
Edward,
You wrote: “It seems the large overshoot of effective demand in 1973 reflects the extent to which the economy was taken by surprise with higher commodity prices, such as fertilizer from Peru and oil from OPEC. Inflation began to rise briskly due to that overshoot. Production was not cut in an attempt to hold down inflation apparently. And even though there was another supply shock later in the 70′s, we do not see an overshoot of effective demand due to a response that raised effective demand by combining a higher labor share with a much more accommodative monetary policy.”
Assuming that free markets controlled oil prices from 1973 to 1985 ignores history. And other commodity prices were insignificant when compared to the effects of oil prices during those years.
History:
1. By the early 1970s, OPEC wanted higher prices for their oil.
2. On 6 October 1973 the Yom Kippur War begins
3. On 16 October 1973 OPEC announced a 70% price increase in oil
4. On 17 October 1973 OPEC announced they would cut production by 5%
5. 19 October 1973 President Nixon requested emergency aid for Israel
6. Libya immediately announces that it would embargo oil shipments to the US.
7. On 20 October 1973 Saudi Arabia and other arab states followed Libya’s policy
8. The oil embargo was then extended to Japan and western Europe.
9. Oil prices rose dramatically by January 1974
See this: http://en.wikipedia.org/wiki/1973_oil_crisis
And this: https://history.state.gov/milestones/1969-1976/oil-embargo
Oil price per barrel history (Nominal):
December 1973 —–$4.31
January 1974 ——–$10.11
January 1979 ——–$14.85
April 1980 ————-$39.50
November 1985 —–$30.81
March 1986 ———-$12.62
See this: http://research.stlouisfed.org/fred2/series/OILPRICE
For yearly average nominal prices and prices in 2014 inflation adjusted dollars see this:
http://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp
None of this was due to the actions of free markets. OPEC dominated the production and sale of oil and they did what monopolies do.
Thus trying to model the US economy over any time period which includes the years from 1973 to 1986 is a nightmare. Either you assume that powerful monopolies are never acting or you assume that they are always acting.
You use an inflation variable to compensate for these oil price movements. (They did strongly affect inflation.) But in the process you have probably injected noise. (Dust) At the very least, consumers attempts’ to keep up with constantly rising prices were causing them to demand higher pay which insured even higher inflation. That interplay has not existed over the last 15 years or so, as wages have stagnated.
Edward,
I have a no nonsense commonsense rule. Consumers can not spend what they do not have and producers will not produce what they can not sell.
I believe that your work on effective demand implies the same thing.
The supply siders love the forest hidden behind all those damnable trees. It never seems to occur to them that our economic system is all about consumers and that we loudly condemned the communist system which attempted to ignore them.
Thus we get Stephen Moore’s opinion piece defending supply side economics with this:
“The Laffer model countered that the primary problem is rarely demand — after all, poor nations have plenty of demand — but rather the impediments, in the form of heavy taxes and regulatory burdens, to producing goods and services.”
What can produce such blindness? Need or desire without income is somehow “demand”!
Let’s hear it for “Supply and Wishes” based economies. Maybe NOT.
Hi Arne,
The Fisher effect depends on the forces to produce or reduce inflation. Basically when the Fed rate becomes stuck in one place for a long period of time, inflation becomes untethered and floats away, like a boat from a dock. Where will inflation go? That depends on the forces moving inflation.
Currently there are forces toward lower inflation. Consumers are losing strength. There is less incentive to invest in productive capacity in the US. Productivity is high and unable to increase more. And now we have oil prices coming down.
So the Fisher effect is a combination of stuck nominal rates and forces for lower inflation. The Fed is unable to move inflation as they would want. But like many say, the Fed is content with low inflation because demand is not inhibited by higher prices.
Hello Reason,
The CPI is more than terms of trade. It is domestic prices influenced by terms of trade, exchange rates, domestic commodities, domestic wages, domestic asset values, and even production. With more domestic production, inflation would come down. It is more than the influence of foreign prices.
Then to your second point about labor share. It is more than a symptom. It is a cause of profit rates.
In the limit function above, replace LS with real wages/productivity. It is the same thing. LS determines profit rates of capital.
Think of it this way… Production is going to make money. Underlying production is a balance between how much will be paid to labor, and how much will be received from labor. Labor has a higher propensity to consume than capital. If you change labor share, you will change production.
Happy New Year Jim,
Let me clarify a point. In the article, I wrote, “The idea was to see how much a forced rise in prices to consumers would affect the effective demand limit.”
I used the word forced for a reason. Sometimes inflation is part of normal free market dynamics, for example when wage increases lead to higher prices. Other times inflation is forced upon a free market.
In 1973, I see the rise in oil as forced upon the US. However, in 1979, the US was prepared for the oil price increase and quickly matched it with wage increases which then became ingrained… something which Volcker had to undo.
The model above takes into account both types of inflation, forced and assimilated. Each scenario produces inflation, but effective demand will be different in each case.
In 1973, effective demand stayed low because labor share rose mildly and monetary policy was very slow to react. An accommodative Fed rate started to kick in mid 1974. Production was slow to react too.
Eventually with the use of computers and faster access to data, the economy is responding much faster to everything, even inflation. 1973 was a wake up call for everyone to get faster control of economic data.
I think if you hit businesses nowadays with the same supply shocks of 1973, they would cut utilization of labor and capital faster.
You bring up a good point too… In 1973 and 1979, wages were being bargained up partly because labor had bargaining power. After Reagan came in, their power diminished and since then, it is much harder to bargain up wages in the face of inflation. This is one reason why now, businesses do not want inflation because it would bring back the need for bargaining power for labor.
Edward,
“This is one reason why now, businesses do not want inflation because it would bring back the need for bargaining power for labor.”
I can’t let this one slide by. If inflation was out the roof, employers would argue to the bitter end that raises were impossible and they would make it stick.
The difference between today and 1980 is that today there are a shortage of jobs. American corporations have moved so much production overseas that we now have a job shortage. Supply and Demand was always the controlling factor and now the Supply of labor exceeds Demand.
In other words, once we consumed the product of each other’s labor. This maintained an on going demand for productive workers. “Those days are gone.”
Jim,
So true… your words.
“Then to your second point about labor share. It is more than a symptom. It is a cause of profit rates.
In the limit function above, replace LS with real wages/productivity. It is the same thing. LS determines profit rates of capital. ”
What policy instrument do you think determines LS? As I see it, manufacturing profits are low while FIRE profits are high. Hint, hint, hint – investing in real productive capacity in the US is not very profitable, as I see it because of a chronically overvalued dollar as indicated by a chronically high trade deficit. That means that there is no broad based demand for capital working labour, and so wages fall, while a combination of low taxes (and low government investment), high leverage, ever more generous IP rules and the US dollars popularity as a reserve currency are pushing profits (or rather rents) up in the FIRE sector.
What I don’t see is what you think can be done about low LS. I read Dean Baker and I understand what he thinks can be done about it. I don’t understand what you want to do about it, because in my view you are seeing the consequence as the cause. Ever higher leverage and an overvalued dollar, combined with wage growth paranoid monetary policy are allowing profits to rise at the expense of labour. You can’t just wish that employers will pay their workers more, you have make them want to pay their workers more, because otherwise they will go somewhere else. (Or the alternative is to just give everybody some more money – a citizen’s dividend and increase taxes so that those with a higher propensity to consume have a higher share of the income.)
Reason,
Sorry for answering late here.
You say that you read Dean Baker… His view is that wages will rise when unemployment gets lower. That has been the trend in the past, but we will not see that as much this time.
You also say that wages will rise when employers want to pay their workers more. I agree with you. From what I see, employers are colluding to keep wages low. Evidence is emerging now.