# New Variable for Effective Demand Limit… part 3

The effective demand equation has made great progress in the last week in spite of me being really sick with fever and congestion. And so I continue the development of the effective demand equation for those nutty readers of Angry Bear blog (meant with respect and camaraderie).

I wrote in part 2 that the model needed a variable to measure the differential between short-term and long-term interest rates. Many times monetary policy is not as tight as the short-term overnight Fed rate may lead us to believe. The Fed can raise the Fed rate, but then watch as long-term rates don’t rise. This happened before the crisis. Monetary policy turned out to be looser than by just looking at the Fed rate.

So I included a variable… the change year-over-year of the difference between the 10-year Treasury ad the Fed rate. (link to data) The limit function now looks like this…

Limit function, L = 0.765LS + 15NX/RGDP – 70CPIall + 70(ED-FF) – 15(10year-FF, yoychange)

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

10year = 10-year Treasury Constant maturity rate

So if the 10-year treasury rises more, point per point, than the Fed rate over the previous year, the limit function drops showing that monetary policy is tighter than just seen from the Fed rate alone. Say the 10-year treasury rose 1% more than the Fed rate over the last year, then the limit function would drop by 0.15%.

This new variable adds a minor adjustment, but QE depended upon this variable. QE sought to increase effective demand by lowering longer term interest rates. Ultimately the effect was minimal as this equation says.

OK… now the graph of the new limit function (orange line).

The tops of business cycles are marked. Whenever the utilization of labor and capital levels off or falls (TFUR, blue), the limit function (orange) either crosses it or caps it. (The overshoot of 1973 was a wake up call for supply shocks. Look how deep the blue line fell afterward.)

What I find most remarkable about this new equation is that it marks the recessions artificially fabricated by Volcker in the 80’s without losing the match to other peaks.

One quick point – by including the rate of inflation, you are including exactly the indicator that triggers action by the fed.

By the way, I don’t know that what you are showing is a big deal surprise to any Keynesians, who always see effective demand as the limiting factor in economies. The question is what is driving the negative slope on your effective maximum capacity utilitisation curve, which (apart from a sudden fall the early 80s and a rise till the mid 90s ) looks pretty much like a straight line falling at about 5% a decade. I suspect monetary policy is large part of the story, but maybe demographics plays a part as well.

Reason,

You are astute. When the coefficients are found to balance the effective demand line upon the peaks of the TFUR, it becomes plain that the battle between the Fed and inflation is most of the story. Sometimes the Fed is able to control inflation and sometimes not. But the battle moves the effective demand line more than anything.

The downward tendency of the effective demand line is due to 3 long-term trends… 1. declining labor share. 2. declining government expenditures as share of real GDP (not in this version of the equation) 3. declining net exports.