New Variables for the Effective Demand equation… part 4
For those who have read this series of posts, you have seen the evolution of an Effective Demand model. At the end of this post, you decide if the model is useful.
The last two variables added to the limit function are for government expenditures and investment. Here is the final equation.
Effective Demand limit function, L = 0.70*LS + 20*NX/rGDP + 20*G/rGDP + 20*I/rGDP – 110*CPIall + 78*(ED-FF) – 75*(yoyC,10year-FF)
LS = labor share index (non-farm business sector), 2009 base year
NX = real net exports
rGDP = real GDP
G = real Government consumption expenditures and gross investment
I = real Gross private domestic investment
CPIall = year over year % change of CPI for all items.
ED = policy rate prescribed by Effective Demand Monetary rule after non-monetary variables have been set.
FF = Fed Funds rate
10year = 10-year Treasury Constant maturity rate
The equation has variables for domestic consumption power (LS), foreign consumption power (NX/rGDP), government consumption (G/rGDP), private investment (I/rGDP), inflation (CPIall) and monetary policy (ED, FF & 10year treasury). All these variables impact demand.
I gave NX, G and I the same coefficient (20) for parity in the equation. The other coefficients were designed to give a consistent limit. I explain this below.
I have put all these variables into an equation for effective demand… NOT AGGREGATE DEMAND, which is always equal to real GDP. Effective demand is the limit upon the utilization of labor and capital for production… and is by definition only equal to real GDP near the natural limit of real GDP.
So here is the graph of the equation above. The orange line is the effective demand limit function that marks the peaks of the TFUR business cycle (blue line). (TFUR = (capacity utilization * (1 – unemployment rate)).
Here is the graph showing the difference between effective demand and the TFUR since 1967 in the above graph. (Effective Demand – TFUR)
The TFUR consistently goes beyond the effective demand limit by almost exactly -1.0%. Of the 13 peaks in this second graph, 9 of them fall very close to the -1.0% line. Two fall closer to -2.0%. One falls at -3.5%. One falls at just under 0% (1984). The coefficients of the equation are designed to give this consistency.
By lining up the peaks on the consistent line of -1.0%, the probability increases that the next business cycle will end near the same -1.0% line. The probability was 92% that the TFUR peaks fell between -0.2% and -2.2% since the 1960’s. The probability was 69% that they fell almost exactly on the -1.0% line.
Of the three peaks that fell below -1.0%, two led to very deep recessions (1973 & 2007). The deep peak at 1997 was due to the 10-year treasury temporarily increasing in relation to the Fed rate (year-over-year change). If not for that 10-year treasury increase, the peak at 1997 would have stopped at -1.0%.
So this model of effective demand gives a reliable and consistent limit function.
In 2015, the TFUR will get closer and closer to the effective demand limit. The TFUR will rise by employing more labor and capital. On the other hand, effective demand can fall in many ways…
- Labor share drops further
- net exports fall
- government expenditures as a % of real GDP falls more
- private investment as a % of real GDP stops rising
- inflation rises
- the Effective Demand Monetary rule starts prescribing a lower rate
- the Fed rate rises
- the 10-year treasury rate rises more than the Fed rate over the past year.
Please not that some of your items could be rearranged. For instance the fed funds rate could be converted to the REAL fed funds rate using inflation (as a proxy for expected inflation). This might be closer to what modern Keynesians would call the monetary policy setting.
Maybe I’m just a little too dense, but I’m finding these jargon heavy posts a bit difficult to comprehend. I’m not a professional/academic economist. I can tell you that if you want to reach out further than that club you have to start to explain in more common terms what the model is trying to explain and what the details of the model mean in each case. For example, “TFUR business cycle” is apparently an important part of the model and, therefore, one’s comprehension of the post. I’ve looked through the post carefully, but find no definition of TFUR. Too many equations that don’t immediately reflect their real world origins. Too many algorithms, as though putting the discussion in an arithmetic frame makes it more understandable. I don’t find that to be the case.
“At the end of this post, you decide if the model is useful.” I’d much prefer that you explain in layman’s terms how it is useful.
Hi Reason,
I could subtract inflation from the Fed rate but I would just subtract it from the ED variable. There would be no change in the equation.
But it is ok… The equation says that the Fed reacts to economic demand conditions which include full inflation, not core inflation. The Fed rate and the ED rate that I use are based on core inflation because it gives a better response to full inflation.
The real interest rates are incorporated in the mechanics of the equation. The ED rate’s equation first calculates the proper short term rate then makes an adjustment for core inflation from target.
Hi Jack,
Right above the first graph I put the equation for the TFUR…
“(TFUR = (capacity utilization * (1 – unemployment rate)).”
You multiply the utilization of capital by the utilization of labor to get a composite measure. TFUR stands for total factor utilization rate.
Let me put the equation into layman’s terms. There is a demand limit upon the business cycle. I view the business cycle as the utilization of labor and capital (TFUR). When the TFUR starts to go down, that can be considered the start of a recession for an employed person, even though the official recession doesn’t start for many quarters later. For me, the TFUR is a more grassroots measure of economic expansion and contraction.
Upon this cycle of utilizing labor and capital, there is demand potential which will ultimately limit the production from labor and capital. The limit function measures this demand potential.