Keynes’ Vision of Effective Demand is Unfulfilled
We hear that aggregate demand must be increased. Just today in a great article giving 3 mismatches that should be fixed in the global economy we read…
“First, aggregate demand is deficient relative to aggregate supply.” – (Restarting the global economy: Three mismatches that need concerted public action, Michael Spence, Danny Leipziger, James Manyika, Ravi Kanbur)
What they really want to say is that Effective Demand is deficient relative to aggregate supply. It is plain that economists still do not understand Keynes’ concept of effective demand. Keynes’ vision of effective demand still goes unfulfilled.
To explain effective demand, I refer to a book by Connell Fanning and David O Mahony, The General Theory of Profit Equilibrium: Keynes and the Entrepreneur Economy. Their book explores Keynes’ views on the profit equilibrium point of the effective demand limit.
Let’s read a bit from the book…
“In other words, the firm’s production and employment are determined by the maximum amount of profit it can hope to achieve and that amount is indicated by the highest point on the aggregate supply function at which it expects to be able to operate. This point is given by the highest level of proceeds it can expect to receive that is, the point of effective demand.”
“Thus the conditions of profit equilibrium may be said to hold when employment (in the individual firm) is such that effective demand and aggregate demand are equal.”
So right away we see a difference between aggregate demand (present demand) and effective demand (future demand limit).
When you look at the aggregate supply function, you see the aggregate demand function cross it at the current state of the economy. Then realize that there is a point on the aggregate supply function in the future where profits will be maximized. That distant point is the Effective Demand limit. When aggregate demand reaches this distant limit, aggregate demand will equal its effective limit and profits are maximized.
What we are really interested in knowing is where this future limit of demand is, because this limit ultimately determines if aggregate demand will end up being deficient for the business cycle. This is why I say above that the authors really needed to say effective demand and not aggregate demand.
How is Effective Demand defined?
In my research on effective demand I have equations to determine the effective demand limit. The basic equation says that labor share will determine the limit for the utilization of labor and capital. In this equation, the right side will tend to stay above zero.
0 < labor share index * conversion factor – (capacity utilization * (1 – unemployment rate))
- Effective demand is represented by… labor share index * conversion factor
- Aggregate supply is represented by… (capacity utilization * (1 – unemployment rate))
When aggregate supply is equal to effective demand, the economy has reached the point of maximizing profits. The economy will not grow at this point in terms of utilizing more composite utilization of labor and capital. And we see this in the data over the years. (link)
Would Keynes agree with this equation?
Fanning and O’Mahony do not have this equation in their book, but since they do a great job explaining the concepts of Keynes, let’s read from their book…
“The point on the aggregate demand function which becomes `effective’ by reason of its being intersected by the aggregate supply function may be said to become so because the entrepreneur decides on the scale of utilization of resources indicated by the point of intersection and so the quantity of output is effectively determined.”
I think that they would agree with my equation because the level of utilization of labor and capital resources is represented.
Would they agree with labor share to represent effective demand? Wouldn’t they also want debt or investment to be included? Let’s read more…
“Keynes’s analysis of the demand for output as a whole is derived from the recognition that `all production is for the purpose of ultimately satisfying a consumer‘”
“Thus an output/income is used both for the purpose of current or immediate consumption and for the purpose of making provision for consumption in the future. The latter is investment. … Accordingly, the demand for current output is attributable to consumption and to investment. In other words, total or aggregate demand, is the sum of the demand for current output for consumption purposes and for investment purposes. Ultimately, therefore, aggregate demand depends entirely on consumption. Or, as Keynes puts it, `Aggregate demand can be derived only from present consumption or from present provision for future consumption‘”
“It is expenditure for immediate consumption purposes only that is directly financed by income. Other types of expenditure, whether on a current output or not, are not directly financed out of income. That part of an income which is not used in the first instance to finance consumption is to be seen as an addition to personal wealth. In that way it constitutes the making of financial provision for consumption in the future and so does not involve demand for current output. For analytical purpose, expenditure even for consumption purposes, other than direct expenditure out of an income on the output the production of which generates the income, must be treated as coming out of wealth. That is to say, it must be treated as coming directly out of wealth and, therefore, only indirectly out of income. Thus on the basis of Keynes’s definitions it is only the expenditure for consumption purposes on the output associated with the income out of which the expenditure is made which is directly financed by that income.”
“Accordingly, it may be concluded that expenditure for consumption purposes on a current output comes from the income generated by that output and from that income only.”
The implication of the above excerpts is that current levels of income for consumer consumption solely determine the limit for output. Investment is based on consumer income. Tell me that does not blow your mind… Ultimately, the supply limit for utilizing labor and capital depends solely on the relative strength of consumer income. In effect, using labor share becomes the best approximation for the present income of the consumer relative to output. Labor share then becomes the best representative for effective demand.
Here on Angry Bear, Steve Roth writes about the importance of Personal Wealth. He is right to do so. Personal wealth is growing among the rich, and falling among the not rich. Ultimately, personal wealth is not a direct factor that determines an effective demand limit. Still, increasing personal wealth among the rich reflects the falling labor share which becomes the sole determinant for the effective demand limit.
The equation I put forth above is simple and has seen resistance from economists. Yet, the equation is working. When we rightly understand Keynes, we will see why the equation works.
Maybe there is an economist out there who could prove how and why this equation works to establish an effective demand limit. How does the percentage given to labor from national income determine the percentage of labor and capital utilization? Why does the relative strength of labor income to output become ultimately the sole limiting factor on output?
As for monetary and fiscal policies trying to push beyond this effective demand limit, the data shows that instabilities like rising inflation will result. The key to really understanding why monetary policies are failing may be due to falling labor share in advanced countries. From this perspective, the Federal Reserve should be more concerned about labor share.
Keynes’ ultimate promise will be fulfilled when a true equation for effective demand is proved.
“…..As for monetary and fiscal policies trying to push beyond this effective demand limit, the data shows that instabilities like rising inflation will result. ”
It’s already happening :
“…Check out London, Manhattan, Aspen and East Hampton real estate prices, as well as high-end art prices, to see what the leading edge of hyperinflation could look like.”
This explains why Yellen and the Fed are so eager to back off on easy money. Since monetary and fiscal policy is designed only to impact the already filthy rich , and since those constituents are now starting to experience troubling levels of inflation in the goods and services they consume , it’s clear that further stimulus would be counterproductive.
Take a bow , Fed. You’ve done your job well.
The take-away I get is that we need to increase labor share.
The question is, how can we do that?
Labor needs to fight…
Here are the 10 biggest strikes in the US…
Here is a long account of the labor struggles in the 1930s.
Here is a video on a labor strike in the 1930’s…
Fight for what, exactly? You don’t just go on strike because you’re mad as 773H, and you’re not going to take it anymore. McDonald’s employees strike for higher wages, and they will get replaced by machines that take their orders. The textile- and steel-workers went on strike for higher wages, and they’re gone — the jobs have been moved overseas.
So labor needs to fight, but what are the concrete goals?
There are many goals in many places of work. I agree with you that the environment is vague. How will unconnected people start supporting each other. One strike brings on supporters and they can grow to other places. If some workers can win wage increases, others will be inspired. When will it happen? I don’t see it happening this year.
One strike might bring supporters — IF the demands are reasonable. If they win higher wages only to see their jobs go overseas, or even just to a Right To Work State, or to see the company go bankrupt, they won’t be getting many supporters.
Perhaps the end of a entirely extractive capitalist system; rebalance of market system.
Political leaders relearn bigger does work for the economy of a nation.
Neither of those sound either reasonable or concrete.
Warren, there are those who believe the capitalist system has run it course and when the system fails because we did not fix the banking system the last time; it is on the verge of collapse now. When this happens we will be force to develop a new economic model.
I think some of the answers are embedded in what Joseph Stiglisz is saying in that with globalized corporations we need to update labors movement and share to “encompass the industry wide strike”. Striking at on plant or even just one company won’t cut it any more. Not in a predatory globalized capitalism world…Another shoe that must drop for labors share to increase is for the Balanced Trade Agenda with the variable rate tariff and currency manipulation, environmental and workers rights provisions must be included. The last thing is to stop all the illegal labor at the border along with corporate inversions and jobs theft from other countries…Yes we have reached the point of diminishing returns so we must act now to make the many changes as things will not get better until we all collectively do so. This is no longer just a union fight. We all have a dog in this fight of predatory global capitalism that has been raping our economy and country. Wake up and smell the coffee…IMHO.
Great comment of yours… The US has to stop racing to the bottom with the other countries. That means raising taxes on higher incomes, raising interest rates, distributing more to lower incomes, raising wages for middle and lower incomes, giving unions back their power to rebalance the economy…
Beene, I am not one of those who believe that the capitalist system has run it’s course. But let’s assume that that belief is correct, and that such a complete collapse does occur that we must develop a new economic model.
The only thing I can think of is actually Biblical. Just think — if EVERYONE gave away 10% of his income, would we have the problems we do now?
I think that would be far better than an all-powerful government that can give you everything you want and take everything you have.
I think you are right, William. But labor is divided, not united. The poor in India have no solidarity with the so-called poor in the United States. What we call poor here is unimaginable wealth to the poor in India and Africa. They have no compunctions about underbidding our workers.
Neither do the corporations have any compunctions about moving the factories to those low-wage countries.
I agree that we don’t want to be in a race to the bottom, but I just don’t see how we can get out of the race. Can we close our borders — no imports? Can we selectively close them — no imports from such low-wage countries?
I understand god is not in vogue; and I was never a good christen, but I always get stuck on where the first atom came from.
Anyway capitalism is one word with a lot of different views on definition. We have the past century to show us what parts of it worked and what parts failed.
Warren, you and Lambert seem to have one version of how we are going to get there. I believe in a more catastrophic event to get the changes needed; but hope you and Lambert are right.
I have watched youtube vids on much more socialist economic models being formulated.
No, Beene, I really don’t have a “version of how we are going to get there.” In fact, I don’t even know where there is.
Neither do I think that we know what parts of capitalism work and which do not, because we do not have agreement on what the word WORKS means in an economic context.
Warren, aside from economist using different formulas and definitions, which like weather reports may be right some times.
We have a historical evidence of what Works best for the nation and the greatest number of people.
Starting with TR with working on eliminating monopolies, and congress and FDR finished the work.
What do you mean “works best for the nation and the greatest number of people”?
Works in what way?
greatest number of people…..middle class expanding
works best for the nation…….the nation is a creditor not a debtor nation
Again, Beene, you are missing a key piece — the measure of “good”.
In another thread, we are discussing the difference in quality of life between Europe and the United States. Is “good” to be measured strictly by one’s income? By the size of one’s house and the number of one’s vehicles? By the number of hours (not) working?
Do we measure “good” by equality of opportunity or equality of outcome?
How do we even define “middle class”?
Warren…anytime the majority of the nations people financial condition is improving it is a measureable good.
Then opportunity and outcomes are a given.
Are you being obtuse; just bored and texting?
“[Anytime] the majority of the [nations’ people’s] financial condition is improving it is a [measurable] good.”
Aside from a few recessions thrown in here and there, has that not been happening?
Warren, no what has been going on for the past 30 to 40 years the middle class has been getting smaller.
How’s that, Beene? By what measure?
Warren by any measure that does not redefine middle class. we might even trust the economist here on the board for an straight answer on this one. Not to mention frequently being mentioned by the fourth rail and even taking heads.
How’s that, Beene? By what measure?
Warren we come full circle; back to the original answer…which was….when the majority of the nation are improving their financial worth.
I would say that, for the vast stretch of this nation’s history, punctuated by a recession or depression here and there, the majority of the people of this nation are improving their financial situation.
According to the latest numbers available from the Census Bureau, in 2014, the median income for men aged 55 to 64 was $43,280. In 2004, that group (aged 45 to 54) had a median income of $52,471. In 1994, that group’s median income was $48,458. In 1984, their median income was $39,281. And in 1974, their median income was $11,751.
(All numbers are inflation-adjusted, 2014 dollars.)
The same pattern holds throughout. Except for the 55-64 age group, median income has increased with age, even adjusting for inflation.
Warren if you go to URL below (page 15) you will see that the number of Americans living in Poverty has steady increased steadily increased over the past 45 years.
The number of a nations poor cannot increase if the majority of the nation is doing better financially.
The Poverty and Inequality Report 2014 – Stanford University
web.stanford.edu/group/scspi/sotu/SOTU_2014_CPI.pdf – Cached – Similar pages
precisely the type of safety net that many people want. Implication: The safety net responded reasonably well to the challenges of the Great Recession.
Warren, I should have said in the above statement that the number living in poverty has more than doubled in some cases. The only segment of the population that did no change much was retired people.