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.