# Come on Banks, take notice of the AS-AD-ED Model

From feedback, I need to write a better post about the AS-ED model. Thanks for the feedback from Coberly, Arne and David at CEPR. (link to previous post)

This post presents what could be a huge breakthrough in understanding the business cycle.

Banks and central banks should take notice here.

### Model of Effective Demand

Figure 1. This is a model for Aggregate supply, aggregate demand and effective demand.

People are familiar with aggregate supply and aggregate demand. In the AS-AD model, AS and AD always cross at the current real GDP and current core CPI, as shown at the red dot in the model. That red dot crossing point will move horizontally to the right as real GDP grows at a stable core inflation rate. Therefore, the AS curve in the model is horizontal to represent growing real GDP at a stable inflation.

### What is the Effective demand limit curve doing in the model?

Keynes described effective demand as the crossing point of aggregate demand and aggregate supply where aggregate profits are maximized. So as aggregate supply (real GDP) grows to the right, there comes a point where aggregate demand equals effective demand. In figure 1, that point is modeled around \$16,9 trillion. There profits would peak and the business cycle would begin a phase of deterioration into an economic contraction, unless other dynamics counteract the effects.

### What is the Basic Model for Effective Demand?

Figure 2. Basic Model of Effective Demand upon Production.

In figure 2, the upsloping straight gray line is the AS curve from figure 1 related to utilization of labor and capital. As labor and capital get more utilized, real GDP production increases. In figure 3, actual data shows that real GDP does move along this straight line from the origin of x and y axes. (2ndQ 2010 to present, quarterly) This pattern is seen in other business cycles too.

Figure 3. Real GDP grows in line with (capacity utilization * (1 – unemployment rate))

In figure 2, the curving upsloping line is the effective demand limit curve. I formulated its equation from predator-prey dynamics in Population Ecology (link) and the work of Samuel Bowles on Lenders and Borrowers under Inequality. (Bowles, Samuel. The new economics of inequality and redistribution. Cambridge University Press, 2012. pp. 42-50)

In figure 2, where the effective demand curve crosses the production curve at the stable equilibrium is the effective demand limit.

The equation for the Effective Demand curve in figure 2 is…

Effective demand limit upon real GDP = rGDP*e*T/L* (1 – (1 – 1/e)*T/L)

rGDP = real GDP
T = capacity utilization * (1 – unemployment rate)
L = effective demand limit function (labor share index * 0.76)
e = 3

The peak of the profit cycle of production can be forecasted with this model since real GDP moves in a linear path and the effective demand limit is projected onto that path. Real GDP moves toward the projected effective demand limit.

### How did the model do during this business cycle?

Figure 4.  6 years of Effective Demand limit curves show great consistency. (25 quarters!) (Refer back to figure 1 for the ED curve in the AS-AD-ED model.

In figure 4, ALL, no cherry-picking, all the effective demand limit curves for 6 years crossed the AS curve in a tight zone. (see oval in figure 4) As real GDP started moving to the right on the AS curve from \$14.5 trillion at the end of 2008, the effective demand curves were waiting around \$16.0 trillion. As a confirmation, when real GDP hit about \$16.1 trillion, the effects of the effective demand limit appeared. The ED crossing points along the horizontal AS curve have a standard deviation of \$130 billion, Not too bad!

The model was a complete success in retrospect.

The equation for the Effective Demand limit curves in figure 4 is the same equation given for the ED curve in figure 2 but with L (effective demand limit function) replaced with (unit labor costs/(1+core CPI))… Now the equation can be plotted in AS-AD-ED space with core CPI on the y-axis.

• L = U/(1+C)
• U = L*((1+C)… This is how U is calculated for the equation below, since L and C are given in the model.

Effective demand limit upon real GDP = rGDP*e*T/(U/(1+C))* (1 – (1 – 1/e)*T/(U/(1+C)))

U = unit labor costs
C = core CPI %

### Conclusion

The tightness of the zone where the ED curves crosses the AS curve for 6 years is significant. The tightness reflects stability of the effective demand limit.

Profits peaked when real GDP hit the zone marked with an oval in 2014 just as Keynes would have forecasted with his explanation of effective demand.

The peak of the profit cycle, which drives the economy and business cycle, began to come into view 6 years in advance!

Really Folks, let that sink in…

That is a huge breakthrough!!!

• The Effective Demand model holds up very well in reality.
• The over-riding relationship between labor share and the utilization of labor and capital is governed by profits.
• The ability to forecast the effective demand limit upon profit cycles has huge value for banks and their investment cycles.