A New Model of the Economy Please

Brad DeLong wrote recently concerning the Uncertainty at the Fed

“The heart of the trouble consists in the fact that neither financial-market participants nor, it seems, the Fed itself know the true state of the economy or how best to model it – especially in the wake of the 2008 financial crisis” (link)

It is a fact he says. The Fed and others do not know how best to model the state of the economy.

I stand alone with a new model for an Effective Demand limit as Keynes envisioned it.

The basic concept behind the model is that the percentage that labor receives of national income determines a limit upon the utilization of labor and capital in production. The key idea is that capital income based upon utilizing capital resources is optimized at the effective demand limit. Thus capital does not want to go beyond the limit because it begins to consume its power position in the aggregate. Capital seeks to consume labor income while maximizing its relative strength in the economic flow of money.

So why is my model good? While Brad DeLong points out the confusion from the Fed, my model is not confused.

  • It knows why capacity utilization is dropping and why unemployment stays low.
  • It knows why the output gap has continuously been revised downward, because the output gap was closed years ago in this business cycle.

output gap update

  • It knows why the Fed seems to want to normalize rates. The economy is at the end of the business cycle. Rates are supposed to be close to normalized by now.

So the confusion over where the state of the economy is has led to the uncertainty that Brad DeLong writes about… on both sides, the central banks and the market participants. We see a situation where the market participants see a different economic potential than economists. They have seen limitations in this business cycle. Yet the Fed is still waiting for inflation and demand to pick up, while top line revenue of firms has already topped out in the aggregate.

The Fed still sees that this business cycle will stay alive for another two years.  The disconnect has been severe for many years causing sluggishness in the economy.

The Fed does not want inflation above target because higher inflation causes distortions and slows growth. However, they have entered another situation where there models are misreading the state of the economy and leading to sluggishness anyway.

What is the equation of the effective demand limit?

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

T = capacity utilization * (1 – unemployment rate)
L = an effective demand limit function (Labor share index * 0.76)
e = 3 … coefficient to set maximum of effective demand at the stable equilibrium with production.

Effective labor share (L) determines the limit upon the % utilization of labor and capital in production. The following graph portrays Keynes’ vision of Effective Demand quite well. Let’s bear in mind that Keynes never gave an equation for effective demand. He only described how it seemed to work.

This equation works. The economy has followed this model for as long as we have data for capacity utilization… since 1967 to now.

limit model 4d

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