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 %
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.
The model above is worth lots of money to banks.
Any bank want to hire me? ¯\_(ツ)_/¯
Questions and comments below.
In its report on “The long-term decline in prime-age male labor force participation,” President Obama’s Council of Economic Advisers writes:
Conventional economic theory posits that more ‘flexible’ labor markets—where it is easier to hire and fire workers—facilitate matches between employers and individuals who want to work. Yet despite having among the most flexible labor markets in the OECD—with low levels of labor market regulation and employment protections, a low minimum cost of labor, and low rates of collective bargaining coverage—the United States has one of the lowest prime-age male labor force participation rates of OECD member countries.
Although it has indeed become conventional, the ‘flexible’ labor markets mantra is not a theory. It is dogma. An article of faith. The theory behind the nostrum of flexible labor markets is Milton Friedman’s natural rate theory of unemployment, which, as Jamie Galbraith pointed out twenty years ago, was constructed by adding expectations to the empirical Philips Curve observation of a relationship between unemployment and inflation:
The Phillips curve had always been a purely empirical relation, patched into IS-LM Keynesianism to relieve that model’s lack of a theory of inflation. Friedman supplied no theory for a short-run Phillips curve, yet he affirmed that such a relation would “always” exist. And Friedman’s argument depends on it. If the Phillips relation fails empirically— that is, if levels of unemployment do not in fact predict the rate of inflation in the short run—then the construct of the natural rate of unemployment also loses meaning.
Galbraith’s evisceration of the natural rate theory and NAIRU is incisive, persuasive and accessible. Read it.
At the other end of the flexibility spectrum, intellectually, is Layard, Nickell and Jackman’s Unemployment: Macroeconomic Performance and the Labour Market. In their influential textbook, Layard et al. grafted the dubious NAIRU concept onto the archaic lump-of-labor fallacy claim to create their own chimera hybrid, the LUMP-OF-OUTPUT FALLACY.
Galbraith’s “Time to Ditch NAIRU” has 293 citations on Google Scholar. Layard et al’s “Unemployment” has 5824.
To appreciate the pretzel logic of Layard et al., one has to first understand that the old fallacy claim is essentially an inversion of the “supply creates its own demand” nutshell known as Say’s Law. Jamie’s dad, John Kenneth Galbraith, had argued back in 1975 that Say’s Law had “sank without trace” after Keynes had shown that interest “was not the price people were paid to save… [but] what was paid to overcome their liquidity preference” and thus a fall in interest rates might encourage cash hoarding rather than investment, resulting in a shortfall of purchasing power.
So, at one end of their graft Layard et al. were resuscitating the old dogma that Keynes had supposedly “brought to an end.” At the other end of the graft was Friedman’s tweaking of an atheoretical empirical observation — the Philips Curve — that was “patched into IS-LM Keynesianism to relieve that model’s lack of a theory of inflation. (James Tobin once elegantly described the Phillips curve as a set of empirical observations in search of theory, like Pirandello characters in search of a plot.)” And let’s not even get started with IS-LMist fundamentalism.
Churchill’s “riddle wrapped in a mystery inside an enigma” quip about the Soviet Union has nothing on Layard et al.’s antithetical and anachronistic graft on a tweak of an atheoretical patch on an unsatisfactory “attempt to reduce the General Theory to a system of equilibrium,” as Joan Robinson described IS-LM “Keynesianism”:
Whenever equilibrium theory is breached, economists rush like bees whose comb has been broken to patch up the damage. J. R. Hicks was one of the first, with his IS-LM, to try to reduce the General Theory to a system of equilibrium. This had a wide success and has distorted teaching for many generations of students. Hicks used to be fond of quoting a letter from Keynes which, because of its friendly tone, seemed to approve of IS-LM, but it contained a clear objection to a system that leaves out expectations of the future from the inducement to invest.
And by “expectations,” Keynes clearly had in mind uncertainty, not honeycomb equilibrium.
So that’s the tangled ‘theory’ behind ‘flexible’ labor market policy prescriptions. A regurgitated dog’s breakfast of contradiction and amnesia.
Layard et al.’s lump-of-output fallacy flexibility chimera thus resembles a sort of a theoretical ouroboros chicken-snake swallowing its own entrails:
To many people, shorter working hours and early retirement appear to be common-sense solutions for unemployment. But they are not, because they are not based on any coherent theory of what determines unemployment. The only theory behind them is the lump-of-output theory: output is a given. In this section we have shown that output is unlikely to remain constant.
This is simply FALSE. Shorter working hours is based on the same theory as full employment fiscal policy: Keynes’s theory. But don’t take my word for it. In an April 1945 letter to T.S. Eliot, Keynes wrote:
The full employment policy by means of investment is only one particular application of an intellectual theorem. You can produce the result just as well by consuming more or working less. Personally I regard the investment policy as first aid. In U.S. it almost certainly will not do the trick. Less work is the ultimate solution.
Olivier Blanchard is criticizing the Aggregate Supply-Aggregate Demand model…
“Turning to the supply side, the contraption known as the aggregate demand–aggregate supply model should be eliminated.” (link)
Let me show you something good… I am the only one in the world using this model of Effective Demand with Aggregate Supply…
What you are looking at is all of the effective demand limit curves from 4th quarter 2008 to 4th quarter 2014. That is 6 years of quarterly data. The crisis started at the end of 2008.
Notice how all of the curves point to a zone at a core inflation target zone of 2%. All of the curves fall into a zone from $15.9 to $16.2 trillion (real 2009 $$) at that core inflation target zone.
When real GDP reached $16.1 trillion in the last half of 2014, hitting the heart of that zone marked in the graph, corporate profits peaked and other factors peaked. The effective demand limit curves began to balloon upward. The business cycle peaked. This AS-ED model had seen it coming for 6 years. That is what the AS-AD model could do, if it incorporated effective demand.
Here is what happened when real GDP hit the zone… You can see the effective demand limit curves starting to move out toward a new zone for the next business cycle. That is how it works.
Think about it… The top of the business cycle was seen developing as far as 6 years in advance by this model!
Olivier Blanchard can eliminate the AS-AD model, but nobody touches my AS-ED model… This model is golden.
Update: The 2nd graph above does not mean that inflation is going up to 8%. The red dots show where the AS and ED curves cross. Those crossing points fall toward the natural limit zone as the AS curves move right in the 1% to 2% inflation horizontal. As real GDP goes by the natural limit, the crossing points move start to move upward like bouncing on the limit zone. Real GDP still moves below near 2% core inflation.
Look at the black horizontal arrow in the 2nd graph that says… “track of real GDP”… that is real GDP moving along near 2%… but the ED limit curve crosses the projected future path of real GDP shown by the black arrow. That crossing point shows us where real GDP will encounter its natural limit.
Update: Effective Demand limit curves use the same equation as in this model for the Effective Consumption Demand curve…
Words fail. Literally. By which I mean ‘literally’.
Open thread: Somebody has to have apposite words.
With the temperature reaching 120 degrees here today in Phoenix (almost a record), allow me to have a little fun with my theoretical model of Effective Demand.
There are two equations in my effective demand research that will be integrated in this post.
First the Effective Demand equation…
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 = an effective demand limit function based on labor share.
e = around 3 (more on this below)
The blue dot in this model represents an unstable equilibrium. The economy would seem to want to move away from this blue dot, either toward collapse or balanced growth.
Now the other equation to be integrated is the short-term real interest rate for monetary policy. This equation comes from my effective demand research.
Short-term real rate = z(T2 + L2) – ( 1 – z)*(T + L)
z = (2*L + Natural real rate)/(2L2 + 2L)
Both equations are also based on T and L, but this short-term real rate one incorporates the natural real rate.
Does it make sense that the real rate would start rising below a T of 40%? Shouldn’t the real rate just keep falling to support the economy at lower and lower rates of resource utilization? We need to integrate the above two models to answer that question.
Notice that the minimum of the short-term real rate at 40% matches the unstable equilibrium in the model of Effective Demand.
Let me put them both on the same graph so that you can see. I put production on the left axis and the interest rate on the right axis.
Now we can answer the question… Why would the short-term real rate rise going below 40%?… The idea would be to lead the economy toward the unstable equilibrium by lowering rates going from 0% to 40%. The central bank says, “The more you use labor and capital, we will lower rates to counteract the force pushing the economy away from the unstable equilibrium toward collapse at 0%. ”
Once on the right side of the unstable equilibrium, the short-term real rate can start to rise slowly toward the natural effective demand limit. (80% in the graph above.) At the natural limit, the short-term real rate would be 0% representing a normalized policy rate from a central bank.
The graph above is based on a natural real rate of economic growth of 0%. But what if the economy was growing at 5% or shrinking at -5%? What would happen to the graph? Let’s look at an economy growing at 5%.
The blue dots do not match up now. The short-term real rate has a new minimum at 37.3%. Now what do we do?
We look at the equation for the Effective Demand limit and see the coefficient of e. We can use that coefficient to calibrate the ED limit equation for the natural real rate. Even though the most precise equation would be a very flat quadratic, a sufficient equation is linear…
e = 3.3*natural real rate + 3
So for a 5% natural real rate, the coefficient e would adjust to… 3.3*0.05+3 = 3.165.
So with just a little change in the e coefficient, the effective demand equation adjusts to the short-term real rate equation. Red dots still match up too.
Now the effective demand equation also incorporates the natural real rate. That is an advancement in the theory.
by Mike Kimel
Who Will Be the Next President?
We don’t know much about Panama before the Spanish arrived other than that it fit the usual pattern you see just about everywhere – there were periods of bloody violence (wars, genocides) alternating with periods of some sort of coexistence. After the Spanish arrived, there was more of the same, but we know more details, most of which we can dispense with here. Eventually, what is now Panama and what is now Colombia made up a single country: the Republic of New Granada, and did so not once, but twice. in 1903, Panama managed to secede from Colombia for good, with some cooperation by the US which was interested in the construction of the Canal.
Today, the differences between Panama and Colombia are apparent. In 2015, GDP per capita in Panama was about $21,800 compared to $13,800 in Colombia. Other measures of well-being favor Panama. For example, its people have a longer life expectancy, partly due to its much lower murder rate. The result is that there is a lot of immigration from Colombia into Panama, much of it illegal. Some estimate that as many as 50% of those illegally in Panama are from Colombia. And some politicians have alleged that Colombians are responsible for a disproportionate amount of the crime that occurs in Panama.</a>
That’s the extent of what I know about the subject. But the other day, apropos of nothing at all, I was wondering – how would the Panamians react if groups of Colombians held large protests against Panamian immigration policy in major cities? What if during those protests, some Colombians waved the Colombian national flag, and several of them stated that one day, Panama would be Colombian again? What if some Colombians burned the Panamian flag? And what if these protesters made a habit of holding their protests at rallies held by groups dedicated to stopping illegal/undocumented immigration from Columbia?
Now, in the US, perhaps either Clinton or Trump will implode on the mountains of toxic baggage that each is carrying around. If not, however, I think the next election will be determined by how many voters would view musings like those in the paragraph above as a close parallel to the current situation in the US.
The soul-searching at the Fed is beginning.
I have written many times for over a year that the Fed will have a period when they start soul-searching. They will realize that the business cycle got away from them and they will not be able to normalize rates. They just got too far behind the curve.
Danielle DiMartino on Boom/Bust said, “I think it was probably one of the most interesting FOMC meetings… I think the fact that Esther George did not descent is telling you that there is an acknowledgement among members of the committee that the United States is probably headed toward a recession.”
DiMartino goes on to say that the Fed should never go to zero bound again and maintain a 2% floor for example, so that the banking system can function in a natural way. 0% does not allow the market to discover prices efficiently.
I do not agree with her on that by the way. The Fed rate should be able to go to 0% but then lift off according to the biz cycle of effective demand. In my view, the Fed should have started lifting rates at some point in 2012. There was still some spare capacity available for the economy to adjust to the disciplining of productivity by raising rates.
Update: A similar view is presented by Signe Krogstrup. (link)
There is hardly any spare capacity left. Profit rates and top line revenue peaked at the end of 2014. The Fed rate is too far behind the curve. The Fed will not be able to raise rates going forward without triggering a contraction.
The Fed is frustrated. They want to normalize rates, but won’t be able to.
The soul-searching has begun.