Understanding Effective Demand with Edward Lambert

A few people have asked me to provide a quick introduction to Edward Lambert’s recent work on Effective Demand, which work I’ve mentioned a few times. That’s ironic, because I made those mentions  in hopes that more-accomplished others would do the same for me.

That help hasn’t been forthcoming, because quite a bit of work and thinking is required to plumb the depths of Edward’s model. So I’ve asked Ed to help me put together a basic introduction. Hopefully I’ll benefit from the blowback of ensuing discussions.

In Chapter 3 of General Theory, Keynes bruits the notion of effective demand. It’s very much the centerpiece of his thinking, but it is almost uniformly ignored in textbooks. He describes it as the intersection of the aggregate demand and aggregate supply curves. Edward adheres to that notion.

While I grasp that thinking in an abstract way, Keynes fails to provide what I need; he’s neither general nor specific enough for me to really grok it. (Dictionary.com: “to understand thoroughly and intuitively.”)

In a general sense, I want to understand what effective demand is, in narrative, descriptive terms explaining human incentives: why people and groups act as they do.

In a specific sense, I want to know the formula to calculate effective demand, so I can plug in publicly available measures (or watch others do so), plot changes in this measure over time, and see what happens.

Edward’s work particularly stands out for me in providing that formula. Whether his formula is “right” or useful remains to be seen. But it’s important; to my knowledge (and Edward’s), no effective-demand theorist, including Keynes, has provided a workable formula. It seems to be the very thing Paul Krugman was asking for four years ago in his lecture on effective demand.

Here’s the formula:

Effective Demand = Real GDP x Labor Share of Income / Capacity Utilization x (1 – Unemployment Rate)

I’ll unpack that below. But first my explanation and understanding.

First: Effective Demand is not a straightforward accounting measurement like Personal Consumption Expenditures or Corporate Profits. It’s much more like estimates of the non-accelerating inflation rate of unemployment (NAIRU) or Potential GDP. It’s an analytical construct, an economic concept that’s useful for sussing out what’s happening in the economy.

With that as background, here’s a shot at providing what Keynes and Edward don’t: an explanation of what effective demand is, at least in this construct. (Note that throughout, here, “capital” means real capital, not “financial capital.” I’m talking about drill presses and such.)

Effective Demand is a measure of how much the economy at a given point in time can, could, increase utilization of labor and capital from current levels, before that increase in utilization (and new real-capital creation) slows or stops due to insufficient demand.

It gives us a measure of the extent to which an economy can use more of its raw production capacity (its labor and capital, working full tilt) — before that increase slows due to the disincentives of insufficient demand/sales.

Effective demand helps us determine the “potential” production in the economy — its potential to employ and create capacity within that demand constraint – the extent to which producers seeking profits will 1.) employ unused and available capacity (mostly by employing more workers, perhaps bidding up wages to do so), and 2.) create new capital/capacity.

Note that “capacity” and “potential” are very different here.

Edward has said that effective demand could be called “opportunity demand.” The concept characterizes the magnitude of the sales and profit upside that producers see ahead when considering whether to expand production by utilizing more capital (by hiring more workers) and creating new capital (also hiring in the process).

Normally in the “good” parts of the business cycle, effective demand does not constrain the utilization of labor and capital. Businesses in aggregate can employ (and create) more resources at the margin, producing more output that they can sell at a profit. But there comes a point at the end of a business cycle where effective demand sets a limit upon the profitable utilization rates of labor and capital, and (hence) restricts the incentives to create and employ new capital.

So let’s go back to the formula, and the terms therein. What story can we tell about effective demand?

Real GDP. When this goes up, effective demand goes up. This seems intuitively obvious.

Labor Share. This is at the heart of the model. Labor share determines the relative power of labor to purchase finished goods. The sale of finished goods determines production and investment in capital capacity. So, when labor share rises, effective demand increases due to more relative power for household consumption demand. Producers see more upside potential, expressed in sales.

Capacity Utilization. This is somewhat counterintuitive. When capacity utilization increases, it decreases effective demand. This is because effective demand is a measure of the demand-incentives for producers to increase utilization. When capacity is already heavily utilized, it’s more expensive (less profitable) for producers to utilize more.

Unemployment Rate. This is even more counterintuitive. When unemployment declines (employment increases), effective demand also declines. Why? Because as the economy reaches the full-employment limit, it’s harder for the whole economy to increase output to the full-tilt limit. And it’s that potential increase that incentivizes producers. The decline in unemployment eventually constrains the potential future rate of that very decline, and the future rate of economic growth. See Edward’s post on this here.

Effective Demand Limit. Real GDP will tend to increase as more capital and labor is utilized. However, there is a limit set by the relative power of labor’s share of income to purchase production. Reductions in that buying power reduce producers’ incentives. The concept here goes back to Keynes’ original statement that employment of the factors of production will be limited at the point of effective demand where “the entrepreneurs’ expectation of profits will be maximised.”

The intuition behind this, in particular the key privileging of labor share in the equation: ultimately, economic activity is directed to producing goods that humans can consume. The desire for that consumption is the ultimate source of demand, hence the driving force behind economic activity (including capital production). Labor income — a very large proportion of which is devoted to consumption spending — is at least a good measure or index of that final demand, and at most the driving force of that demand.

I want to keep this post short (oops, too late), but before leaving I want to return to the key virtue of Edward’s work: the ability to plot this explicitly formulated measure of effective demand over time, and see how it has moved in relation to other measures. The graphs below, from this post, show how it has moved over several business cycles, plotted relative to 1. real GDP and 2. utilization of capital and labor.

As you can see, the ends of business cycles (beginnings of recessions), are characterized in this model by a stylized fact: real GDP approaching or exceeding this measure of effective demand. Capacity utilization increases quite smoothly up to that point (the “good” part of the business cycle), then declines (often after a chaotic period that can last quite a while; see 1995-2000).

These graphs seem to tell a very consistent and compelling story. I’ll leave it to Edward’s post to explain the individual dynamics of these periods in more detail.

Leading up to the Recession of 1974

Leading up to the Recession of 1980

Leading up to the Recession of 1991

The almost Recession of 1994 and the Recession of 2001

Leading up to the 2008 Recession

Leading up to the next Recession

Engineers and others with similar bent might find it useful to think of the intersecting aggregate supply and aggregate demand curves as the X and Y arms of a 2D plotter. The effective demand paths you see above are the lines that plotter draws over time.

Another physical metaphor, characterizing the lines/measures as pulling and pushing on each other: effective demand as portrayed here seems to act like an attractor, pulling up both real GDP and capacity utilization. But unlike a magnet, for instance, the attraction effect gets weaker as the lines converge. And when real GDP exceeds effective demand, we see a very strong attraction effect pulling those two measures back down again.

Cross-posted at Angry Bear.