The famous economist John Maynard Keynes tried to put forth a theory of effective demand. Keynes even devoted chapter 3 of his General Theory book to it. However, nowadays you will not see the term effective demand in economic textbooks. What happened to it? Why is the term effective demand missing from common discourse?

Keynes laid down some basic ideas about effective demand but did not give specific equations. It is clear that Keynes distinguished effective demand from aggregate demand. Still modern economists equate effective demand with aggregate demand. This is a mistake. Now we only see the term aggregate demand in textbooks.

Consequently, there is a missing piece of economic theory that is still yet to be found. How then can we understand effective demand? Will we ever have a workable model for it?

Developing a model of effective demand was my doctoral work. This is the cornerstone equation of the model.

         0% < labor share – (utilization rate of capacity * utilization rate of labor)

The equation basically says that the percentage of national income going to labor (labor share) sets a limit upon the multiple of the utilization rates of capital capacity and labor. The multiple cannot be greater than labor share.

The equation shows ‘demand’ through a relative amount of money given to labor (labor share) as opposed to money given to those who own capital. Capital income at a macro level depends on selling to those who do not have capital income. Certainly many economists would say there is no difference between money spent in the economy from capital and labor incomes. However, capital production is ultimately directed towards a final consumption by people who give their labor.

The equation shows the term ‘effective’ by saying that the income share of final consumers sets a limit upon how firms utilize their capital and employment. There is an effective demand limit upon production. Capital income measures its production according to the relative strength of labor income. Thus, if people are paid less, they demand less, and firms would have to produce less for them. On the other hand, if people are paid more, they can demand more, and firms would have to increase production.

So, there is a relationship of mutual dependence between labor income and capacity utilization. The equation I use above says the dependence has a limit. So, when the limit of labor share falls, it will push down capacity utilization.

Do we see this effective demand limit in the data? Here is data for the United States since 1969 to the 2nd quarter of 2017 (quarterly data).

Yes… the limit holds in the data. The blue line sees resistance at 0% shown by the horizontal red line. (data at FRED)

When I first presented this model to economists in 2013, the blue line had not yet reached the red line. The other economists were very skeptical that the line would stop at a zero lower bound. They did not think the equation was valid. Then in 2014, the blue line bounced off the effective demand limit of labor share, as my equation predicted. Since then it has risen and is once again heading down toward the limit.

In the last two business cycles, the blue line reached the limit two times before a recession hit. Is the same pattern setting up this time?

We should know within a year, if the blue line will hit resistance again on the lower red horizontal line. If we see resistance again, the evidence for the equation gets stronger.

What would happen at the effective demand limit? Basically labor share will rise in relation to capacity utilization. If unemployment starts to rise at that time, a recession would be spreading through the economy. 

The effective demand limit lines are concentrating toward a limit on real GDP of around $17.250 trillion.

Now, real GDP does not need to stop increasing at the limit, but if a recession is strong enough it will. Real GDP may continue rising, and we just see labor share rising in relation to capacity utilization.

Either way, the stock markets will react. Profits will stagnate, as firms try to re-balance. When the economy is rising to the limit, profits in the macroeconomy rise and firms share in those profits. However, profits become a zero sum game at the effective demand limit. If one firm increases profits, then other firms lose an equal amount of profits. If the effect triggers problems, then the profit competition cascades into a recession.