Read: Variables For An Effective Demand Limit To The Business Cycle Part 1

For those nutty readers that follow the effective demand story that I present on Angry Bear, today, the first day of 2015, marks a breakthrough. I just posted yesterday a model to expand the variables for assessing the effective demand limit upon production. Today a new variable is added to the mix with interesting results…

Here is the graph that ended the previous post…

Graph #1

We see an effective demand limit (orange line) upon the production cycle of utilizing labor and capital (blue line). The problem remained that there were still gaps that had to be filled. Let me point them out.

Graph #2

If I increased the coefficient on the variable for monetary policy (ED-FF), I could close the gaps at 1981 and 2000, but a gap would then open up at 1979. Like this…

Graph #3

Would it be possible to close the gaps in graph #2 without opening up other gaps that have already closed? It almost seems impossible or super complicated?

Well, let's go back and look at the stagflation of the late 70′s. What happened? The abrupt rise in commodity prices produced a price supply shock which affected demand to the extent that production had to be cut. As the effective demand model is designed to show the times when production is cut, it has to incorporate the effects of supply shocks too.

So I incorporate another variable into the limit function. Let me first place the new graph which incorporates this new variable.

Graph #4

Let's analyze this graph first… You will see that the huge gap in 1981 closed while the gap in 1979 did not open. Closing that gap in 1981 is a big accomplishment in understanding the effective demand limit.

You will also see that the gap in 2000 closed. This also was an important gap to close in order to coincide effective demand with the beginning of the 2001 recession. You will also see that the gap from 1995 to 1998 was stable. Maintaining the stability of this gap in the model was important because the economy was riding the natural limit of real GDP in a stable way during those years. Production increases through 1997, but fell back to below effective demand.