E Dr. Lambert's Effective Demand Recession Indicator

There is a simple explanation of Edward Lambert's concept of Effective Demand. It is provided by Angry Bear blogger Steve Roth.  This is just an explanation that we all can understand. Applying this guide to the real economy may change your thinking, and certainly will add an economic indicator to your arsenal.

Here are 5 points of the model:

1. Real GDP: During the business cycle, when real GDP goes up, so does Effective Demand.

2. Labor Share:  When labor share rises, effective demand increases due to more relative power for household consumption demand. 

3. Capacity Utilization: When capacity is heavily utilized, then it costs more to produce goods.

4. Unemployment Rate: When unemployment declines, effective demand declines. At the full employment limit, it is difficult for the economy to produce more. Full unemployment constrains future growth. 

5. Effective Demand Limit: Real GDP increases as more capacity and labor is utilized. However, there is a limit set by the relative power of labor's share of income to purchase goods. This is not an issue during the business cycle but becomes a problem at the end of the business cycle.

Edward Lambert expands on number 5: 

In a business cycle, real GDP rises as more labor and capital are utilized. When real GDP reaches the level of effective demand (potential demand), a recession would ensue. The economy will go through various changes between the time real GDP reaches effective demand and the start of the recession.


 So, when real GDP exceeds effective demand the economy slows. Roth says:

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).

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Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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Comments

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Ghjukliokss 7 months ago Member's comment

Good article.

Wendell Brown 9 months ago Member's comment

Kudos on a really great article, Gary. (Even if the title does sound like a men's hair tonic lol).

Gary Anderson 9 months ago Author's comment

Your take on the title, Wendell, is very astute and very funny. In the second to last paragraph I meant to say notational demand rather than potential demand as notational demand would reflect what people could buy (and borrow) if they were more able to do so. There is a lot of demand just not being met due to the reality of effective demand limit.