Yellen Wants To Understand Effective Demand

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By Edward Lambert

Janet Yellen gave a speech where she posed four questions to economists in general seeking answers. The first question she asked was this...

The Influence of Demand on Aggregate Supply

The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?

"Prior to the Great Recession, most economists would probably have answered this question with a qualified "no." They would have broadly agreed with Robert Solow that economic output over the longer term is primarily driven by supply - the amount of output of goods and services the economy is capable of producing, given its labor and capital resources and existing technologies. Aggregate demand, in contrast, was seen as explaining shorter-term fluctuations around the mostly exogenous supply-determined longer-run trend."

Janet Yellen is really asking for research into effective demand. She sees a weakness in aggregate demand affecting aggregate supply or potential output. That is effective demand, but she cannot even use the term effective demand because economists do not understand it.

I have been researching effective demand for four years. I have seen really a complete lack of understanding of what effective demand is among economists. It surprises me that Janet Yellen would be calling for research on its dynamics.

She does not really understand effective demand yet though. She goes on in her speech about hysteresis which is a short-term shock, which produces a long-run effect. Effective demand is not a short-run shock. It is based on the relative strength of labor share to profit share. A lower labor share sets a lower limit upon potential output. And the drop in labor share is not short-term. It has been constant for years since the crisis.

I have models that can be built on by other researchers. It truly is important for economics to finally understand and define effective demand.