Simon Wren-Lewis wrote about Aggregate Demand and the Labour Market. He shows that an aggregate demand constraint can keep employment from reaching its natural rate. He is actually describing effective demand in his post. So I have made 2 changes to his title in the title of this post. I have changed aggregate demand to effective demand. Also I have changed the spelling of labour to labor, which is the American way to spell it. (When I was young I used to spell it labour because of my family’s Canadian background.)
He presented a graph with real wages on the y-axis and labor on the x-axis. He then drew the normal supply and demand curves in the labor market. The two lines cross at the natural rate of employment. Then he drew a vertical line to the left of the crossing point showing an aggregate demand constraint that can keep employment from reaching the natural rate.
I determine effective demand by labor share. I will change his graph by putting labor share on the y-axis instead of real wages. Then you not only reflect real wages but also the inverse relationship to productivity. What would the diagram look like with labor share on the y-axis?
Real wage = labor share * productivity
Labor share = real wage/productivity
So in my graph, if you hold productivity constant, the demand and supply curves are the same as found in the graph of Mr. Wren-Lewis.
The labor share of natural employment
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In this graph, the horizontal dashed line shows that the current labor share will allow the labor market to clear at the natural rate of employment.
Yet, you might be asking about productivity. How does productivity fit in?
The data shows that productivity will increase when labor employment falls to the left of the effective demand vertical line (green). But when labor employment returns to the vertical line, productivity stops increasing. So at the effective demand limit (green line) his graph and my graph are essentially the same.
That makes sense because being more productive at the effective demand limit creates production that may not be sold at a sticky real wage. So we solve a portion of the productivity puzzle here.
