KEYNESIAN PRINCIPLE OF EFFECTIVE DEMAND.

The principle of effective demand is basic to Keynes’ general theory of employment.

Effective demand, which is the sole determinant of employment, is the logical starting

point of Keynes’ theory of employment.

Employment depends upon effective demand and unemployment is the result of

deficiency of effective demand. As employment increases, output and real income also

increases.

A fundamental principle is that as the real income increases, consumption also increases,

but by less than the increase in income. Therefore, in order to have sufficient demand to

sustain an increase in employment, there must be an increase in investment equal to the

gap between income and consumption demand out of that income.

In other words, employment cannot increase unless investment increases. This is the core

of the principle of effective demand.

Meaning of Effective Demand:

Effective demand refers to the total demand of the community which is met by

corresponding supply.

Keynes uses the term ‘effective’ for two reasons:

(a) It shows that the demand is effective in determining the level of employment,

(b) It emphasises the distinction between a mere desire to buy and the desire plus ability

and willingness to buy.

It is not mere desire to buy but effective demand that affects the volume of employment.

At various levels of income, there are corresponding levels of demand, but all the levels

of demand are not effective. Only that level of demand is effective which is fully met by

the corresponding supply.

According to Stonier and Hague, effective demand “is the aggregate demand price which

becomes effective, because it is equal to aggregate supply price and thus represents a

position of short run equilibrium.” In the words of D. Dillard, “The adjective ‘effective’

is used to designate the point on aggregate demand curve where it is intersected by the

aggregate supply curve.”

Effective demand manifests itself in spending of income or the flow of total expenditure

in the economy. The flow of expenditure determines the flow of income because one

man’s expenditure is another man’s income. The flow of expenditure also represents the

value of total output because total price of national output is just the same thing as the

total expenditure made and the total income received by the community.

Total expenditure, which represents total demand for goods and services, comprises of

consumption expenditure and investment expenditure. To meet this demand, workers are

employed to produce the required consumer goods and investment goods.

Thus, Effective demand (ED)

= total expenditure

= Expenditure on consumption goods (C) + Expenditure on investment goods (I)

= National income (Y)

= Value of national output (O)

= Total employment (N)

or ED = N = O = Y = C + I

In this way, effective demand represents the economy’s general equilibrium level at

which

(i) aggregate supply (total income) = aggregate demand (total expenditure)

Y = C + I … (1)

or alternatively,

(ii) total saving = total investment

S = I … (2)

(Since total saving is equal to total income minus total consumption (S = Y – C),

therefore Y = C + I can be written as Y – C = I or S = I)

To sum up, effective demand determines the equilibrium level of employment (or output

or income) in a capitalist economy. At this level, aggregate demand is equal to aggregate

supply. The entrepreneurs earn maximum profits and have no incentive to offer more or

less employment.

Determinants of Effective Demand:

Effective demand depends upon aggregate demand and aggregate supply. It refers to the

point of intersection between aggregate demand function and aggregate supply function.

This point also determines the volume of employment.

Just as in the Marshallian analysis, price is determined by the forces of market demand

and supply, similarly in the Keynesian analysis, effective demand is determined by the

forces of aggregate demand and aggregate supply.

Thus, there are two determinants of effective demand:

(i) Aggregate demand function

(ii) Aggregate supply function

(i) Aggregate Demand Function:

Keynes relates demand for goods with demand for labour and expected sale proceeds

with the volume of employment. The aggregate proceeds expected from a given amount

of employment is called aggregate demand price of the output of that amount of

employment.

Aggregate demand price refers to the amount of maximum sales revenue expected from

the total output produced at a particular level of employment in the economy. According

to D. Dillard, “The aggregate demand price for the output of any given amount of

employment is the total sum of money, or proceeds, which is expected from the sale of

the output produced when the amount of labour is employed”.

In the words of S tonier and Hague, “The aggregate demand price at any level of

employment is the amount of money which all the entrepreneurs in an economy taken

together really do expect that they will receive if they sell the output produced by this

given amount of men.”

Aggregate demand function (ADF) is a schedule of the various amounts of money which

the entrepreneurs in an economy expect from the sale of their output at varying levels of

employment. Aggregate demand function relates various volumes of employment in the

economy with the sale proceeds expected from their output.

Or, to put it differently, aggregate demand function reveals planned or intended

expenditure at different levels of income. In the words of D. Dillard, aggregate demand

function “is a schedule of the proceeds expected from the sale of the output resulting

from varying amounts of employment.”

Aggregate demand price, or the maximum sale proceeds expected from a given level of

output and employment, depends upon total expenditure flow of the economy, which, in

turn, is determined by the spending decisions of the community as a whole.

In a capitalist economy, total expenditure of the economy comprises of total consumption

expenditure (C) and total investment expenditure (I). Thus, aggregate demand is equal to

total consumption expenditure plus total investment expenditure.

Aggregate demand function is illustrated through an example given in Table-1. Column

(2), which represents aggregate demand function, gives different aggregate demand

prices (or maximum expected receipts) at different levels of employment. It is clear from

the table that aggregate demand price increases with the increase in employment.

In Figure-10, AD curve represents aggregate demand function. It shows that aggregate

demand price is an increasing function of the volume of employment. AD curve goes up

towards right reflecting that there is a direct relation between aggregate demand price and

the level of employment; aggregate demand price increases as the amount of employment

increases and vice versa.

Shape of AD Curve:

AD curve first rises quite steeply, but this rapidity tends to slacken at higher levels of

employment. This shape of AD curve implies that expected receipts increase rapidly in

the initial stages of rise in employment.

But gradually this increase slows down when employment reaches higher levels. It

follows from the fact that with income and employment at low levels, the community will

be too poor to save much of its earnings.

(ii) Aggregate Supply Function:

There is a certain amount of proceeds which is necessary to induce employers as a whole

to offer any given aggregate amount of employment. This minimum price or proceeds

which will just include employment on a given scale is called the aggregate supply price

of that amount of employment.

In other words, aggregate supply price refers to the minimum expected proceeds which

are necessary to induce entrepreneurs to provide a certain amount of employment.

According to Stonier and Hague, “At any given level of employment of labour, aggregate

supply price is the total amount of money which all the entrepreneurs in the economy,

taken together, must expect to receive from the sale of the output produced by that given

number of men, if it is to be worthwhile employing them.”

Aggregate supply function represents different amounts of money which the

entrepreneurs must get from the sale of output at varying levels of employment with the

corresponding minimum amounts of sale proceeds of output resulting from those

volumes of employments.

Or, stated in a different way, aggregate supply function represents different levels of

income (and thus output and employment) which the entrepreneurs will supply at

different levels of expenditure.

In the words of D. Dillard, “The aggregate supply function is a schedule of the minimum

amount of proceeds required to induce various quantities of employment.” Thus, while

aggregate demand function refers to the maximum expected sale proceeds, aggregate

supply function considers the minimum sale proceeds necessary.

In Table-1, Column (3) shows the aggregate supply function which is an increasing

function of employment. As the minimum amount of proceeds increases, a greater

amount of employment will be offered. In order to employ one lakh workers, the

employers must expect to get a minimum of Rs. 4 crores from the sale of the resulting

output.

Similarly, the minimum sale proceeds for two lakh workers is Rs 9 crores, and so on. AS

curve in Figure-10 represents aggregate supply function. AS curve also goes up towards

right, showing that the aggregate supply price (or the minimum expected sale proceeds)

increases with the increase in employment.

Shape of AS Curve:

The shape of AS curve depends upon the relationship between employment and marginal

productivity. The AS curve rises slowly to begin with implying that employment would

increase fairly rapidly at first as amount received from selling output of the economy rose

from zero.

This is because the cost of production would not initially rise rapidly. Later on, AS

curves rises progressively as employment increases because at higher levels of

employment cost of production rises more rapidly.

At full employment level (i.e., after point F), AS curve becomes a vertical straight line,

indicating that no increase in receipts would increase employment further.

Equilibrium Level of Employment or Point of Effective Demand:

The equilibrium level of employment and income in an economy is determined by the

point of intersection between aggregate demand function and aggregate supply function.

This is also the point of effective demand.

Aggregate supply function represents costs, while aggregate demand function represents

the expected receipts of all entrepreneurs taken together in the economy. So long as the

receipts of all entrepreneurs taken together in the economy.

So long as the receipts are greater than the costs, the employment in an economy will go

on increasing. This process will continue till receipts become equal to costs. In no case

the entrepreneurs would offer employment to workers if the costs are greater than the
receipts. The determinants of equilibrium level of employment or the point of effective

demand can be explained with the help of below Table-1 and fig-10

In Table-1, the equilibrium level of employment is 4 lakh workers. At this level, both the

aggregate supply price (i.e., the expected minimum costs) and aggregate demand price

(i.e. expected maximum receipts) are equal to Rs. 34 crores. At employment level less

than 4 lakh workers, aggregate demand price is greater than aggregate supply price.

Hence employment will tend to increase. On the other hand, at an employment level more

than 4 lakh workers, aggregate supply price exceeds aggregate demand price. Therefore

employment will tend to decrease.

In Figure-10, the aggregate demand schedule (AD) and aggregate supply schedule (AS)

intersect at point E, which represents the point of effective demand. The equilibrium level

of employment is ON, at which receipts and costs are equal to EN. At ON employment

level, entrepreneurs maximise their expected profits.

Any other level of employment will reduce the profits and the economy will not be in

equilibrium. For example, at ON, level of employment the expected receipts are greater

than the expected costs (AN1 > BN1).

This will induce the entrepreneurs to employ more workers. On the other hand, at

ON2 level of employment, expected costs are greater than expected receipts (FN2 >

GN2). Therefore this level of employment will not be offered by the producers.

Thus, the equilibrium level of employment or the point of effective demand is determined

at point E where aggregate demand price (expected receipts) equals aggregate supply

price (expected costs), offering employment to ON workers.

Less-than-Full Employment Equilibrium:

The economy in equilibrium does not mean the economy in full employment equilibrium.

The point of effective demand, which represents the equilibrium level of employment

does not necessarily indicate a full employment level.

Keynes’s, main contribution is to show that less-than-full employment equilibrium is

possible and, in a capitalist economy, this is a normal feature. In such an economy

investment is generally inadequate to fill the gap between income and consumption.

In Figure-11, point E is the point of effective demand, but the employment level

consistent with this point (i. e. ON) is less- than full employment level, because there

exists NNf amount of unemployment. In order to attain full employment level, aggregate

demand must rise from AD to

The new point of effective demand (point F) will represent the full employment

equilibrium level ONf, Further increase in aggregate demand (i.e. AD2) will take the

economy to point F1, which indicates over-full employment equilibrium. In this situation,

output and employment does not increase, but, due to increase in demand, only prices

tend to rise.

Relative Importance of ADF and ASF:

In Keynes’ theory, aggregate supply function (ASF) is not of so much importance

because of two reasons:

(i) Keynesian economics is short-term economics. In the short period, aggregate supply

cannot be manipulated.

(ii) Keynes’ theory primarily deals with an economy facing unemployment. In such a

situation, it is not desirable to manipulate ASF through relationalisation (i.e.,

mechanisation). If costs are sought to be reduced through mechanisation then, instead of

reducing, it will increase unemployment further.

This, however, does not mean that ASF is not at all important. In an inflationary situation,

when there is over-full employment, manipulation of aggregate supply function by

reducing costs and increasing productive efficiency becomes indispensable.

Thus, Keynes gave exclusive attention to aggregate demand in his analysis. That is why,

his theory of employment may be more properly called the theory of aggregate demand.

Role of Government:

In the original Keynesian theory, government expenditure is not considered. But, the

post-Keynesians give due recognition to government expenditure as a source of effective

demand. Government expenditure has become an important determinant of effective

demand in modern capitalist economies.

The special significance of government expenditure is that it is autonomous in nature, i.e.,

it is influenced more by social and political factors rather than economic factors. Foreign

sector also provides another source of effective demand.

Thus, to be realistic, the components of effective demand or aggregate demand are:

(i) Consumption expenditure (C);

(ii) Investment expenditure (I);

(iii) Government expenditure (G) and

(iv) Foreign expenditure on domestic goods and services over and above domestic

expenditure on foreign goods and services (X-M).

Thus, ED = AD = C + I + G + (X-M)

Importance of Effective Demand:

The importance of Keynes’ concept of effective demand is clear from the following

points:

I. Main Determinant of Employment:

 Effective demand occupies an important place in the Keynesian theory of employment.

Effective demand is the sole determinant of employment and unemployment is result of

deficiency of effective demand. Effective demand expresses itself in the spending of

income. Thus, it is the level of spending on which employment depends.

II. Repudiation of Say’s Law:

The principle of effective demand has repudiated Say’s law of markets according to

which supply creates its own demand. If Say’s law were true then aggregate demand

would be equal to aggregate supply at all levels of employment. But, the principle of

effective demand has shown that aggregate demand and aggregate supply are not always

in equilibrium and normally this equilibrium is achieved at less- than-full

employment. The concept of effective demand has made it clear that what is produced is

not automatically consumed or invested at the rate which will keep the factors of

production fully employed.

III. Contradiction in Pigou’s Argument:

The theory of effective demand has revealed the inherent contradiction in Pigou’s

argument that wage cuts will remove unemployment. According to Keynes, employment

will increase by increasing effective demand. But, a cut in wages will cause a reduction

in effective demand.

IV. Emphasis on Demand Side:

In contrast to the classical emphasis on supply side, Keynes laid more emphasis on

demand side and traced fluctuations in output and employment to changes in aggregate

demand. Aggregate supply is assumed to be given in the short period.

V. Importance of Investment:

The theory of effective demand also shows that in order to maintain effective demand (or

the level of employment) at the original level, real investment, equal to the gap between

income and consumption, must be made. Employment cannot expand unless investment

expands.
VI. Paradox of Poverty:

Keynes’ principle of effective demand provides an explanation of the paradox of poverty

amidst plenty. In the words of D. Dillard, “Keynes’ principle of effective demand

furnishes an explanation of the paradox of poverty in the midst of potential plenty, one of

the gravest contradictions of capitalism.”

The advanced capitalist economies are always under constant fear of unemployment and

panic of depression. The reason is that as income increases, consumption also increases,

but by less than the increase in income.

This gap between income and consumption widens at higher levels of employment (as

experienced by rich economies), and is not removed automatically without an active

participation of the government. Thus, the deficiency of aggregate demand leads to large-

scale unemployment and becomes the cause of poverty in an otherwise affluent economy.

Such a problem exists only for rich economies. A poor country on, the other hand, has no

difficulty in employing all its resources because it will tend to spend on consumption a

large proportion of its total income.

Only a small gap needs to be filled by investment and, the stock of capital being small,

good opportunities exist to fill the gap by additional investment. Thus, according to

Keynes, “The richer the community, the more obvious and outrageous the defects of the

economic system.”

Criticisms of Keynes’ principle of effective Demand:

Keynes’ principle of effective demand has been criticised on the following grounds:

(i) Hazlitt feels that the use of the term ‘effective’ before demand is superfluous and

misleading. Demand in economics is always effective, otherwise it is merely a desire or

wish.

(ii) Keynes’s theory is concerned only with involuntary unemployment. Other types of

unemployment, such as frictional, seasonal, disguised, voluntary, have been ignored.

(iii) According to Hutt, the very notion of effective demand, as propounded by Keynes, is

objectionable because he has reversed the cause and effect relationship. There are
circumstances (e.g., in case of underdeveloped countries) where employment is not

determined by demand, but rather affects demand itself.

(iv) Keynes has established a direct relationship between income, demand and

employment. But the critics feel that no such relationship exists in reality. Employment,

besides effective demand, also depends upon skill formation, inventions, techniques of

production, etc.

(v) The principle of effective demand is not applicable in underdeveloped countries

where the problem is not of deficiency of effective demand, but of inelastic supplies.

Despite this criticism, the principle of effective demand continues to remain the vitally

important part of the modern macro-economic analysis. Without relating aggregate

demand and aggregate supply functions, all discussions concerning the determination of

income and employment are futile.

-By
Sanika Santosh Pednekar
SYBMS/A
52