by The Principle of Effective Demand is John Maynard Keynes’s book The General Theory of Employment, Interest and Money. The principle presented in that chapter is that the aggregate demand function and the aggregate supply function intersect each other at the point of effective demand and that this point can be consistent with a state of under-employment and under-capacity utilization. Another way of expressing this, in pre-Keynesian terminology, is to say that “demand creates its own supply” which gives primacy to a shifting demand function that can be insufficient to give an economy full employment in the long term, in contrast to the Say’s law which insists “supply creates its own demand” and doesn’t allow the possibility of long-term unemployment as the supply figure is always, by definition, a fixed amount that demand will match.
According to Keynes it is the principle of effective demand that determines the level of output and employment in a country.
In chapter 3, in which Keynes uses the term ‘effective demand’ 15 times in expounding his principle of effective demand, he defines the concepts of an aggregate demand and an aggregate supply, and then defines the concept of effective demand as the point of intersection of these two aggregate functions – at this point of intersection, the aggregate demand becomes “effective”.
The importance of the term ‘effective demand’ to Keynesian Economics in general is shown in the fourth paragraph of the chapter, where he states that this concept of effective demand, referring to the intersection of the supply and demand functions, is the “substance of the General Theory” and says that “the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.”
Effective Demand
Keynes’ theory of employment is based on the principle of effective demand. In other words, level of employment in a capitalist economy depends on the level of effective demand. Thus, unemployment is attributed to the deficiency of effective demand and to cure it requires the increasing of the level of effective demand.
Effective demand refers to the willingness and ability of consumers to purchase goods at different prices. It shows the amount of goods that consumers are actually buying supported by their ability to pay.
Effective demand excludes latent demand where the willingness to purchase goods may be limited by the inability to afford it or lack of knowledge.
In Keynes’s macroeconomic theory, effective demand is the point of equilibrium where aggregate demand = aggregate supply. The importance of Keynes’ view is that effective demand may be insufficient to achieve full employment due to unemployment and workers without income to produce unsold goods.
Factors affecting effective demand
The main factors affecting ‘effective demand’ will be
- Price
- Income: A rise in income will tend to cause rising demand.
- Availability of credit. If consumers and firms are able to borrow, then they have an effective demand to buy or invest. If credit is constrained, their effective demand is limited by the lack of access to credit.
In order to meet such demand, people are employed to produce all kinds of goods, both consumption goods and investment goods. However, to complete our discussion on effective demand, we need another component of effective demand the component of government expenditure. Thus, effective demand may be defined as the total of all expenditures, i.e.
C + 1 +G
where C stands for consumption expenditure
I Stands for investment expenditure
G Stands for government expenditure
