You are on page 1of 3

The Principle of Effective Demand | Keynesian Theory of

The principle of effective demand lies at the heart of Keynes general
theory of employment. The dictum of the theory is that the volume of
employment depends on the level of effective demand in an economy.
A corollary, thus, may be drawn that unemployment is due to a
deficiency of total demand (i.e., effective demand). Hence, Keynes
employment theory may be described as the demand efficiency theory.
Broadly speaking, Keynes designated the term effective demand to
denote the total demand of goods and services (both for consumption
and investment) by the people in a community. In a money economy,
thus, effective demand manifests itself in the spending of income or
the flow of expenditure.
The flow of expenditure in turn determines the flow of income, as one
mans spending becomes the income of another. In real terms, the
expenditure flow in a community consists of consumption expenditure
and investment expenditure expressing the total demand for goods
and services. To meet such demand, people are employed either in
producing consumption goods (consumption demand) or in producing
capital goods (investment demand).
Employment increases only when the total demand either from the
consumption side or from the investment side increases. A
fundamental principle is that consumption increases with an increase
in income, but less proportionately. As a result, there will be a widening
gap between income and consumption; hence to sustain the flow of
expenditure, the gap must be filled up by appropriate investment

This means that the level of effective demand and resulting

employment can be sustained only if investment demand increases
with an increase in income. Thus a deficiency in effective demand is
caused when investment inadequately fills up the gap between income
and consumption.
This results in creating unemployment in the countrys economy.
Hence, it may be concluded that in order to promote employment,
increasing investment in the economy should increase effective
Since Keynes sought to explain the point of effective demand in a
capitalist economy, free from government intervention, he considered
consumption and investment expenditure of the community relating to
private individuals and enterprises only.
But, in modern times, a capitalist economy is actually a mixed
economy due to the governments interference and the existence of
public sector. Thus, government expenditure is also a significant
determinant of effective demand in a modern economy.
Modem economists, therefore, define effective demand as:
Effective demand = + I = G, where,
= Consumption expenditure of the households.
I = Investment expenditure of private firms.
G = Governments expenditure on consumption and investment goods.
It must, however, be noted that government expenditure is
autonomous. Thus, it is the outcome of governments value judgment

and policies based on political and social considerations rather than on

economic forces.
Following Keynes, we shall, however, restrict our analysis to the
consumption and investment elements of effective demand relating to
the private sector only. It must be borne in mind that investment and
employment activities in the private sector are induced and not
autonomous as in the case of public sector.