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Q. what do you understands by effective demand? Will the level of effective demand be always associated with full employment?


Effective demand represents that aggregate demand or total spending (consumption expenditure and investment expenditure) which matches with aggregate supply (national income at factor cost).

In other words, effective demand is the signification of the equilibrium between aggregate demand (C+I) and aggregate supply (C+S). This equilibrium position (effective demand) indicates that the entrepreneurs neither have a tendency to increase production nor a tendency to decrease production. It implies that the national income and employment which correspond to the effective demand are equilibrium levels of national income and employment.

Unlike classical theory of income and employment, Keynesian theory of income and employment emphasizes that the equilibrium level of employment would not necessarily be full employment. It can be below or above the level of full employment.

In simple terms, Quantity of a good or service that consumers are actually buying at the current market price is called effective demand.

Importance of Effective Demand

The principle of effective demand is the most important contribution of J.M. Keynes. Its importance in macro economics, in brief, is as under:

(i) Determinant of employment:- Effective demand determines the level of employment in the country. As effective demand increases employment also increases. When effective demand falls, the level of employment also decreases.

(ii) Say's Law falsified:- It is with the help of the principle of effective demand that Says Law of Market has

been falsified. According to the concept of effective demand whatever is produced in the economy is not automatically consumed. It is partly saved. As a result, the existence of full employment is not possible.

(iii) Role of investment:- The principle of effective demand explains that for achieving full employment

level, real investment must equal to the gap between income and consumption. In other words, employment cannot expand, unless investment expands. Therein lies the importance of the concept of effective demand.

(iv) Capitalistic economy:- The principle of effective demand makes clear that in a rich community, the gap

between income and expenditure is large. If required investment is not made to fill this gap, it will lead to deficiency of effective demand resulting in unemployment.

Determinants of effective demand

The determinants of effective demand are:-

(1) Aggregate Demand (C+l):

Aggregate demand refers to the sum of expenditure, households, firms and the government is undertaking on consumption and investment in an economy. The aggregate demand price is the amount of money which the entrepreneurs expect to receive as a result of the sale of output produced by the employment of certain number of workers. An increase in the level of employment raises the expected proceeds and a decrease in the level of employment lowers it.

The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l) for goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and indirectly on the level of employment.

(2) Aggregate Supply (C+S):

The aggregate supply refers to the flow of output produced by the employment of workers in an economy during a short period. In other words, the aggregate supply is the value of final output valued at factor cost. The aggregate supply price is the minimum amount of money which the entrepreneurs must receive to cover the costs of output produced by the employment of certain number of workers.

The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other part is saved (S) in the form of inventories of unsold output. The aggregate supply curve, (C+S) is positively sloped indicating that as the level of employment increases, the level of output also increases, thereby, increasing the aggregate, supply. Thus, the aggregate supply (C+S) depends upon the level of employment through4he economy's aggregate production function.

through4he economy's aggregate production function. In figure (32.3), the aggregate demand curve (C+l),

In figure (32.3), the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at point E 1 which is an effective demand point. At point E 1 , the equilibrium of national income is OY 1 . Let us assume that in the generation of OY 1 level of income, some of the workers willing to work have not been absorbed. It means that E 1 (effective demand point) is an under employment equilibrium and OY 1 is under employment level of income.

The unemployed workers can be absorbed if the level of output can be increased from OY 1 to OY 2 which we assume is the full employment level. We further assume that due to spending by the government, the aggregate demand curve (C+I+G) rises. As a result of this, the economy moves from lower equilibrium point

E 1 to higher equilibrium point E 2 . The OY is now the new equilibrium level of income along with full employment. Thus E 2 denotes full employment equilibrium position of the economy.

Thus government spending can help to achieve full employment. In case the equilibrium level of national income is above the level of full employment, this means that the output has increased in money terms only. The value of the output is just the same to the national income at full employment level.

Do you know:- J. M. Keynes wrote his famous book 'General Theory'. In it he presented an explanation of the Great Depression of 1930's and suggested measures for the solution. He also presented his own theory of income and employment.

According to Keynes:

"In the short period, level of national income and so of employment is determined by aggregate demand and aggregate supply in the country. The equilibrium of national income occurs where aggregate demand is equal to aggregate supply. This equilibrium is also called effective demand point".

On the other hand, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so. It is defined either as absolutely 0% rate of unemployment, as by James Tobin, or as the level of employment rates when there is no cyclical unemployment. It is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non- cyclical types of unemployment. Unemployment above 0% is advocated as necessary to control inflation, which has brought about the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU)*; the majority of mainstream economists mean NAIRU when speaking of "full" employment.

Diagram of macroeconomic circulat ion L S ≤ L D is the full employment situation,

Diagram of macroeconomic circulat ion L S ≤ L D is the full employment situation, one in which the rate of unemployment is zero or neg ative (corresponding to a labor shortfall).

‘Full employment’ has come to m

ean different things to different people, and it sh ould therefore not be

taken for granted that it is clear what th e term means.

The first issue concerns the resources r eferred to by the term. Does the term refer to fu ll employment of all resources, or only the full employment of labor? While there is obviously some relatio n between the employment of labor and the employme ent of other resources, full employment will be u sed here to refer only to labor. Full employment of plant and equipment as well as labor will be referred to a s ‘full capacity utilization’ or ‘full employment of reso urces.’

The second definitional issue regards th e level of employment referred to by the term “ full employment.” Contrary to the intuitive, common-sens e meaning of the term, most economists and pol icy makers do not equate “full employment” with “zero u nemployment.” Looked at through the lens of c oncepts such as the “natural rate of unemployment” and the “non accelerating inflation rate of unemploym ent” (NAIRU)*, “full employment” has come to indicate that level of employment that is associated with pric e stability, even if that means millions of individuals read y and willing to work are unemployed.

But the million dollar question is why

there is a need of full employment?

The aim of full employment can found in writing of “Luigi Pasinetti” (an Italian econo mist of the Post- Keynesians school):-

“The aim,” Pasinetti writes, “is clear: achieving the full utilization of available labour, i.e. full employment” (1993, p. 128). a magnitude of national relevance [is] the physical quantity of labour that is available in the whole economic system. And it is clearly a matter of general concern that it should entirely be employed— i.e., that there should be full employment. (1993, p. 23)

Full employment is too important for an economic system as a whole. Keynes was therefore right in advocating, at the institutional level, the inclusion of full employment into the objectives of overall economic policy, in the sense that the community as a whole takes charge of it as a goal to be pursued with whatever measures of economic policy 7may be appropriate, whenever the spontaneous forces of interaction between employers and workers fail to bring it about. (1993, p. 132).

Moreover it is,

1. A policy of full employment promotes economic growth and a policy of economic growth increases employment.

2. Full employment means full utilisation of job opportunities within the limits of available resources.

3. Full employment is a static concept. It refers to the utilisation of existing production capacity of the economy under static conditions i.e. with given economic resources, production methods and technology.

4. Full employment is a short-term concept. It means elimination of unemployment in the short-run.

5. The policy of full employment involves giving employment at current wage rates, whereas the policy of economic growth aims at providing employment at ever-increasing wage rate, thus improving the living standards of the people.

6. The policy of full employment is a demand-oriented policy. It aims at increasing the effective demand because deficiency of effective demand is the main cause of unemployment.

7. The policy of full employment is more suitable for the developed economies

But many economists had found problem with fixing effective demand at full employment

1. Working with the marginal efficiency of money to influence private investment in the face of depressed expectation, Keynes argued, may prove to be like “pushing on a string.” This would make monetary policy futile, especially when interest rates are already very low. Secondly, boosting the marginal efficiency of capital (or profit expectations) also has its limitations because it is not under the direct control of policy.

2. Low rates of interest and an increase in total money expenditures can improve the profits outlook and entice entrepreneurs to redirect their money from financial assets to real production. Government spending can be thought of as filling “the cash boxes of private entrepreneurs” (Kregel 2008), but how large an injection of liquidity is need to induce those investors to start employing is difficult to gauge. This is because while aggregate demand will increase the amount of liquid assets in the system, it may not be able to expediently shift individual preference away from holding them. Such would be the problems under a liquidity-trap scenario where money, as Keynes argued, becomes “a bottomless sink of purchasing power…[and] there is no value for it at which demand [for it] is diverted … into a demand for other things” (Keynes 1964 [1936]: 231).

employment, a larger proportion of it will go to swell the incomes of entrepreneurs and a smaller proportion to swell the incomes of wage earners and other price cost factors. (Keynes 1964 [1936]:


Conclusion: - Keynes’s effective demand approach to employment determination is not the same as the modern aggregate demand approach. Revisiting Keynes’s contribution makes clear why pinning the point of effective demand at full employment is impossible to do via aggregate demand stimuli. This is due to the structure of the economy, which ensures that near full employment, more money expenditures generate inflation and erode income distribution. To get to full employment, Keynes argued for a better targeting of demand, not necessarily for more aggregate demand.

Do you know: - In a letter to T.S. Elliot, Keynes commented that the trouble with designing policies for full employment is that economists lacked both the intellectual conviction of their feasibility and the cleverness to design them.

Mathematical Explanation*

Let Z be the aggregate supply price of the output from employing N men, the

relationship between Z and N being written Z = φ(N), which can be called the Aggregate

Supply Function. Similarly, let D be the proceeds which entrepreneurs expect to receive

from the employment of Nmen, the relationship between D and N being written D = f(N), which can be called the Aggregate Demand Function.

Now if for a given value of N the expected proceeds are greater than the aggregate

supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to

increase employment beyond N and, if necessary, to raise costs by competing with one

another for the factors of production, up to the value of N for which Z has become equal to

D. Thus the volume of employment is given by the point of intersection between the

aggregate demand function and the aggregate supply function; for it is at this point that the

entrepreneurs’ expectation of profits will be maximised. The value of D at the point of the

aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.

The classical doctrine, on the other hand, which used to be expressed categorically in

the statement that “Supply creates its own Demand” and continues to underlie all orthodox

economic theory, involves a special assumption as to the relationship between these two

functions. For “Supply creates its own Demand” must mean that f(N) and φ(N) are equal

for all values of N, i.e. for all levels of output and employment; and that when there is an

increase in Z( = f(N)) corresponding to an increase in N, D( =f(N)) necessarily increases

by the same amount as Z. The classical theory assumes, in other words, that the aggregate

demand price (or proceeds) always accommodates itself to the aggregate supply price; so

that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.

If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment.

“For over four decades, Luigi Pasinetti has made seminal contributions in virtually every important debate and discussion concerning economic theory and policy, resulting in a framework that does in fact consider value and distribution, money and effective demand, and structural and technological change in a dynamic, evolutionary context. In this way, Pasinetti has elaborated and synthesized the work and spirit of his teachers and mentors:

Kahn, Kaldor, Robinson, Sraffa, Goodwin, and Leontief. In doing so, Pasinetti has done more than accomplish a great intellectual achievement. While this he has certainly accomplished, Pasinetti first and foremost has developed a framework for understanding the economic society in which we actually live, one which is characterized by ongoing structural and technical change, deficiencies in aggregate effective demand, and persistent unemployment. Such understanding is necessary if policies are to be devised that can eliminate unemployment, reduces poverty, and generates the economic security necessary for a more prosperous society.”


“Full Employment Policies must consider effective demand and structural and technological change” By Mathew Forstater

(University of Missouri, Working Paper No. 14)