The Theory of Effective Demand is a central concept in Keynesian economics. It explains how the level of income, output, and employment is determined in an economy. According to Keynes, employment depends not on supply but on effective demand, which represents the total demand for goods and services at a given level of employment.
Effective demand refers to that level of aggregate demand which is sufficient to induce producers to supply a certain level of output. It is the point where aggregate demand equals aggregate supply.
Effective Demand = Consumption (C) + Investment (I)
Effective demand consists of two main components:
Consumption is relatively stable, while investment is more volatile and plays a crucial role in determining effective demand.
Keynes explained that the level of employment is determined at the point where aggregate demand equals aggregate supply. Aggregate demand represents expected receipts from the sale of output, while aggregate supply represents total cost of production.
When aggregate demand is high, producers increase production and employment. When aggregate demand is low, production declines, leading to unemployment.
Equilibrium occurs at the point where aggregate demand curve intersects the aggregate supply curve. This point is called effective demand, and it determines the level of output and employment in the economy.
Keynes argued that this equilibrium may occur at less than full employment, leading to involuntary unemployment. Therefore, the economy does not automatically reach full employment.
Effective demand determines equilibrium level of employment
The theory of effective demand is a cornerstone of Keynesian economics. It provides a realistic explanation of how output and employment are determined in an economy. Despite some limitations, it remains highly relevant in understanding modern economic problems and policy formulation.