Principle of Effective Demand

Keynes’s principle of effective demand explains how an economy can settle at a level of production that leaves willing workers unemployed. In Keynes’s formulation, effective demand is the value of aggregate demand at the level of employment where entrepreneurs’ expected sales proceeds equal the proceeds needed to make that employment worthwhile. This equilibrium need not provide full employment.

How effective demand determines employment

Firms employ workers to produce goods they expect to sell profitably. Employment therefore depends on expected demand for output, not simply on the number of people willing to work.

• The aggregate demand function relates each possible level of employment to the sales proceeds entrepreneurs expect from the resulting output.
• The aggregate supply function relates each employment level to the proceeds required to make employing that number of workers worthwhile.
• Their intersection determines effective demand and equilibrium employment. Below this point, expected proceeds encourage expansion; beyond it, expected proceeds are insufficient to justify further employment.
• In the simplified closed-economy model without government, aggregate expenditure consists of consumption and investment.

Why equilibrium can involve involuntary unemployment

Involuntary unemployment occurs when people willing to work at prevailing wages cannot obtain jobs. Keynes argued that deficient demand can prevent firms from employing them even though the economy has unused productive capacity.

• Consumption normally rises as income rises, but by less than the increase in income. Investment must therefore fill the growing gap between income and consumption if higher output is to be sustained.
• Investment depends on expected returns and financing conditions; it does not automatically reach the level required for full employment.
• If planned expenditure is insufficient, unsold inventories encourage firms to reduce production and employment. Falling income then reduces consumption further.
• Adjustment can stop at an underemployment equilibrium, where planned expenditure equals output but some workers remain unemployed. Equality between planned saving and investment therefore does not establish full employment.

Implications for wages and employment policy

The central problem is deficient aggregate demand, rather than workers collectively choosing leisure or refusing available jobs.

• A general wage cut does not guarantee higher employment: lower wage incomes can weaken consumption, so an economy-wide wage reduction cannot be analysed like a cost reduction for one firm.
• Fiscal expansion, including public investment, can raise demand directly and generate further consumption through the multiplier.
• Demand expansion can increase output and employment when productive resources are idle; its employment gains become constrained as the economy approaches full capacity.