The Principle of Effective Demand
  • Principle  of  effective  demand  is  basic  to  Keynes 
   analysis of income, output and employment. 
  • It is outlined in Keynes' path breaking book, "General 
   theory  on  Employment,  Interest  and  Money", 
   published in 1936.
  • A  fundamental  principal  is  that  as  the  real  income 
   increases,  consumption  will  also  increase  but  by  an 
   amount  which  is  less  than  the  increase  in  income. 
   Therefore in order to have enough demand to sustain 
   an increase in employment there must be an increase 
   in  real  investment equal to the gap between income 
   and consumption.
                                Income
                             Employment
                               Effective 
                               Demand
      Aggregate Demand                           Aggregate Supply 
          Function                                   Function
       Consumption    Investment    Government 
        Expenditure   Expenditure    Expenditure
      Income     Propensity    Rate of       Marginal 
                 to consume    Interest    Efficiency of 
                                             Capital
         Subjective         Objective 
           Factors           Factors
         Effective Demand
  The  aggregate  demand  in  a  two  sector  economy 
  consists  of  consumption  demand  and  investment 
  demand. 
  At various level of employment and income, there are 
  corresponding  levels  of  demand,  but  all  levels  of 
  demand are not effective only that level of demand is 
  effective which is fully met by the aggregate supply so 
  that  the  firms  do  not  have  tendency  to  increase  or 
  decrease the level of employment and output. 
  Thus effective demand represents ' equilibrium level of 
  employment.'
    Determinants of Effective Demand
  According to Keynes, effective demand is determined 
  by two factors
  1. Aggregate Demand Function (ADF)
  2. Aggregate Supply Function (ASF)
  1. Aggregate Demand Function: It refers to the 
   schedule of maximum sales proceeds which the firms 
   expect to receive from the sale of output resulting 
   from different levels of employment. 
   Aggregate demand price is the amount of money 
   which the firms expect to receive from the sale of 
   output produced at a particular level of employment. 
                                                          ADF
 ADF                        ADF
    O               Employment    O                Employment
    The vertical intercept of ADF shows autonomous consumption (i.e. the level 
    of expenditure at zero level of employment and output). 
    Non-linear ADF shows that the propensity to consume diminishes along with 
    the  increase  in  employment  and  output.  Linear  curve  shows  constant 
    marginal propensity to consume (MPC).