Principle of Effective Demand

The Principle of Effective Demand:

The principle of effective demand engages a key position in the Keynesian theory of employment. Efficient demand is the capability and willingness to spend by individuals, firms and government. The level of output generated and therefore the level of employment based on the level of total spending in the economy.

Keynes employed ‘aggregate demand and aggregate supply approach’ to elucidate his simple theory of income determination. The word ‘aggregate’ is employed to explain any quantity which is a grand total for the whole economy.

Aggregate demand is the net demand for all commodities (i.e., goods and services) in the economy. Aggregate supply is the net commodities supplied in the economy. Such two factors are termed by Keynes as aggregate demand function (i.e., ADF) and the aggregate supply function (i.e., ASF).

Keynes made it obvious that the level of employment based on aggregate demand and supply. The equilibrium level of income or output based on the relationship among the aggregate demand curve and supply curve. Since Keynes was fascinated in the immediate troubles of the short run, he ignored the aggregate supply function and focused on aggregate demand. And he attributed unemployment to scarcity in aggregate demand.

It is significant to note that all demand is not efficient. According to Keynes, efficient demand is that point where ADF and ASF are equivalent. ASF symbolizes cost and ADF symbolizes receipts. Cost should not exceed receipt. Whenever the entrepreneurs find that their receipts are less than their costs, they will stop providing employment to the new workers. So long as their receipts are higher than the prices, they will raise employment as they can raise their gains by offering more and more employment.

As already stated, the point of intersection among the two curves exhibits the maximum possible employment. According to Keynes, the level of employment based on total demand and unemployment outcomes as a consequence of a fall in net demand. When unemployment is to be avoided, the remedy lies in raising the efficient demand.

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