Jochen Hartwig states in a paper… “…it is beyond doubt that the Principle of Effective Demand is the centerpiece of the economics of Keynes.” (Hartwig, 2002)
Another source wrote… “There is little doubt that Keynes regarded the principle of effective demand as one of his most fundamental contributions to economic science – perhaps the most fundamental of all.” (Unknown)
But who would have known? Because Hartwig also writes… “Perhaps the most influential textbook ever written is Paul A. Samuelson’s Economics. But … neither in the first nor in later editions of the book is the term “Effective Demand” ever mentioned. And this holds for many other best-selling textbooks too. Textbooks tend to neglect Effective Demand.” (Hartwig, 2002)
What is going on? The centerpiece of Keynes’ economics is neglected in textbooks??? This should not be … It is obvious that there is a problem in understanding effective demand. So let’s understand what effective demand really is.
Unknown source wrote… “The principle (of effective demand) may be summed up by saying that the scale of output and employment as a whole is determined chiefly by the equilibrium between demand and supply of output as a whole (i.e. by the volume of effective demand).”
Let me boil this down… There is an equilibrium point between supply and demand that determines the scale of output and employment, all at the aggregate level. As Keynes saw it, supply and demand both increase as output increases, with more demand than supply. But demand increases at a slower rate than output, so that there is a point at which they cross and are in equilibrium. At this point, output is limited by demand and both demand and supply stop increasing. It is in this way that the “scale” of output and employment is “determined” by the equilibrium crossing point.
The unknown source later writes… “Since the level of total income is positively correlated with the level of total labor employment, there should also exist a strong positive relationship between the volume of total product demand and the level of total labor employment...”
I think this is where economists have gone off track in understanding effective demand. They have ended up seeing effective demand in an "accounting" way rather than an "economic" way.
The quote basically says that demand rises as unemployment falls. That seems obvious if you see demand as the money in people’s hands or as the money that is spent according to Keynes’ aggregate demand curve involving consumers, government, investment and net exports. The assumption is that total product demand is based on the utilization rate of labor, in other words, the unemployment rate. This accounting approach is not a good way to try to define effective demand. For this reason, effective demand has become a useless concept.
My equation defines effective demand in another way, because according to my equation, effective demand rises, as unemployment rises, not falls.
Let me show you how this works… For instance, suppose a real GDP of $10 trillion, an effective labor share of 75%, a constant capacity utilization of 78% and an unemployment rate of 5%. According to my equation…
Effective demand = $10 trillion * 0.75/(0.78*(1-0.05)) = $10.12 trillion
We can see that effective demand is above real GDP as Keynes envisioned it. The economy is also close to the equilibrium point between supply and demand. Therefore we can assume the economy is at the limit of effective demand. Now we raise unemployment to 10%. This assumes that the economy is now functioning below full capacity, right? Because we were just at 5% unemployment. So, what happens to Effective demand?
Effective demand = 10 * 0.75/(0.78*(1-0.10)) = $10.68 trillion
Effective demand rose with more unemployment. That contradicts the quote above. How could there be less employed, but more demand? Well, look at this... real GDP and effective labor share have not changed. There is still $7.5 trillion dollars in effective labor income to spend in the economy. ($10 trillion * 75% effective labor share).
So then you might say that demand didn’t actually change at all because total effective labor income didn’t change, or as the quote said above, the “total volume of effective demand” didn’t change. Well, my reply is simple… the volume of labor income is not Effective demand. I define Effective demand as total economic demand. Let me explain…
Total economic demand increased because total economic demand involves two forms of demand, latent and expressed. Latent demand is demand that is unexpressed because of lack of money or unavailable goods, but it is still there. Latent demand is similar to the concept of opportunity cost, in that the true cost of a purchase may be greater than the amount of the purchase. Latent demand implies that the true demand may be greater than the money you see in the hands of labor. You could at some point call effective demand … opportunity demand.
So, when we increased unemployment, latent demand increased. We assumed the economy was then performing below full utilization of labor. Therefore, the economy had the “opportunity” capacity to increase utilization of labor to satisfy the latent demand. As the economy employs more people, keeping real GDP constant (which doesn’t happen in real life, but we have to distinguish the dynamics in the equation) opportunity demand decreases making effective demand decrease as well. Eventually, effective demand decreases until it is equal to real GDP, and that point will “determine the scale of employment”, which is the definition of effective demand as given from the unknown quote above.
So my equation actually describes effective demand appropriately.
My equation for effective demand does not say that effective demand equals the money that people spend nor is it positively correlated with employment. Rather, effective demand is a measure of the opportunity demand for business to increase utilization of labor and capital to satisfy potential demand in the economy (potential up to the equilibrium point of effective demand and real GDP). The demand above effective demand curve is beyond the reach of the economy. The demand under the effective demand curve is within the reach of the economy.
The equation also says that effective demand is positively correlated with real GDP and “separately” with effective labor share of income. Likewise, effective demand is negatively correlated with the utilization rates of labor and capital.
I hear it said that there is a lack of demand in the economy. But let me ask… Is there a lack of effective demand in the economy?... Well, effective demand was high until the end of 2011. Labor lacked financial liquidity to freely express their demand. Also business was getting back on its feet to supply that demand. This all led to high latent/opportunity demand. Since the end of 2011, effective demand has been low and limiting utilization of capital and labor.
Hartwig, J. (2002). Trying to Make Sense of the Principle of Effective Demand. Seventh Annual Post Keynesian Workshop, Vol. 22. Kansas City, Missouri, USA.
Unknown. (n.d.). The Keynesian Principle of Effective Demand. Retrieved from https://cowles.econ.yale.edu/P/cm/m27/m27-04.pdf