On the Angry Bear blog, a commenter named Axt113 asked about effective demand. I referred him to Chapter 3 of Keynes' General Theory... He responded.

Okay, I found the section, it says:

“The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.”

Okay, so effective demand is the equilibrium point of aggregate supply and aggregate demand, but that implies that shifts to aggregate demand and aggregate supply ( in the short run), will change effective demand.

So wouldn’t increasing aggregate demand, by higher wages shift effective demand upwards?

Here is my response...

Don’t confuse the AS-AD model that we normally learn with the model that Keynes is presenting in that section.

The normal model puts AS = AD at any point in time. The lines always cross. What is consumed equals what is supplied.

Now Keynes model puts demand above supply at any point in time. Demand above supply gives entrepreneurs incentive to employ more labor and capital. Yet, the difference between demand and supply gets smaller as more labor and capital are utilized. So imagine two lines that meet at some distant point. One line is demand above the other line of supply. The point at which these two lines meet is effective demand. If we see the point as stationary, then as you employ more labor and capital beyond the point, demand will go below supply. Then entrepreneurs will un-employ labor and capital.

So the normal model has AS and AD moving together. In Keynes model, the economy is moving toward a “fixed” long run equilibrium state between supply and demand.

Now, you are asking if increases in wages can shift that stationary point of effective demand… I would say Yes, as long as labor’s share of national income rises.

Let me explain my model… put price on the y-axis to show what is supplied and demanded. But on the x-axis put the utilization of labor and capital. The x-axis now represents how the economy grows by utilizing more labor and capital. As you move right on the x-axis, you utilize more labor and capital with the demand line higher than the supply line. Eventually you reach the equilibrium point between supply and demand. The equilibrium level of effective demand on the y-axis is the top side of potential GDP. That is the effective demand point that Keynes describes…. beyond which employment of more labor is not wanted by firms.

For me, that equilibrium point is determined by labor’s share of national income… Not by labor’s total income, but by labor’s % share. Very different concept.

Now what could shift that equilibrium point upward? There are many ways… I will give 2.

1. We could raise labor’s share. That would shift the demand up, sliding the equilibrium point up and to the right along the supply curve. ultimate potential GDP is raised and the natural rate of unemployment is raised.

2. We could just raise wages. But now that would shift the demand curve to the right, but also shift the supply curve to the left. So you may end up simply increasing the total amount at the equilibrium point as seen on the y-axis. Yet, the top limit for utilizing labor and capital seen on the x-axis has not changed. Your level of full employment has not changed.

What can cause that equilibrium point of effective demand to fall?

This is what happened after the crisis… labor share fell. The demand curve shifted to the left. The result was that the equilibrium point now reflects a lower total value of the economy (GDP on y-axis) and a lower full employment level of labor and capital (higher natural unemployment and lower capacity utilization on x-axis). Potential GDP also fell.

OK… now does raising wages raise the effective demand limit? That depends on how you measure the effective demand limit, either by the y-axis or the x-axis. You could see GDP increasing (y-axis), but the natural level of unemployment has not changed (x-axis).

For me, effective demand must be primarily determined by the x-axis. The x-axis reflects Keynes’ focus in Chapter 3 on the rate of employment of labor to describe the effective demand limit.

So when you say that raising wages should raise the effective demand limit, we need to study the effect to know how. Did potential GDP rise? Did the natural rate of unemployment rise? You could get different answers to those questions.

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