Many think that effective demand is simply aggregate demand. But that is not true. They are different concepts. It is very important in the current economic sickness to understand the role of effective demand. So I will define effective demand in this post as Keynes saw it.
1. Effective Demand is not Aggregate Demand
Don’t confuse the AS-AD model with effective demand. The common AS-AD model puts AS = AD at any point in time. The lines always cross. What is consumed equals what is supplied. That is in agreement with Say's law.
When Keynes defined the concept of effective demand, he did not describe the AS-AD model where you have price level on the y-axis and real output on the x-axis. (see Chapter 3 of Keynes' General Theory) Keynes' model put demand above aggregate supply at any point in time. Demand above aggregate supply gives entrepreneurs incentive to employ more labor and capital. The difference between demand and aggregate 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 aggregate supply. But the demand line is not aggregate, but rather effective demand. The point at which these two lines meet is the effective demand limit upon full employment.
Here is the model I use for how Keynes described effective demand.
I put price value on the y-axis to show what is supplied and demanded. But on the x-axis I put the utilization of labor and capital. The x-axis 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 point is where Keynes defined effective demand. It is where you will find your full employment level for utilization of labor and capital. Therefore, the point where the two lines cross is the natural level of real output. That is the effective demand point that Keynes describes….
If we see the crossing point as stationary, then as you employ more labor and capital beyond the point, effective demand will go below what entrepreneurs will supply. Then entrepreneurs will un-employ labor and capital because they see their profit rates maximize.
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.
(note: The difference between the aggregate supply and effective demand lines measures the spare capacity in the economy in terms of both labor and capital.)
2. Effective Demand is based on Labor's Share of National Income
For me, the line of effective demand is determined by labor’s share of national income in relation to the utilization of labor and capital on the x-axis… Not by labor’s total income, but by labor’s % share. You can actually change labor's total income without changing its share.
3. Shifts of the Effective Demand line
The effective demand line can shift when labor's share changes. An increase in labor share will shift the effective demand line upward. The equilibrium point shifts up and right along the aggregate supply line allowing more utilization of labor and capital at a higher natural level of real output.
4. Shifts of the Aggregate Supply line... Productivity Increases
The aggregate supply line will shift up and down too. If productivity increases, output per utilization rate of labor and capital rises, and we see the AS line shift upward. Yet the result is to shift the equilibrium point of effective demand to the left, thus lowering the natural level of output in terms of utilizing labor and capital. Thus productivity increases are not possible when the economy is near the equilibrium point. Entrepreneurs would want to un-employ labor and capital.
That is why the data shows that productivity will stabilize when the economy is near the effective demand limit. So the productivity conundrum is no mystery, when effective demand is properly understood.
This graph shows productivity stalls against the effective demand limit. When the line in the graph moves away from the ED limit, we see productivity increases. That is when the utilization of labor and capital is to the left of the equilibrium point in the model given above.
5. Vertical Shift of Equilibrium Point
Look at the graph of productivity. Find the points for 1994 through 1997. Productivity did not move for 4 years against the ED limit. But then look at how the plot moved up along the limit for a couple years before the 2001 recession (0.73 to 0.80 range). So I ask... How was productivity able to increase at the ED limit? Wouldn't the equilibrium point move to the left and shut down utilization of labor and capital?
The answer is that the equilibrium point in the model shifted up vertically.
As productivity increased, effective demand had to increase at the same time. How did this happen? Well, labor share rose during that period of time, which shifted the effective demand line upwards.
(Note: The utilization rates of labor and capital had to stay steady in order for the equilibrium point to rise vertically. So as unemployment fell during that time, we saw capacity utilization fall too. As more labor was employed, less capacity had to be employed in order to not go beyond the profit maximization point of the ED equilibrium point.)
6. Drop in Potential GDP after the Crisis
After the crisis we saw labor share fall.
The effective demand line in the model shifted downward thus moving the equilibrium point of the natural output level down along the aggregate supply line. The y-axis then tells us that potential GDP declined. The x-axis then explains the higher unemployment rate and the lower capacity utilization rate that we see. Once you understand effective demand as Keynes saw it, the drop in potential GDP and the rise in the natural rate of unemployment is no mystery. But the CBO is slow to understand this.
7. Looking at Current Effective Demand
This chart has the most recent data on effective demand. (1Q-2014)
Productivity is stalled. Profit rates have peaked. There is very little spare capacity left as the lines are very close. We are at the effective demand limit. Full employment now sits at a lower level. Even the Fed may be realizing this.
Keynes defines effective demand as a distinct equilibrium point and not an infinite range of values along the aggregate supply curve...
"For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of the proceeds over the factor cost."
"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. Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.
"The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and continues to underlie all orthodox economic theory, involves a special assumption as to the relationship between these two functions. ... The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having a unique equilibrium value, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.
"If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment.... Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile."
I am helping to write that vitally important chapter. Economists must understand effective demand as Keynes saw it. There are a lot of futile discussions abounding out there.
UPDATE: What stops productivity from just rising up the "slope of 1" line in part 4. This graph shows the answer. Increased productivity shifts the aggregate supply curve up. As the equilibrium point moves left, profit rate maximization moves left too. Thus firms trying to maximize profits would be forced to un-employ labor and capital if they tried to raise productivity against the effective demand limit.