Keynes wrote in Chapter 3 of his grand book, "... the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profits will be maximised. 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."
The equation I present in this blog is actually the equation for the aggregate demand function, but this equation determines the point of intersection for effective demand. And understanding effective demand is now more important. For that reason, I call this blog "Effective Demand". Anyways, there is a need in economics to have a good and simple equation for determining effective demand.
One does not hear the term effective demand in the discourse. And this is not good, because it was one of Keynes' primary concepts. I attribute this to not having had a good equation for it.
Michael Kalecki, who was a contemporary of Keynes, also worked on the concept of effective demand. Kalecki also took an approach based on profits. He said that positive profit margins encouraged the utilization of capital and labor and increased output. He also said that the distribution of income between wages (labor income) and profits (capital income) affects effective demand. He hypothesized that the effect was based on different propensities to consume. Basically, he helped develop an understanding that output increases to a level where profits are maximized.
What then is Effective Demand? In my view it is two things...
- The intersection between effective aggregate demand and aggregate supply. This intersection determines the limits to the aggregate profit rate. The intersection denotes the "Zero Lower Bound" of effective demand.
- The difference between effective aggregate demand and aggregate supply. When effective aggregate demand is well above aggregate supply, we have a situation where the economy can expand to the point of the intersection. The economic dynamics when there is "some" difference between EA demand and A supply are different from those at the intersection.
Between the two aspects, we can see a business cycle forming of expansions and contractions within limits. The equation I put forth for effective demand establishes where we are within the business cycle, and is also capable of establishing the limits of that cycle. In future posts I will talk about these limits more. Actually we are reaching the limit of the current expansion in terms of utilization of labor and capital and aggregate profit rates.
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