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Dedicated to pie

Q. what do you understands by effective demand? Will the level of effective demand be

always associated with full employment?

***

Effective demandrepresents that aggregate demand or total spending (consumption expenditure andinvestment expenditure) which matches with aggregate supply (national income at factor cost).

In other words, effective demand is the signification of the equilibriumbetween aggregate demand (C+I) and

aggregate supply (C+S). This equilibrium position (effective demand) indicates that the entrepreneurs neither

have a tendency to increase production nor a tendency to decrease production. It implies that the nationalincome and employment which correspond to the effective demand are equilibrium levels of national income

and employment.

Unlike classical theory of income and employment, Keynesian theory of income and employmentemphasizes that the equilibrium level of employment would not necessarily be full employment. It can be

below or above the level of full employment.

In simple terms, Quantity of a good orservice that consumers are actually buying at the current market price

is called effective demand.

Importance of Effective Demand

The principle of effective demand is the most important contribution ofJ.M. Keynes. Its importance in

macro economics, in brief, is as under:

(i)Determinant of employment:- Effective demand determines the level of employment in the country. As

effective demand increases employment also increases. When effective demand falls, the level ofemployment also decreases.

(ii)Say's Law falsified:- It is with the help of the principle of effective demand that Says Law of Market has

been falsified. According to the concept of effective demand whatever is produced in the economy is not

automatically consumed. It is partly saved. As a result, the existence of full employment is not possible.

(iii) Role of investment:- The principle of effective demand explains that for achieving full employment

level, real investment must equal to the gap between income and consumption. In other words, employmentcannot expand, unless investment expands. Therein lies the importance of the concept of effective demand.

(iv) Capitalistic economy:- The principle of effective demand makes clear that in a rich community, the gapbetween income and expenditure is large. If required investment is not made to fill this gap, it will lead to

deficiency of effective demand resulting in unemployment.

Determinants of effective demand

The determinants of effective demand are:-

(1) Aggregate Demand (C+l):

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Aggregate demandrefers to the sum of expenditure, households, firms and the government is undertaking on

consumption and investment in an economy. The aggregate demand price is the amount of money which theentrepreneurs expect to receive as a result of the sale of output produced by the employment of certain

number of workers. An increase in the level of employment raises the expected proceeds and a decrease in

the level of employment lowers it.

The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of

employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l) for

goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and indirectlyon the level of employment.

(2) Aggregate Supply (C+S):

The aggregate supply refers to the flow of output produced by the employment of workers in an economy

during a short period. In other words, the aggregate supply is the value of final output valued at factor cost.The aggregate supply price is the minimum amount of money which the entrepreneurs must receiveto cover

the costs of output produced by the employment of certain number of workers.

The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other part is saved

(S) in the form of inventories of unsold output. The aggregate supply curve, (C+S) is positively slopedindicating that as the level of employment increases, the level of output also increases, thereby, increasing

the aggregate, supply. Thus, the aggregate supply (C+S) depends upon the level of employment through4heeconomy's aggregate production function.

In figure (32.3), the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at pointE

1which is an effective demand point. At point E

1, the equilibrium of national income is OY

1. Let us assume

that in the generation of OY1

level of income, some of the workers willing to work have not been absorbed.

It means that E1

(effective demand point) is an under employment equilibrium and OY1

is under employment

level of income.

The unemployed workers can be absorbed if the level of output can be increased from OY1

to OY2

which we

assume is the full employment level. We further assume that due to spending by the government, theaggregate demand curve (C+I+G) rises. As a result of this, the economy moves from lower equilibrium point

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E1

to higher equilibrium point E2. The OY is now the new equilibrium level of income along with full

employment. Thus E2

denotes full employment equilibrium position of the economy.

Thus government spending can help to achieve full employment. In case the equilibrium level of national

income is above the level of full employment, this means that the output has increased in money terms only.

The value of the output is just the same to the national income at full employment level.

Do you know:- J. M. Keynes wrote his famous book 'General Theory'. In it he presented anexplanation of the Great Depression of 1930's and suggested measures for the solution. He alsopresented his own theory of income and employment.

According to Keynes:

"In the short period, level of national income and so of employment is determined by aggregatedemand and aggregate supply in the country. The equilibrium of national income occurs whereaggregate demand is equal to aggregate supply. This equilibrium is also called effectivedemand point".

On the other hand, full employment is a condition of the national economy, where all or nearly allpersons willing and able to work at the prevailing wages and working conditions are able to do so. It is

defined either as absolutely 0% rate of unemployment, as by James Tobin, or as the level of employment

rates when there is no cyclicalunemployment. It is defined by the majority of mainstream economists as

being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-

cyclical types of unemployment. Unemployment above 0% is advocated as necessary to control inflation,

which has brought about the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU)*;

the majority of mainstream economists mean NAIRU when speaking of "full" employment.

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Diagram of macroeconomic circulat

rate of unemployment is zero or ne

Full employment has come to m

taken for granted that it is clear what th

The first issue concerns the resources r

resources, or only the full employment

employment of labor and the employm

to labor. Full employment of plant and

utilization or full employment of reso

The second definitional issue regards t

Contrary to the intuitive, common-sens

equate full employment with zero unatural rate of unemployment and the

employment has come to indicate that

that means millions of individuals read

But the million dollar question is wh

The aim of full employment can found

Keynesians school):-

on LS LD is the full employment situation,

ative (corresponding to a labor shortfall).

an different things to different people, and it sh

e term means.

eferred to by the term. Does the term refer to f

of labor? While there is obviously some relatio

nt of other resources, full employment will be

equipment as well as labor will be referred to a

rces.

e level of employment referred to by the term

e meaning of the term, most economists and pol

employment. Looked at through the lens of cnon accelerating inflation rate of unemploym

level of employment that is associated with pri

and willing to work are unemployed.

there is a need of full employment?

in writing of Luigi Pasinetti (an Italian econo

one in which the

ould therefore not be

ll employment of all

between the

sed here to refer only

full capacity

full employment.

icy makers do not

ncepts such as thent (NAIRU)*, full

e stability, even if

ist of the Post-

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The aim, Pasinetti writes, is clear: achieving the full utilization of available labour, i.e. full employment

(1993, p. 128). a magnitude of national relevance [is] the physical quantity of labour that is available in the

whole economic system. And it is clearly a matter of general concern that it should entirely be employed

i.e., that there should be full employment. (1993, p. 23)

Full employment is too important for an economic system as a whole. Keynes was therefore right in

advocating, at the institutional level, the inclusion of full employment into the objectives of overall economic

policy, in the sense that the community as a whole takes charge of it as a goal to be pursued with whatever

measures of economic policy 7may be appropriate, whenever the spontaneous forces of interaction between

employers and workers fail to bring it about. (1993, p. 132).

Moreover it is,

1. A policy of full employment promotes economic growth and a policy of economic growth increases

employment.

2. Full employment means full utilisation of job opportunities within the limits of available resources.

3. Full employment is a static concept. It refers to the utilisation of existing production capacity of the

economy under static conditions i.e. with given economic resources, production methods and

technology.4. Full employment is a short-term concept. It means elimination of unemployment in the short-run.

5. The policy of full employment involves giving employment at current wage rates, whereas the policy

of economic growth aims at providing employment at ever-increasing wage rate, thus improving the

living standards of the people.

6. The policy of full employment is a demand-oriented policy. It aims at increasing the effective

demand because deficiency of effective demand is the main cause of unemployment.

7. The policy of full employment is more suitable for the developed economies

But many economists had found problem with fixing effective demand at full employment

1. Working with the marginal efficiency of money to influence private investment in the face of

depressed expectation, Keynes argued, may prove to be like pushing on a string. This would make

monetary policy futile, especially when interest rates are already very low. Secondly, boosting the

marginal efficiency of capital (or profit expectations) also has its limitations because it is not under

the direct control of policy.

2. Low rates of interest and an increase in total money expenditures can improve the profits outlook and

entice entrepreneurs to redirect their money from financial assets to real production. Government

spending can be thought of as filling the cash boxes of private entrepreneurs (Kregel 2008), but

how large an injection of liquidity is need to induce those investors to start employing is difficult togauge. This is because while aggregate demand will increase the amount of liquid assets in the

system, it may not be able to expediently shift individual preference away from holding them. Such

would be the problems under a liquidity-trap scenario where money, as Keynes argued, becomes a

bottomless sink of purchasing power[and] there is no value for it at which demand [for it] is

diverted into a demand for other things (Keynes 1964 [1936]: 231).

3. Large-scale public works are needed not only for the swift reduction in unemployment, but also for a

generalized socialization of investment, which Keynes considered to be a prerequisite for economic

stability. If the increase in demand is directed to products with a relatively low elasticity of

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employment, a larger proportion of it will go to swell the incomes of entrepreneurs and a smaller

proportion to swell the incomes of wage earners and other price cost factors. (Keynes 1964 [1936]:

287)

Conclusion: - Keyness effective demand approach to employment determination is not the same as the

modern aggregate demand approach. Revisiting Keyness contribution makes clear why pinning the point of

effective demand at full employment is impossible to do via aggregate demand stimuli. This is due to the

structure of the economy, which ensures that near full employment, more money expenditures generate

inflation and erode income distribution. To get to full employment, Keynes argued for a better targeting of

demand, not necessarily for more aggregate demand.

Do you know: - In a letter to T.S. Elliot, Keynes commented that the trouble with designing policies for full

employment is that economists lacked both the intellectual conviction of their feasibility and the cleverness

to design them.

Mathematical Explanation*

LetZbe the aggregate supply price of the output from employingNmen, the

relationship betweenZandNbeing writtenZ= (N), which can be called theAggregate

Supply Function. Similarly, letD be the proceeds which entrepreneurs expect to receive

from the employment ofNmen, the relationship betweenD andNbeing writtenD =f(N),

which can be called theAggregate Demand Function.

Now if for a given value of N the expected proceeds are greater than the aggregate

supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneurs to

increase employment beyond N and, if necessary, to raise costs by competing with one

another for the factors of production, up to the value of N for which Z has become equal to

D. Thus 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 classical doctrine, on the other hand, which used to be expressed categorically inthe 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. For Supply creates its own Demand must mean thatf(N) and (N) are equal

for all values of N, i.e. for all levels of output and employment; and that when there is an

increase in Z( =f(N)) corresponding to an increase in N, D( =f(N)) necessarily increases

by the same amount as Z. The classical theory assumes, in other words, that the aggregate

demand price (or proceeds) always accommodates itself to the aggregate supply price; so

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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 expansionof 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.

For over four decades, Luigi Pasinetti has made seminal contributions in virtually every

important debate and discussion concerning economic theory and policy, resulting in a

framework that does in fact consider value and distribution, money and effective demand,

and structural and technological change in a dynamic, evolutionary context. In this way,Pasinetti has elaborated and synthesized the work and spirit of his teachers and mentors:

Kahn, Kaldor, Robinson, Sraffa, Goodwin, and Leontief. In doing so, Pasinetti has done

more than accomplish a great intellectual achievement. While this he has certainly

accomplished, Pasinetti first and foremost has developed a framework for understanding

the economic society in which we actually live, one which is characterized by ongoing

structural and technical change, deficiencies in aggregate effective demand, and persistent

unemployment. Such understanding is necessary if policies are to be devised that can

eliminate unemployment, reduces poverty, and generates the economic security

necessary for a more prosperous society.

Source:-

Full Employment Policies must consider effective demand and structural and

technological change By Mathew Forstater

(University of Missouri, Working Paper No. 14)