Macro Economics, Keynesian theory of Effective Demand

1. EFFECTIVE DEMANDEFFECTIVE DEMAND

2. Apr 13, 2016 2
Effective Demand
• Keynes: Output and employment are
affected by changes in Effective D in the
economy.
• Effective D = Consumption D + Investment
D
• If Effective D is low, then employment and
output will also be low.
• In capitalist systems, Effective D is always
low.

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• This is because as Y increases, C does
not increase at the same rate.
• Savings increase, and forms a leakage
out of the system.
C =f(Y), and S =f(Y).
Y↑, then C ↑ < Y ↑, S ↑
• Investment has to increase to fill in this
gap.

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• Effective Demand is influenced by two
factors:
1. Aggregate demand and 2. Aggregate
Supply.
o Aggregate Demand Function is a
schedule of receipts that entrepreneurs
expect for the sale of their products.
o Aggregate Supply Function is a schedule
of costs of producing various amounts of
output.

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Equilibrium
• Employment depends on Effective D.
• Effective demand is determined by the
intersection of AD and AS.
• Both curves are positively related to
levels of employment.
• As employment increases, demand for
goods and services increases. (AD)
• Supply and cost of production also
increases (AS).

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Effective D
N
Agg D
N1
E
Q
Q1
0
Agg S
D > S,
Q ↑
N0
S > D,
Q ↓
N2
Effective D is
at point E,
with output
Q1, and
employment
0N1.
But it need
not be full
employment
equilibrium.

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Unemployment
• Usually point E is at less than full
employment, or unemployment.
• To reach full employment, investment
should be large enough to fill the gap
between Y and C.
• If Investment is not high enough, there will
be unemployment equilibrium situation.

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Effective Demand
Effective Demand = Total output (C+I)
= National Expenditure
= National income
= total employment
There is no reason why the economy must
come to equilibrium at full employment.

9. Apr 13, 2016 9
Role of Government
• The economy can experience
recessionary gaps or inflationary gaps
• Aggregate Supply will always adjust to
Aggregate Demand, not the other way
around
• Therefore, Government has an important
role and responsibility to manage the
economy

10. Apr 13, 2016 9
Role of Government
• The economy can experience
recessionary gaps or inflationary gaps
• Aggregate Supply will always adjust to
Aggregate Demand, not the other way
around
• Therefore, Government has an important
role and responsibility to manage the
economy