Effective Demand

According to Keynes, the level of income and employment in an economy depends on the level of effective demand. The higher the effective demand, the higher is the level of income and employment and vice versa. Effective demand refers to that level of aggregate demand which is fully matched by the corresponding aggregate supply. According to Stonier and Hague, “It is that demand price which becomes effective because it is equal to the aggregate supply price and thus represents a short-run equilibrium.”

In a capitalist society, the volume of employment depends on what the employers as a class decide who act taking into account the market forces. Besides the volume of employment, a private entrepreneur takes into account the supply price and demand price of that volume of employment. Supply price is the amount of money which the entrepreneur must expect to receive from the sale of output produced by employing a particular volume of labour. This otherwise means the cost of producing output consistent with that volume of employment. Demand price, on the other hand, is the amount of money which the entrepreneur does really expect to receive from the sale of output produced by employing a given volume of labour. This otherwise means the amount of money that others will spend to purchase the output consistent with that volume of employment. The entrepreneur will offer that volume of employment in which his supply price is equal to his demand price. The same argument applies to the economy as a whole. Total volume of employment in the economy is therefore, economy as a whole. Total volume of employment in the economy is therefore, dependent on aggregate supply price and aggregate demand price and it will settle at the point where aggregate supply price is equal to the aggregate demand price. That point is the point of effective demand which determines the equilibrium level of income.