Principle of effective demand

The Principle of Effective Demand is the title of chapter 3 of John Maynard Keynes's book The General Theory of Employment, Interest and Money.[1] The principle presented in that chapter is that the aggregate demand function and the aggregate supply function intersect each other at the point of effective demand and that this point can be consistent with a state of under-employment and under-capacity utilization.[2] Another way of expressing this, in pre-Keynesian terminology, is to say that "demand creates its own supply" which gives primacy to a shifting demand function that can be insufficient to give an economy full employment in the long term, in contrast to the Say's law which insists "supply creates its own demand" and doesn't allow the possibility of long term unemployment as the supply figure is always, by definition, a fixed amount that demand will match.

Significance

According to Keynes it is the principle of effective demand that determines the level of output and employment in a country. This is in sharp contrast with neoclassical theory (Keynes called "classical economics") that claims that the employment is determined at the point where the wage is equal to the marginal product of labor is equal to wage (First Postulate of "Classical Economics" See The General Theory, Chapter 2). The principle of effective demand is the negation of this First Postulate.

The importance of the term 'effective demand' to Keynesian Economics in general is shown in the fourth paragraph of the chapter, where he states that this concept of effective demand, referring to the intersection of the supply and demand functions, is the "substance of the General Theory" and says that "the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend."

Formulation

Keynes's original formulation

In chapter 3, in which Keynes uses the term 'effective demand' 15 times in expounding his principle of effective demand, he defines the concepts of an aggregate demand and an aggregate supply, and then defines the concept of effective demand as the point of intersection of these two aggregate functions - at this point of intersection, the aggregate demand becomes "effective".[3]

This formulation was criticized by New Keynesians who think it lacks micro foundations. As a result, they came to refuse original formulation and the principle of effective demand. They explained the persistence of unemployment by the price rigidity. See New Keynesian Economics Volume Ⅰ edited by Gregory Mankiw and D. Romer.

New formulation

A new formulation of the principle of effective demand is proposed in a paper by Shiozawa 2021 The principle of effective demand: New formulation.[4] This is a microfounded version of the effective demand.

Controversy

New classical economics criticized Keynes and his followers claiming that Keynesian economics has no microfoundations an therefore invalid as theory. New Keynesian economics defended Keynes and Keynesian policy and tried to produce microfoundations to Keynesian economics. In doing so, it denied the concept of "effective demand" and denied the validity of the principle of effective demand. Post Keynesian economics defended Keynesian policy justifying it by the rigidity of prices.[5]

See also

References
  1. Keynes, J. M. (1936). The General Theory (rendered into HTML by Steve Thomas in 2003) (PDF). University of Missouri-Kansas city.
  2. Geoffrey Harcourt and Peter Riach (2006). The General Theory. 1. Routledge. p. 95.
  3. Geoffrey Harcourt, Peter Riach (2006). The General Theory. 1. Routledge. p. 93.
  4. Shiozawa, Y. 2021 The principle of effective demand: New formulation. The Review of Keynesian Studies 3: 67-95
  5. J. E. King 2002 A History of Post Keynesian Economics Since 1936, Edward Elgar, Cheltanham, UK.
This article is issued from Wikipedia. The text is licensed under Creative Commons - Attribution - Sharealike. Additional terms may apply for the media files.