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Table of Contents
Define effective demand
Effective demand meaning – In ordinary sense demand means desire it becomes effective when income is spent on buying consumption goods and investment goods.
The term ‘effective demand‘ refers to the aggregate amount spent on goods and services by the whole community in a specified period. Thus effective demand signifies the total spending of community.
The effective demand is determined by the equality of aggregate demand function (ADF) and aggregate supply function (ASF).
Importance of Effective Demand
The principle of effective demand is the most important contribution of Keynes. It is the soul of the Keynesian theory of employment. The importance of Keynesian concept of effective demand can be understood from the following facts-
• Determinant of employment – Effective demand determines the level of employment in a country. When effective demand increases, employment also increases and a decline in effective demand decreases the level of employment.
Thus the basic cause of unemployment is deficiency of effective demand.
• Rejection of Say’s law and full employment theories – The principle of effective demand reject Say’s law of market that supply creates its own demand and that full employment equilibrium is a normal situation in the economy.
This principle points out that underemployment equilibrium is a normal situation and full employment equilibrium is accidental.
In a capitalist economy, supply fails to creates its own demand because the whole of earned income is not spent on the consumption of goods and services.
• Rejections of Pigou’s wage cut policy – Prof. Pigou says, full employment is attained by reducing the money wages. However, the wage cut policy of Prof. Pigou is also cancelled by the principle of effective demand.
According to Keynes reduction, in money wages will bring down the consumption expenditure on goods and services, there by causing a decline in the level of employment.
• Role of investment – The principle of effective demand is based on aggregate expenditure, i.e. consumption expenditure and investment expenditure, but in the lesser proportion.
Thus there is a gap between income and consumption, which leads to a reduction in the level of employment. This can be failed up by increasing investment expenditure because in the short run consumption expenditure remains stable.
• Paradox of poverty in the midst of potential plenty – In a free enterprise economy, the theory of effective demand explains the paradox of poverty in the midst of potential plenty.
Effective demand is determines by aggregate demand function, which is composed of consumption expenditure. The basic principle is that when income rises consumption also rises but in lesser proportion.
This leads to a gap between income and consumption, which must be failed up by the required investment expenditure.
If sufficient investment is not forth coming to fill up this gap then it leads to deficiency of effective demand resulting in unemployment.
Conclusion
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