Effective demand refers to the total demand for goods and services in an economy, which includes consumption demand and investment demand. According to Keynes, effective demand determines the level of output and employment in an economy. Effective demand is low in capitalist systems because savings increase as income rises, creating a "leakage" out of the system that must be filled by investment in order to maintain output and employment levels. The economy reaches equilibrium at the point where aggregate demand and aggregate supply curves intersect, but this equilibrium may occur at less than full employment if investment is insufficient to make up the gap between income and consumption. The government therefore has an important role in managing aggregate demand to minimize unemployment.

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.

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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