## Defining Effective Demand as Keynes saw it

A commenter on our Angry Bear blog, Axt113, asked questions to understand what effective demand is. He/she like many think that effective demand is simply aggregate demand. But that is not true. They are different concepts. It is very important in the current economic sickness to understand the role of effective demand. So I will define effective demand in this post.

### 1. Effective Demand is not Aggregate Demand

Don’t confuse the AS-AD model with effective demand. The common AS-AD model puts AS = AD at any point in time. The lines always cross. What is consumed equals what is supplied. That is in agreement with Say’s law.

When Keynes defined the concept of effective demand, he did not describe the AS-AD model where you have price level on the y-axis and real output on the x-axis. (see Chapter 3 of Keynes’ General Theory) Keynes’ model put demand above aggregate supply at any point in time. Demand above aggregate supply gives entrepreneurs incentive to employ more labor and capital. The difference between demand and aggregate supply gets smaller as more labor and capital are utilized. So imagine two lines that meet at some distant point. One line is demand above the other line of aggregate supply. But the demand line is not aggregate, but rather effective demand. The point at which these two lines meet is the effective demand limit upon full employment.

Here is the model I use for how Keynes described effective demand.

I put price value on the y-axis to show what is supplied and demanded. But on the x-axis I put the utilization of labor and capital. The x-axis represents how the economy

grows by utilizing more labor and capital. As you move right on the x-axis, you utilize more labor and capital with the demand line higher than the supply line. Eventually you reach the equilibrium point between supply and demand. The equilibrium point is where Keynes defined effective demand. It is where you will find your full employment level for utilization of labor and capital. Therefore, the point where the two lines cross is the natural level of real output. That is the effective demand point that Keynes describes….

If we see the crossing point as stationary, then as you employ more labor and capital beyond the point, effective demand will go below what entrepreneurs will supply. Then entrepreneurs will un-employ labor and capital because they see their profit rates maximize.

So the normal model has AS and AD moving together. In Keynes model, the economy is moving toward a “fixed” long run equilibrium state between supply and demand.

(note: The difference between the aggregate supply and effective demand lines measures the spare capacity in the economy in terms of both labor and capital.)

### 2. Effective Demand is based on Labor’s Share of National Income

For me, the line of effective demand is determined by labor’s share of national income in relation to the utilization of labor and capital on the x-axis… Not by labor’s total income, but by labor’s % share. You can actually change labor’s total income without changing its share.

### 3. Shifts of the Effective Demand line

The effective demand line can shift when labor’s share changes. An increase in labor share will shift the effective demand line upward. The equilibrium point shifts up and right along the aggregate supply line allowing more utilization of labor and capital at a higher natural level of real output.

### 4. Shifts of the Aggregate Supply line… Productivity Increases

The aggregate supply line will shift up and down too. If productivity increases, output per utilization rate of labor and capital rises, and we see the AS line shift upward. Yet the result is to shift the equilibrium point of effective demand to the left, thus lowering the natural level of output in terms of utilizing labor and capital. Thus productivity increases are not possible when the economy is near the equilibrium point. Entrepreneurs would want to un-employ labor and capital.

That is why the data shows that productivity will stabilize when the economy is near the effective demand limit. So the productivity conundrum is no mystery, when effective demand is properly understood.

This graph shows productivity stalls against the effective demand limit. When the line in the graph moves away from the ED limit, we see productivity increases. That is when the utilization of labor and capital is to the left of the equilibrium point in the model given above.

### 5. Vertical Shift of Equilibrium Point

Look at the graph of productivity. Find the points for 1994 through 1997. Productivity did not move for 4 years against the ED limit. But then look at how the plot moved up along the limit for a couple years before the 2001 recession (0.73 to 0.80 range). So I ask… How was productivity able to increase at the ED limit? Wouldn’t the equilibrium point move to the left and shut down utilization of labor and capital?

The answer is that the equilibrium point in the model shifted up vertically.

As productivity increased, effective demand had to increase at the same time. How did this happen? Well, labor share rose during that period of time, which shifted the effective demand line upwards.

(Note: The utilization rates of labor and capital had to stay steady in order for the equilibrium point to rise vertically. So as unemployment fell during that time, we saw capacity utilization fall too. As more labor was employed, less capacity had to be employed in order to not go beyond the profit maximization point of the ED equilibrium point.)

### 6. Drop in Potential GDP after the Crisis

After the crisis we saw labor share fall.

The effective demand line in the model shifted downward thus moving the equilibrium point of the natural output level down along the aggregate supply line. The y-axis then tells us that potential GDP declined. The x-axis then explains the higher unemployment rate and the lower capacity utilization rate that we see. Once you understand effective demand as Keynes saw it, the drop in potential GDP and the rise in the natural rate of unemployment is no mystery. But the CBO is slow to understand this.

### 7. Looking at Current Effective Demand

This chart has the most recent data on effective demand. (1Q-2014)

Productivity is stalled. Profit rates have peaked. There is very little spare capacity left as the lines are very close. We are at the effective demand limit. Full employment now sits at a lower level. Even the Fed may be realizing this.

Keynes defines effective demand as a distinct equilibrium point and not an infinite range of values along the aggregate supply curve…

“For entrepreneurs will endeavour to fix the amount of employment at the level which they expect to maximise the excess of the proceeds over the factor cost.”

“The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called *the effective demand. *Since this is the substance of the General Theory of Employment, which it will be our object to expound, the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend.

“The classical doctrine, on the other hand, which used to be expressed categorically in the statement that “Supply creates its own Demand” and **continues to underlie all orthodox economic theory**, involves a special assumption as to the relationship between these two functions. … The classical theory assumes, in other words, that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price; so that, whatever the value of N may be, the proceeds D assume a value equal to the aggregate supply price Z which corresponds to N. That is to say, effective demand, instead of having **a unique equilibrium value**, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labour sets an upper limit.

“**If this were true, competition between entrepreneurs would always lead to an expansion of employment** up to the point at which the supply of output as a whole ceases to be elastic, i.e. where a further increase in the value of the effective demand will no longer be accompanied by any increase in output. Evidently this amounts to the same thing as full employment…. Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. **If, however, this is not the true law** relating the aggregate demand and supply functions, **there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile**.”

I am helping to write that vitally important chapter. Economists must understand effective demand as Keynes saw it. There are a lot of futile discussions abounding out there.

**UPDATE**: Arne asked a question of why productivity cannot just rise up the “slope of 1″ line in part 4. This graph shows the answer. Increased productivity shifts the aggregate supply curve up. As the equilibrium point moves left, profit rate maximization moves left too. Thus firms trying to maximize profits would be forced to un-employ labor and capital if they tried to raise productivity against the effective demand limit.

Thanks Edward,

This clears up the questions I had about your view of Keynesian effective demand.

I’m not 100% convinced yet about your theory (50-50 right now), but I’ll keep an eye out over the next year or so to see how things play out .

Axt113,

Let me know if you bet against me… : )

What still bothers me is: What is the utility of calculating a value of effective demand at a point in time when there is no equilibrium if effective demand is defined as an equilibrium point? What I see you saying is that we really are near equilibrium, but I do not see why that says anything about where we go from here.

Why can we not just slide up your slope=1 line in the chart of part 4.

Note: I think I understand that sliding up that line would require an increase in labor share as the economy continues to grow.

Hi Arne,

Calculating the value of effective demand gives a measure of spare capacity, which is important for all kinds of policy and investment.

Where do we go from here? If you look back at the past, utilization of labor and capital will hit a wall, then the business cycle unravels, unless labor share can be raised like it did at the end of the 90′s.

If you slide up the line in part 4, that means that output is increasing per utilization of labor and capital In other words, productivity is increasing. That means that the aggregate supply line in the first graph given at the beginning shifts upward… more output at the same utilization of labor and capital. If the aggregate supply line shifts upward and the horizontal effective demand line stays steady, the equilibrium point moves left. And remember, Keynes said that firms do not want to go right of the equilibrium point. Thus firms are forced to lower utilization of labor and capital if we just try to increase productivity against the effective demand limit.

I will add a graph at the end of the post to show that.

You lost me.

Next year, GDP and effective demand will not be 14T. If there has been investment, then your blue line will not have the same slope next year. Both the orange and the blue lines will shift.

Does not 1994 to 1997 have an increase in GDP along with an increase in productivity while GDP stays near effective demand?

Oh Arne,

That model is just a model. The numbers on the y-axis are just for show. They are not meant to be real numbers.

1994 to 1997 did not see hardly any increase in productivity. There is a little area on the productivity graph for 1994 to 1997. There are almost 20 dots bunched on top of one another in a small area. Then you see the plot start moving up along the “slope of 1″ line. That is when productivity grew.

As far as investment, look at the graph in part 7. Real GDP rises in a quadratic curve with the utilization of labor and capital. Investment follows the rise in real GDP (aggregate supply). Does effective demand change from investment? No…

Edward, I confess: I read your stuff only casually, but usually it doesn’t “click” for me. Sometimes it still doesn’t click when I put effort into it. Now, for example. You write:

When Keynes defined the concept of effective demand, he did not describe the AS-AD model… Keynes’ model put demand above aggregate supply at any point in time… So imagine two lines that meet at some distant point. One line is demand above the other line of aggregate supply. But the demand line is not aggregate, but rather effective demand.You define “effective demand” as a line. Your points #2 and #3 also make this clear.

You define “effective demand” as a

line. Keynes defines it as anintersection point. You quote him:The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.You emphasize it, writing:

Keynes defines effective demand as a distinct equilibrium pointYet you seem to suggest agreement between Keynes and yourself. I don’t get it.

//

Oh… I always figured the “vitally important chapter” was the one Keynes himself wrote.

The Arthurian,

Many times it is hard to make clear what already seems confusing. But let me give it a try…

If I called the effective demand line the aggregate demand line, you would be even more confused. You would very easily confuse it with the aggregate demand line of the AS-AD model. I wanted to avoid that.

So now in your mind, you have to distinguish between the effective demand line that I drew to represent Keynes’ aggregate demand line, from the aggregate demand line in the AS-AD model.

You have to throw out the window the AD line from the AS-AD model. Get it out of your head for a second.

Then look at the effective demand line that I drew in the first graph above. At 60% on the x-axis, Keynes would say that aggregate demand was above aggregate supply. Yet, I cannot say aggregate demand because people get confused. So I say that effective demand is above aggregate supply, and thus there are profit incentives to increase utilization of L and C to the right on the x-axis as Keynes would see it.

Keynes only used labor employment in his description of effective demand. But just using labor employment will not give you a workable equation for effective demand. The data don’t give it. Keynes should have referred to both employment of labor and capital. Then you get a workable equation.

Eventually, the effective demand line crosses the aggregate supply line. Where they cross, is their equilibrium point. Keynes calls the point simply effective demand.

I call it various names, effective demand limit, effective demand equilibrium point, natural level of real output. For me, effective demand is much more than the equilibrium point. My effective demand line gives a measure of spare capacity away from the equilibrium point. So I am extending the vision of Keynes. Sorry…

Keynes never quite defined an equation for effective demand, even though his intuition could describe it. Many have tried since to define an equation. So that vitally important chapter is still being written. I am helping to develop some ideas for that chapter, which has not been finished yet.

There is more work to be done. But some pieces are coming together.

If I infer from this excellent piece of write-up that expansionary income, fiscal, and monetary policies favor higher effective demand in the US, will I be wrong?

Maurice Dobb,

Yes, you would be wrong. Expansionary income does not favor higher effective demand.

You can flood the economy with expansionary money, and the money will circulate through the economy, but if labor share does not change, the same percentage ends up in the hands of capital and labor. The natural level for utilizing labor and capital will not change.

Expansionary money favors the power of capital. What is needed for higher effective demand is a policy that favors the power of labor.

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