Paul Krugman leads us to Effective Demand

On June 10th, 2009, Paul Krugman gave a lecture at the London School of Economics on how economics should be taught differently after the crisis. (It was actually the third lecture over 3 days. All 3 lectures are available on youtube and I highly recommend them even after 4 years.)

Paul Krugman made 3 references to Keynes’ concept of effective demand in that 3rd lecture. The basic tone is that we need to work on making effective demand useful. It is evident that Paul Krugman has an interest and a respect for the concept of effective demand.

I have developed a new model for effective demand. In future posts at Angry Bear blog, Steve Roth and I are going to be explaining what this new model of effective demand is, how it works and how it can be useful.

For the moment Paul Krugman will lead us to look at effective demand.

Effective demand & an equilibrium limit on employment

In the video on youtube for Krugman’s lecture, at the 20 minute point, Paul Krugman is talking about some criticisms against Keynes. One is that Keynes didn’t have a notion about equilibrium. From the lecture Paul Krugman says…

“You’ll also see people say, well, you know, economists have this notion of equilibrium and Keynes didn’t do that. But, this is Chapter 3 where he lays out the essentials of the general theory. And he says very much, “I am looking for an equilibrium that determines the level of unemployment. I’m looking for, you know… It’s actually in economics style where one curve crosses another curve. And then we’re going to talk about what moves those curves around.””

This is the part from Keynes’ chapter 3 of the General Theory book that Krugman referred to.

“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.”

Keynes is looking for an equilibrium between demand and supply that determines the limit upon employment. He refers to this equilibrium limit as effective demand.

The principles of effective demand that I put forth state that the SRAS (short-run aggregate supply) curve and the effective demand curve will cross at the LRAS (long-run aggregate supply) curve. The LRAS curve is the notion of the natural real GDP at full-employment where output will not increase, but the price level will. The LRAS also gives us the NAIRU level of unemployment.


Graph #1

The equilibrium that Keynes is looking for is the intersection of the SRAS, LRAS and effective demand curves. Employment will be limited at this intersection which represents potential output. Keynes wanted to tell us that effective demand can establish this intersection even at a level below what economists would consider full-employment.

As Krugman explains Keynes thoughts on effective demand, the key issue is an equilibrium with effective demand that determines the level of unemployment. The graph above shows this with the NAIRU determined at the LRAS curve.

Keynes wrote this in chapter 3…

“Thus the volume of employment is not determined by the marginal disutility of labour measured in terms of real wages, except in so far as the supply of labour available at a given real wage sets a maximum level to employment. The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages — not the other way round. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment.

“This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.”

Keynes is defining effective demand as a limit upon employment. He first says that employment is not determined by the point at which business is no longer willing to pay a certain real wage, but rather by levels of consumption and new investment. Thus, if consumption and new investment result in deficient demand, employment will be capped at a level below which business would still be willing to hire more workers based on the real wage. In other words, business would hire more workers, but there isn’t enough consumption and new investment to justify it.

Keynes is implying in the quote above that an increase in real wages can increase employment. How does this happen? Demand is the constraint on employment, not real wages. Thus real wages would increase and as you increase demand through higher real wages, the result is increased employment. because you have relaxed the demand constraint.

Effective demand & recessions

Then comes the issue of recessions and business cycles. At the 48 minute point of the video, Paul Krugman says…

“Keynes really put the question of why demand fluctuates on one side. But certainly it’s something we ought to be interested in. Particularly we ought to have some way of thinking about when it is that the bottom is likely to fall out on the economy. But almost nothing done on that.”

I recently posted a series of graphs looking at how effective demand determines the point at which a recession is likely to occur. So we know that the preliminary insights of Keynes into effective demand are within our grasp. Effective demand not only sets the stage for a recession, but it also caps employment and capital utilization before the recession starts.

Effective demand… making it happen

Keynes refuted Say’s law that “Supply creates its own demand”. Keynes stated that demand determines supply. Effective demand speaks to the relative purchasing power of consumers to determine supply. For instance, imagine an economy where labor gets paid 25% of national income. The domestic market for goods would simply provide less to consumers.

At the 53 minute point of the video, Krugman emphasizes Keynes’ focus on demand…

“Where do we go from here? First of all, I think, economists have really got to go back and say that these basic Keynesian type models need to be studied. People need to know that there is this issue about demand. They need to know that sometimes things that can’t be fully justified in terms of maximization are really important… that we need to have a whole different style of teaching. I don’t quite know how we make that happen.”

After all the above, what can I conclude?

Krugman says we need to develop the concept of effective demand better… make it more useful.

Well, 4 years later, we now have a model of effective demand; Steve Roth and I are going to work it out for you in future posts.