Example of not understanding Effective Demand


The Economist online magazine has an article called, Jobs are not Enough, where they show a poor understanding of effective demand.

“Economic growth over the business cycle is driven mostly by swings in demand, and in recent years demand has been held back: households have been repaying their debts; the government has restrained its spending and raised taxes; and interest rates, having reached zero, are unable to fall further”

OK, demand drives the business cycle.

“Over the long run, however, a country’s potential growth depends on supply: how many workers it has and how productive they are. The recent divergence between America’s employment and output suggests the country faces not just deficient demand but also enfeebled supply, as more people working without more output means lower productivity. That is bad news for all Americans since their standard of living depends on productivity.”

Then they drop demand from the equation and say that potential growth depends on supply. What happened to demand which was driving the business cycle? For me, they simply do not understand the concept of effective demand, which is the demand measurement for determining the limits of potential output.

They take this error in understanding to the next level… by saying that supply is the problem for high unemployment and low output. They specifically point to productivity, which is actually constrained by effective demand. And the current poorer standard of living is caused not by supply problems, but by demand problems… namely, low labor share. They are not making the proper connections between effective demand, productivity, output and unemployment.

Like Keynes said, until people understand effective demand, “all discussions concerning the volume of aggregate employment are futile.” (link)