Monday, August 24, 2009

Effective Demand

Keynes measured employment in terms of national output or income. According to him greater the output greater shall be the employment and lesser the output lesser shall be the employment. But national output in turn depends upon effective demand

Effective demand = National Income/Output = Employment

By effective demand we do not mean mere desire but desire backed by ability and willingness to buy both consumer goods and capital goods. Hence effective demand refers to the “sum total of spending goods”. Thus according to Keynes effective demand is the sole determinant of employment in an economy. Effective demand is determined by the forces of aggregate demand function and aggregate supply function. Aggregate demand function implies a schedule of different amounts of money which entrepreneurs in an economy expect from the sale of their output and different levels of employment. Aggregate supply function is schedule of various amounts of money which represents the cost of the various outputs at different employment levels. So long as the cost is less than receipts the producers will go on producing the goods and employment will be increasing till receipts become equal costs. In case the cost exceed the receipts, the production shall be stopped and employment and employment within economy will decrease.

On Y-axis different amounts receipts from sale or expenditure by the community is represented and on X-axis volumes of employment are depicted. Curve AD represents the Aggregate demand function and curve AS represents the Aggregate Supply function at corresponding employment level. Curve AD indicates how much money the producers expect to get when they employ various amounts of workers and curve AS shows how much money the producers must get or represents the cost of various output different levels of employment. For example when OP1 men are employed, producers expect to receive OM1 (or P1H1) from the sale of their output. But supply price at this level i.e. OP1 men is OM2 or P1K1. In the initial stages AD curve shows steeper rise than the AS curve. But in the latter positions of curve AD shows a positive slope (rise up). It is because of the fact when production is less, there is a keen competition among the consumers to possess goods so that they may offer prices higher than the cost. But as scale of production increases costs rise and ‘offer prices’ of consumers fall. When employment level is OP1 the producers supply price P1K1 or M3 but they expect to get P1H1 or M1 and there by gain to the extent of K1H1 or M2M1. The competition among producers will encourage employment. At the output level OP the amount expected by producers and the must amount for producers are equal i.e. PH or (OM) = PH (or OM); hence H is the point of equilibrium employment. The employment will not increase to level of OP2 because at the point OP2 the must amount is P2H2 (or OM3) and the amount expected is P2K2. It means producers will suffer loss to the tune of K2H2, if any producer produced beyond point P. Hence OP is the ideal employment size.

First at the point K and the second at point K the equilibrium levels are shown. It implies that though there is OP size of labour force in the country but only OP amount of labour force is employed. Labour force to the extent of PP¢ is unemployment is point K and not point K1 i.e. at less than the full employment. Here by unemployment we mean only involuntary unemployment and not frictional, structure or voluntary unemployment.

Keynes holds that equilibrium at point K will be less than full employment. Keynes assumes that in short period aggregate supply function is constant because teachings of production cannot change under short period before achieving full employment.

We have said that employment is governed by effective demand so unemployment is due to lack of sufficient effective demand must be increased. During deflation expenditure on consumers goods as well as on producer’s goods must be increased to increase employment and during the inflation consumption and investment must be curtailed.

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