What is effective demand?

John Maynard Keynes, answered from the texts and cited to the page.

John Maynard Keynes answers

Effective demand is the point at which entrepreneurs' expectations of proceeds are brought into conjunction with the conditions of supply — the specific level of employment at which the aggregate demand function and the aggregate supply function intersect, and at which the expectation of profit is maximised.¹ Let me put the machinery more precisely.

Call Z the aggregate supply price of the output from employing N men, and D the proceeds entrepreneurs expect to receive from employing N men.² If D exceeds Z at some level of employment, entrepreneurs have an incentive to expand employment further, bidding up factor costs if necessary, until Z and D are equal. The point of intersection is effective demand — not a range, not an average, but a determinate value.³

The classical doctrine denies that this point has any special significance, because it holds that supply creates its own demand: that the aggregate demand price always accommodates itself to the aggregate supply price for every possible level of output.⁴ On that view, effective demand has no unique equilibrium value — it is an infinite range of values, all equally admissible, and employment is determined only by the marginal disutility of labour at the upper end.⁵

Say's Law, stated plainly, is simply the proposition that there is no obstacle to full employment.⁶ If Say's Law were true, competition among entrepreneurs would always drive employment toward the point at which output as a whole ceases to be elastic — which is to say, full employment, by definition.⁷ But it is not true; and if it is not true, there is a vitally important chapter of economic theory that remains to be written.

That chapter turns on what governs D. Consumption — the part of effective demand I call D₁ — depends on the propensity to consume, a psychological characteristic of the community that relates aggregate income to aggregate expenditure on consumption.⁸ Investment — D₂ — depends on the inducement to invest, which is itself governed by the relation between the marginal efficiency of capital and the complex of interest rates on loans of various maturities and risks.⁹

Given those two quantities, there is only one level of employment consistent with equilibrium; and there is no general reason whatever for expecting that level to coincide with full employment.¹⁰ Full employment is a special case, realised only when, by accident or design, current investment provides exactly the demand required to fill the gap between what a fully employed community would produce and what it would choose to spend on consumption.¹¹ That is the optimum relationship the classical theory silently assumes as the general case. It is not the general case.

Sources

the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximises the entrepreneur's expectation of profit.
The General Theory of Employment, Interest and Money, pp. 71–72
Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z =4(N), which can be called the Aggregate Supply Function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D =/(N), which can be called the Aggregate Demand Function.
The General Theory of Employment, Interest and Money, pp. 41–42
Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs' expectation of profits will be maximised. 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.
The General Theory of Employment, Interest and Money, pp. 41–42
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.
The General Theory of Employment, Interest and Money, pp. 41–42
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.
The General Theory of Employment, Interest and Money, pp. 41–42
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.
The General Theory of Employment, Interest and Money, pp. 42–43
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.
The General Theory of Employment, Interest and Money, pp. 42–43
The relationship between the community's income and what it can be expected to spend on consumption, designated by D,, will depend on the psychological characteristic of the community, which we shall call its propensity to consume.
The General Theory of Employment, Interest and Money, pp. 44–45
The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks.
The General Theory of Employment, Interest and Money, pp. 44–45
Thus, given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium; since any other level will lead to inequality between the aggregate supply price of output as a whole and its aggregate demand price. But there is no reason in general for expecting it to be equal to full employment.
The General Theory of Employment, Interest and Money, pp. 44–45
The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another... it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.
The General Theory of Employment, Interest and Money, pp. 44–45