Effective demand

Effective demand (in macroeconomics usually regarded as synonymous with aggregate demand), is an economic principle that suggests consumer needs and desires must be accompanied by purchasing power (money) to be considered effective in discussions of supply and demand for the determination of price.

Classical economists Adam Smith and David Ricardo embraced Say's Law, suggesting that "supply creates its own demand." According to Say's Law, for every excess supply (glut) of goods in one market, there is a corresponding excess demand (shortage) in another. This theory suggests that a general glut can never be accompanied by inadequate demand for products on a macroeconomic level. In challenge of Say's Law, Thomas Malthus, Jean Charles Leonard de Sismondi, and other 19th Century economists argued that "effective demand" is the foundation of a stable economy. Responding to the Great Depression of the 20th Century, John Maynard Keynes concurred with the latter theory, suggesting that "demand creates its own supply."

According to Keynesian economics, weak demand results in unplanned accumulation of inventories, leading to diminished production and income, and increased unemployment. This triggers a multiplier effect which draws the economy toward underemployment equilibrium. By the same token, strong demand results in unplanned reduction of inventories, which tends to increase production, employment, and incomes. If entrepreneurs consider such trends sustainable, investments typically increase, thereby improving potential levels of production.

Michal Kalecki developed theories of effective demand similar to Keynes', based in Marxism rather than neoclassical framework. But, published mainly in Polish, the language difference is said to have limited the spread of Kalecki's ideas, compared to Keynes.

Definition

The effective demand principle states that “in a market economy – and, therefore a monetary economy, where money attend all functions (medium of exchange, unit of account and store of value), in every transaction of buying and selling there is only one autonomous decision: the spending one. In result, every spending determines an income of the same extent. By aggregation, the totality of spending in any given period is always equal and determines the totality of income”.