Effective Demand The starting point of Keynes's theory of employment and income is the principle of effective demand. Effective demand denotes money actually spent by the people on products of industry. The money which entrepreneurs receive is paid in the form of rent, wages, interest and profit. Therefore effective demand equals national income.
- - Theories of Employment and Income An increase in the aggregate effective demand would increase the level of employment. A decline in total effective demand would lead to unemployment. Therefore, total employment of a country can be determined with the help of total demand of a country. According to the Keynes's theory of employment, “Effective demand signifies the money spent on consumption of goods and services and on investment.
The total expenditure is equal to the national income, which is equivalent to the national output”. The relationship between employment and output of an economy depends upon the level of effective demand which is determined by the forces of aggregate supply and aggregate demand. ED = Y = C + I = Output = Employment Effective demand determines the level of employment in the economy. When effective demand increases, employment will increase.
When effective demand decreases, the level employment will decline. The effective demand will be determined by two determinants namely consumption and investment expenditure. The consumption function depends upon income of the people and marginal propensity to consume. According to Keynes, if income increases, consumption will also increase but by less than the increase in income.
The rate of interest and marginal efficiency of capital determine the investment levels. Rate of interest depends on money supply and liquidity preference. Keynes has given importance to the concept of liquidity preference. Liquidity preference is based on three motives namely transaction motive, precautionary motive and speculative motive.
MEC depends on two factors namely Prospective yield of capital asset and supply price of capital, i.e rate of interest. (For more details see Chapter ) . . Aggregate Demand Function (ADF) In the Keynesian model, output is determined mainly by aggregate demand.
The aggregate demand is the amount of