Effective demand

Effective demand

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In economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market. In the aggregated market for goods in general, effective demand is the same thing as aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 when the demand for goods is influenced by spillovers from quantity constraints from other markets. The concept of effective supply parallels the concept of effective demand. The concept of effective demand or supply becomes relevant when markets do not continuously maintain equilibrium
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...


Examples of spillovers

One example involves spillovers from the labor market to the goods market. If there is labor market disequilibrium such that individuals cannot supply all the labor they want to supply, then the amount that they are able to supply will influence their demand for goods; the demand for goods, contingent on the constraint on the amount of labor that can be supplied, is their effective demand for goods. In contrast, if there were no labor market disequilibrium, individuals would simultaneously choose both their quantity of labor to supply and the quantity of goods to purchase, and the latter would be their notional demand for goods. In this example, the effective demand for goods would be less than the notional demand for goods.

Conversely, if there are goods market shortages, individuals may choose to supply less labor (and enjoy more leisure) than they would in the absence of goods market disequilibrium. The amount of labor they choose to supply, contingent on the constraint on the amount of goods they can buy, is the effective supply of labor.

Another example involves spillovers from credit markets to the goods market. If there is credit rationing
Credit rationing
Credit rationing refers to the situation where lenders limit the supply of additional credit to borrowers who demand funds, even if the latter are willing to pay higher interest rates. It is an example of market imperfection, or market failure, as the price mechanism fails to bring about...

, some individuals are constrained in the amount of funds they can borrow to finance goods purchases (including consumer durables and houses), so their effective demand for goods, as a function of this constraint, is less than their notional demand for goods (the amount they would buy if they could borrow all they want to).

Firms can also exhibit effective demands or supplies that differ from notional demands or supplies. They too can be credit constrained, resulting in their effective demand for goods such as physical capital
Physical capital
In economics, physical capital or just 'capital' refers to any already-manufactured asset that is applied in production, such as machinery, buildings, or vehicles. In economic theory, physical capital is one of the three primary factors of production, also known as inputs in the production function...

 differing from their notional demand. In addition, in a time of labor shortage, they are constrained in how much labor they can employ; therefore the amount of goods they choose to supply at any potential goods price—their effective supply of goods—will be less than their notional supply. And if firms are constrained by excess supply in the goods market, limiting how much goods they can supply, then their effective demand for labor will be less than their notional demand for labor.

The excess demands in different markets can influence each other. The presence of excess demand in one market influences effective demand or supply in another market, which may influence the degree of disequilibrium in the latter market; in turn, the constraints imposed on participants in that market influence their effective demand or supply in the former market.


Classical economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...

 David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...

 embraced Say's Law
Say's law
Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...

, suggesting, in Keynes's
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 formulation, that "supply creates its own demand
Supply creates its own demand
"Supply creates its own demand" is the formulation of Say's law by John Maynard Keynes, and is considered by him one of the defining characteristics of classical economics...

." 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
General glut
In macroeconomics, a general glut is when supply exceeds demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume said production....

 can never be accompanied by inadequate demand for products on a macroeconomic level. In challenge of Say's Law, Thomas Malthus
Thomas Malthus
The Reverend Thomas Robert Malthus FRS was an English scholar, influential in political economy and demography. Malthus popularized the economic theory of rent....

, Jean Charles Leonard de Sismondi
Jean Charles Léonard de Sismondi
Jean Charles Léonard de Sismondi , whose real name was Simonde, was a writer born at Geneva. He is best known for his works on French and Italian history, and his economic ideas.-Early life:...

, and other 19th Century economists argued that "effective demand" is the foundation of a stable economy. Responding to the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

 of the 20th Century, John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 concurred with the latter theory, suggesting that "demand creates its own supply."

According to Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

, weak demand results in unplanned accumulation of inventories, leading to diminished production and income, and increased unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

. This triggers a multiplier effect
Multiplier (economics)
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

 which draws the economy toward underemployment equilibrium
Underemployment equilibrium
In Keynesian economics, underemployment equilibrium refers to a situation with a persistent shortfall relative to full employment and potential output so that unemployment is higher than at the NAIRU or the "natural" rate of unemployment. This situation is not seen as solvable via laissez-faire...

. By the same token, strong demand results in unplanned reduction of inventories, which tends to increase production, employment, and incomes. If entrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...

s consider such trends sustainable, investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

s typically increase, thereby improving potential levels of production.

Michal Kalecki
Michal Kalecki
Michał Kalecki was a Polish economist who specialized in macroeconomics of a broadly-defined Keynesian sort...

 developed theories of effective demand similar to Keynes', based on Marxism
Marxism is an economic and sociopolitical worldview and method of socioeconomic inquiry that centers upon a materialist interpretation of history, a dialectical view of social change, and an analysis and critique of the development of capitalism. Marxism was pioneered in the early to mid 19th...

 rather than the neoclassical framework. But, published mainly in Polish, the language difference is said to have limited the spread of Kalecki's ideas, compared to Keynes'.

The effective demand principle

The effective demand principle states that “in a market economy
Market economy
A market economy is an economy in which the prices of goods and services are determined in a free price system. This is often contrasted with a state-directed or planned economy. Market economies can range from hypothetically pure laissez-faire variants to an assortment of real-world mixed...

 – and, therefore a monetary economy, where money attends 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. As a result, all spending results in income of the same extent. By aggregation, the totality of spending in any given period is always equal to and determines the totality of income”.

Further reading

  • Buiter, Willem, and Lorie, Henri, "Some unfamiliar properties of a familiar macroeconomic model," The Economic Journal, December 1977, 743-754.
  • Korliras, Panayotis, "A disequilibrium macroeconomic model," Quarterly Journal of Economics
    Quarterly Journal of Economics
    The Quarterly Journal of Economics, or QJE, is a peer-reviewed academic journal published by the Oxford University Press and edited at Harvard University's Department of Economics. Its current editors are Robert J. Barro, Elhanan Helpman and Lawrence F. Katz...

    , February 1975, 56-80.
  • Lorie, Henri, "Price-quantity adjustments in a macro-disequilibrium model," Economic Inquiry, April 1978, 265-287.
  • Tucker, Donald, "Credit rationing, interest rate lags, and monetary policy speed," Quarterly Journal of Economics
    Quarterly Journal of Economics
    The Quarterly Journal of Economics, or QJE, is a peer-reviewed academic journal published by the Oxford University Press and edited at Harvard University's Department of Economics. Its current editors are Robert J. Barro, Elhanan Helpman and Lawrence F. Katz...

    , February 1968, 54-84.
  • Tucker, Donald, "Macroeconomic models and the demand for money under market disequilibrium," Journal of Money, Credit and Banking
    Journal of Money, Credit and Banking
    The Journal of Money, Credit and Banking is a peer-reviewed economics journal covering monetary and financial issues in macroeconomics. It is published by Wiley-Blackwell on behalf of the Ohio State University.-Replicability:...

    , February 1971, 57-83.
  • Varian, H., "The stability of a disequilibrium IS-LM model," Scandinavian Journal of Economics
    Scandinavian Journal of Economics
    The Scandinavian Journal of Economics was established as the Ekonomisk Tidskrift in 1899 by David Davidson. It became the Swedish Economic Journal in 1965 and then the Scandinavian Journal of Economics in 1976...

    , 1977(2), 260-270.