Home > Uncategorized > The subtleties of effective demand

The subtleties of effective demand

from Asad Zaman

As I read more and more about effective demand, I got more and more confused — how can I explain this concept to my poor students, if I don’t understand it myself? There are a huge number of articles with different and conflicting views and interpretations of this concept, which Keynes describes as being central to his theory. Let me proceed to clarify the insights that have resulted from struggling with this material, and going through many iterations of revisions in terms of how to make sense of this theory.

Keynes and followers — both the Hicks-Hansen-Samuelson variety, as well as true blue post Keynesians — argue that it is deficiencies in the Aggregate Demand which lead to the unemployment equilibrium which is central to Keynesian economics. Stated in very simple terms, the argument can be phrased like this. The process of production generates factor incomes. These incomes are exactly the source of the demand for the product. If all the income generated is always spent on purchase of products, then the aggregate demand will exactly equal the aggregate supply — this is Say’s Law. In this case, there is no concept of shortfall in aggregate demand which could lead to unemployment.

However, Keynes and his followers deny the equality. They argue that some portion of the factor income could go into savings, thereby lowering the aggregate demand. Now the aggregate demand could be greater or lesser than the aggregate supply. An equilibrium would occur when the two are the same, but there is no guarantee that this equilibrium would occur at full employment. The standard diagram used to illustrate this idea is given below:  read more

  1. September 25, 2018 at 1:50 am

    Zaman is a honest person. He has a courage to confess that he cannot understand the principle of effective demand. Keynes could not explain his concept clearly and logically. There are many contradictory arguments in The General Theory. It is natural that those Keynesians now called New Keynesians abandoned the concept of effective demand (they only retained the concept of “aggregate demand”).

    Post Keynesians are against this solution but could not present a coherent and consistent theory of effective demand. This is one of the reasons why I asked a question in ResearchGate:

    Does Post Keynesian Economics need no theoretical foundantions?

    In my opinion, it is necessary to re-define the principle of effective demand at the product level. In short, we need a new theory of value and a new theory of quantity adjustment. The principle of effective demand is re-formulated as Sraffa principle. I have given a rough picture of my understanding in my paper: The revival of classical value theory (Chap. 8 in The Rejuvenation of Political Economy, Routledge, 2016). I am preparing a new book with two of my colleagues under the title Microfoundantions of Evolutionary Economics that will be published next year. Adjustment process will be explained in detail in this book and we get a very foundation for understanding the principle of effective demand at a macro level.

    Another important point in understanding the principle of effective demand is to deny the famous identity: I = S. This is the main cause of confusions which occur in macroeconomic level arguments. This is the reason why I asked this question also in ResearchGate:

    Is saving necessarily invested or not? How can this contradiction in Keynes be solved?

    • Calgacus
      September 26, 2018 at 6:45 am

      Yoshinori Shiozawa, I was deeply puzzled by this sort of thing for years. Discussed it a bit at billyblog and here too a while ago. IMHO (and in Randall Wray’s) the very best papers that explain I=S are by the institutionalist economist John Fagg Foster. And also his wife, Gladys Parker Foster which I think are even better on this. Claude Gnos has a paper on ex-ante & ex-post analysis and its irrelevancy that I found very helpful here too.

      It is all completely trivial. Completely obvious once you finally see it, and as the Fosters explain, in Keynes. In other words, it is the hardest type of thing of all to get straight and understand.

      Is saving necessarily invested or not?

      The problem is that the question is wrong, something which some of the answerers at researchgate were maybe tending toward.

      Savings cannot be invested. Investment causes saving, not the other way around. There is no saving that doesn’t come from investment already, “that can be invested.”

      Can’t say more. Hope this is coherent and to the point. Too weak to follow detailed arguments, Recovering from surgery.

      • September 26, 2018 at 8:30 am

        Dear Calgacus,

        thank you for arguing this point while you are recovering from surgery. I hope you will soon be fine so that we can exchange our opinions with full strength.

        Calgacus> Investment causes saving, not the other way around. There is no saving that doesn’t come from investment already, “that can be invested.”

        This is the most often repeated explanation of why I = S holds. Investment induces the same amount of saving as the investment. That is all right. But, what happens next? Is all saving invested? This is the very question I am asking for.

        The answer depends on the definition of the term “investment”. If investment means all amount of money that is saved as deposit or “invested” in the financial market, all the saving will be invested and the equality S = I holds. However, if investment means that of real investment like capacity building and increasing inventory stocks for firms or house building for consumers, then some part of saving may remain hoarded when there are no enough investment plans. In the latter case, S is not all invested and the effective demand will be reduced than C + S and the economy must shrink.

        If C + I composes effective demand, I must be interpreted in the second meaning. There is a confusion here, either in Keynes and his followers. Keynes could not grasp the true meaning of Hoarding. Keynes in Chapter 12, Section V
        of his General Theory identifies the hoarded money as the whole stock of money, but hoarding is to reserve some parts of money income as idle money. In old days, people hoarded money as a stock of gold in their storehouse. In modern day, people keep their money as bank deposit. But only a weak mechanism works so that the deposit is all invested in something which composes the effective demand.

  2. Prof Dr James Beckman, Germany
    September 25, 2018 at 10:04 am

    Decades ago I gave this up and went into a multi-period, systems’ approach with my business & engineering students. Multi-periods allow the worker to buy all or some of this period’s production, as the worker has both savings & debts from the past to enter the calculation. The systems’ approach allows us to disregard the obvious possible/likely lack of independence between periods & variables such as income, taxes, saving, borrowing, consumption & investment (education, home, travel, etc). New math is required & many of us have found differential equations to carry much of the analytic load. Of course, as soon as one wants to tighten the model they find themselves with the same quandaries as the particle physicists, folks like Einstein & Planck. Not bad company, I suspect.

  3. Craig
    September 26, 2018 at 6:10 pm

    Economists, including such luminaries as Steve Keen, Michael Hudson and the various advocates of MMT, do not look at the mutually digital natures of double entry bookkeeping and the money and pricing systems and so do not comprehend the monetary and economic policy and timing significances to be derived from those utterly integrated commercial infrastructure and empirical tools. They also apparently do not have a good grasp of the signatures of paradigm changes all of which the policies to be derived from the above significances accomplish.

    New paradigms integratively account for and resolve lingering problems in the old/current paradigm. They do this by cutting through all of the complexities with a single new concept that simultaneously fits within all of the legitimate structures present and yet transforms and creates an entirely new pattern.

    While well considered research on lower levels than paradigm changes is well and good, committing at least equal consideration to exploring and comprehending new paradigms would seem to be more fruitful because of their integratively deductive and inductive nature and the sweepingly rapid and permanent changes they effect.

  4. October 3, 2018 at 7:01 pm

    http://www.coppolacomment.com/2017/03/adam-smiths-destructive-hand.html Adam Smith’s Destructive Hand by Frances Coppola, March 3, 2017 Adam Smith’s “invisible hand” is perhaps one of the most misunderstood concepts in economics. It is usually interpreted to mean that when individuals all operate according to their own self-interest, their actions somehow combine to create a well-ordered, well-functioning society “as if guided by an invisible hand”.

    To be fair, this statement about the “invisible hand” (from the Theory of Moral Sentiments) does seem to mean exactly that:

    [The rich] consume little more than the poor, and in spite of their natural selfishness and rapacity…they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.

    This should have been challenged long ago on the lack of counterfactual evidence. It is an assertion, not a fact. Nonetheless, despite the glaring inequalities in our world today, it could be true…

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