Question

What are the main defects of the theory of Effective Demand?

Answer 1

Main defects of the theory of Effective Demand are:

1. Superfluous use of the word “Effective”: Critics like Hazlitt and Hutt argued that the term “effective” demand is misleading because demand in economics inherently means demand backed by purchasing power. Thus, calling it “effective” demand is redundant and may confuse the concept.
2. Partial treatment of unemployment: The theory mainly addresses “involuntary unemployment” but does not adequately explain other types of unemployment such as frictional, seasonal, disguised, or voluntary unemployment. Hence, it is considered incomplete.
3. Not applicable to underdeveloped countries: The theory assumes that demand determines employment but in underdeveloped countries the problem often lies in supply-side constraints (inelastic supply) rather than a deficiency of demand. So, aggregate demand may not be the binding constraint in such economies.
4. Cause and effect relationship reversed: Some economists, including Hutt, argue that Keynes mistakenly reversed cause and effect by positing that employment depends on demand whereas in some cases employment (and thus income) influences demand, especially in underdeveloped economies.
5. Role of expectations complicates the concept: Effective demand includes expected future receipts. Since part of effective demand is based on expectations, not all of it is realized demand, making the concept less concrete and harder to use as a policy tool.
6. No direct relation between income, demand, and employment: Critics state that employment depends not only on demand but also on factors like skill development, technology, and innovations. Therefore, Keynes’ neat direct relationship amongst income, demand, and employment is seen as overly simplistic.