Question

Critically examine the theory of Effective Demand.

Answer 1

The theory of Effective Demand, introduced by Keynes, states that the level of employment is determined by the aggregate demand that equals aggregate supply, called effective demand. It shows that insufficient aggregate demand can lead to unemployment even when resources are available, rejecting classical ideas like Say’s Law. The theory emphasizes the importance of consumption, investment, and government spending in maintaining employment.

However, its defects include:

• The term “effective” is redundant since demand inherently means demand backed by purchasing power.
• It mainly explains involuntary unemployment, ignoring other types.
• The theory is less applicable to underdeveloped countries with supply constraints.
• Critics say the cause-effect relationship is sometimes reversed, as employment can influence demand.
• It incorporates expectations, making “effective” demand somewhat uncertain.
• It oversimplifies the relationship between income, demand, and employment.

Thus, while the theory is crucial for understanding demand-driven employment, it has limitations in scope and application.