Effective Demand

Abstract

This is the term used by Keynes in his General Theory (1936) to represent the forces determining changes in the scale of output and employment as a whole. Keynes attributed the first discussions of the determinants of the supply and demand for output as a whole to the classical economists, in particular the debate between Ricardo and Malthus concerning the possibility of ‘general gluts’ of commodities, or what has come to be known as Say’s Law of Markets. Indeed, Keynes’s theory was intended to replace Say’s Law, although the emergence of effective demand from his Treatise on Money (1930) critique of the quantity theory of money, and his insistence on its application in what he originally called a ‘monetary production economy’, suggests that it should also be seen in antithesis to classical monetary theory. For Adam Smith (1776, p. 285), ‘A man must be perfectly crazy who … does not employ all the stock which he commands, whether it be his own or other peoples’ on consumption or investment. As long as there was what Smith called ‘tolerable security’, economic rationality implied that it was impossible for demand for output as a whole to diverge from aggregate supply. Although Smith (p. 73) did call the demand ‘sufficient to effectuate the bringing of the commodity to the market’, the ‘effectual demand’ ‘of those who are willing to pay the natural price’ of the commodity, the idea referred to divergence of market from natural price of particular commodities and the process of gravitation of prices to their natural values. J.B. Say’s discussion of the problem of the ‘disposal of commodities’ adopted Smith’s position. Against those who held that ‘products would always be abundant, if there were but a ready demand, or market for them,’ Say’s ‘law of markets’ argued ‘that it is production which opens a demand for products’ (1855, pp. 132–3); if production determined ability to buy, then demand could not be deficient. While excesses in particular markets were admitted, they would always be offset by deficiencies in others. Ricardo used similar arguments against Malthus, who responded by suggesting that:

This chapter was originally published in The New Palgrave: A Dictionary of Economics, 1st edition, 1987. Edited by John Eatwell, Murray Milgate and Peter Newman