Principle of effective demand

The Principle of Effective Demand is the title of chapter 3 of John Maynard Keynes's book The General Theory of Employment, Interest and Money.[1] The principle presented in that chapter is that the aggregate demand function and the aggregate supply function intersect each other at the point of effective demand and that this point can be consistent with a state of under-employment and under-capacity utilization.[2] Another way of expressing this, in pre-Keynesian terminology, is to say that "demand creates its own supply" which gives primacy to a shifting demand function that can be insufficient to give an economy full employment in the long term, in contrast to the Say's law which insists "supply creates its own demand" and doesn't allow the possibility of long term unemployment as the supply figure is always, by definition, a fixed amount that demand will match.

According to Keynes it is the principle of effective demand that determines the level of output and employment in a country.

In chapter 3, in which Keynes uses the term 'effective demand' 15 times in expounding his principle of effective demand, he defines the concepts of an aggregate demand and an aggregate supply, and then defines the concept of effective demand as the point of intersection of these two aggregate functions - at this point of intersection, the aggregate demand becomes "effective".[3]

The importance of the term 'effective demand' to Keynesian Economics in general is shown in the fourth paragraph of the chapter, where he states that this concept of effective demand, referring to the intersection of the supply and demand functions, is the "substance of the General Theory" and says that "the succeeding chapters will be largely occupied with examining the various factors upon which these two functions depend."