Leakage from the circular flow= S + T + M
Injection into the circular flow = I + G + X
The four-sector model of the circular flow of income and expenditure (Table 2.20) shows the locations of leakages (S, T, M), and those of injections (I, G, X).
Effective Demand, the sole determinant of employment, is determined by two factors which Keynes called “Aggregate Demand Function” and “Aggregate Supply Function”. It may be defined as the level of employment at which the Aggregate Demand Function CADF) is equal to the Aggregate Supply Function (ASF).
Aggregate Demand Function (ADF) may be defined as a schedule of various amounts of money which entrepreneurs in an economy expect from the sale of outputs at varying levels of employment. It represents receipts, which entrepreneurs (taken together) expect from sale of output.
Aggregate Supply Function (ASF), on the other hand, may be defined as a schedule of various amounts of money which the entrepreneurs in an economy must receive from the sale of outputs at varying levels of employment. It refers to costs, which entrepreneurs incur on production.
At any particular level of employment, if receipts are less than costs, producers shall stop production and refuse to maintain the corresponding level of employment of workers. It goes without saying that so long as the costs remain less than the receipts, the employment in an economy shall go on increasing until both of them are equalized.
In layman’s language, Effective Demand refers to that level of demand, which can be matched by the producers without having to change their pace of production. For instance, demand of 120 units or that of 80 units cannot be matched by the producers currently producing 100 units without a change in their pace of production.
Hence these levels of demand do not represent effective demand. Instead, demand of exactly 100 units is the effective demand as the same can be matched by producers without having to change their pace of production.
Likewise, Aggregate Demand Function (ADF) may be interpreted as the expected receipt of the producers from the sale of their output. Expected receipts must include implicit and explicit costs so that the producers find production remunerative enough to continue.
On the same lines. Aggregate Supply Function (ASF) may be interpreted as the minimum receipts of the producers from the sales of the output that are must for the producers for continuation of production. For the sake of simplicity, let us take ADF as ‘price’ and ASF as ‘cost’. Taking both of them on vertical axis and employment on horizontal axis, we can represent the point of effective demand diagrammatically as in Figure 3.1.
ASF schedule registers slow growth at the initial stages but picks up very fast as the level of employment rises. It becomes vertical at full employment level, OF. On the contrary, ADF schedule grows very fast at the initial levels of employment, but as the employment increases, its rate of growth begins to decline.
At sufficiently higher levels of employment, ADF becomes almost horizontal. The two schedules intersect each other at point E, the point of effective demand. At this point, ADF = ASF and the corresponding level of employment is ON.
By definition, ON serves as a measure of effective demand. Treating ADF as receipts and ASF as costs, the excess of ADF over ASF may be taken as the producer’s margin of profit. Area between the two is maximum when employment is ON.
Total profit is thus maximized at ON level of employment. Effective demand can therefore be treated as the equilibrium level of employment, which can be reached below the full employment level, OF (Fig. 3.1).
J.M. Keynes evolved the concept of effective demand while studying the causes of depression that had gripped the entire Europe during 1930s. The cause of depression, as held by J.M. Keynes, comprised leakages from the circular flow of income and expenditure.
The leakages led to the deficiency of demand with result that markets got flooded with unsold stocks. In their bid to reduce supply, producers resorted to retrenchment of productive factors, which resulted in massive unemployment during 1930s.
The disposable income of the factor-owners registered a steep fall, aggravating the problem of demand-deficiency. Depression dawned upon the producers and the householders alike.
The period of depression shattered the common faith in Say’s Law of Markets, which finally collapsed when neither of its two implications could stand on their own to lend any strength to it any longer.
To study Keynesian theory, let us therefore begin with the study of effective demand and its components. ASF, assumed constant in shortrun by Keynes, effective demand depended solely on ADF in short run. ADF or Aggregate Demand Function, represented by consumption and investment demands may thus be termed as aggregate demand (AD). Thus,
ADF or simply aggregate = Consumption demand (C) + Investment demand (AD) demand (I)
According to Keynes, effective demand must be high to keep depression at bay. This implies that ADF and hence consumption and investment demands must be high (Table 3.3).
For the consumption demand to be high, income and the propensities to consume should all be high. On the contrary, consumption demand is low when propensities to consume are low or propensities to save are high.
Deficiencies in consumption demand caused by a rise in thriftiness (savings) can be compensated through conversion of savings into investment. For this to happen, marginal efficiency of capital (MEC) should be greater than the rate of interest.
Given the supply price of capital, prospective yield should be as high as possible for MEC to be high. For the rate of interest to be low, demand for money needs to be curtailed given the supply of money in the short run.
Transaction and precautionary components of demand being interest inelastic, it is speculative demand that needs to be reduced. This is the crux of the Keynesian Theory of Employment, the main pillars of which can be presented schematically as in Table 3.3.