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What Is Effective Demand?

B. Turner
B. Turner

In economic study, aggregate demand represents the total value of goods and services that consumers must buy for a market to remain in equilibrium. At equilibrium, the supply of goods is exactly equal to the demand, so there are no shortages or overages. This equilibrium demand is also referred to as notational demand, and represents a largely theoretical value. For a more real-world approach, economists rely on effective demand. Effective demand captures the total value of products that consumers actually buy at a given price, rather than the value of products required to reach equilibrium.

At the start of the 19th century, economic study was dominated by the idea that supply dictated demand. According to a widely-held economic theory from this period known as Say's Law, the level of aggregate demand will be exactly equal to the amount of product that manufacturers choose to produce. One critic of this theory was Thomas Robert Malthus, an economist who argued that Say's Law led to economic recessions. Malthus believed that companies who assumed that consumers would buy whatever they chose to make would end up producing too much product, or the wrong products. When consumers failed to buy these products, the economy would shrink, resulting in a recession.

John Maynard Keynes.
John Maynard Keynes.

Malthus' theory was largely ignored for the next century, and Say's Law remained the dominant theory. It wasn't until the 1930s that John Maynard Keynes published new work in economics that rejected Say's Law and embraced the concept of effective demand. According to Keynes, demand creates supply, rather than the other way around. Theoretically, equilibrium occurs when aggregate supply and aggregate demand are equal. After Keynes' major works were published, economists began to understand that in the real world, it was up to consumers to set aggregate demand, leaving suppliers to respond by setting the appropriate level of aggregate supply based on this demand.

The concept of effective demand can be illustrated graphically using an aggregate expenditures function, which shows the relationship between production rates and expenditures. If Say's Law were true, expenditures would rise by one unit for every one unit increase in production. Instead, the aggregate expenditures function illustrates that for every one unit increase in production, expenditures increase by less than one full unit. This helps to illustrate the concept of effective demand, and disproves the idea behind Say's Law. Instead of simply buying whatever suppliers produce, consumers choose how to spend their money, and may decide not to spend it at all if supply does not match demand.

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    • John Maynard Keynes.
      John Maynard Keynes.