KEYNES' APPROACH OF AGGREGATE EFFECTIVE DEMAND
AND DETERMINATION OF INCOME
Binod Goswami
Nowgong Girls’ College
John Maynard Keynes was a prominent economist whose work
laid the foundation for modern macroeconomics. His approach to
aggregate effective demand and the determination of income is a
central aspect of Keynesian economics.
Keynes put forwarded the theory of aggregate effective demand
and income in his book “The General Theory of Employment,
Interest and Money” published in 1936. Keynes first of all
criticized the classical theories which were based on the
assumption of full employment and long run. According to him it is
not possible to achieve full employment automatically in real world
and in the long run we are all dead; hence problems be solved in
the short run only.
Keynes maintained that in a closed economy aggregate effective
demand is the determinant of employment, output and income of
an economy. At equilibrium employment, output and income are
equal. His theory is based on the following assumptions-
i. The economy is closed.
ii. There is perfect completion in the market.
iii. Government plays active role in economic affairs.
iv. The law of diminishing return operates.
v. The economic activities are confined to short run.
According to Keynes effective demand is the point at which
aggregate supply of an economy is equal to aggregate demand.
Thus aggregate supply function and aggregate demand function
are the two main determinant of aggregate effective demand.
Aggregate Supply Function: Aggregate Supply Function (ASF) is
a schedule of the various amount of money which the
entrepreneur in an economy must receive from the sale of output
at varying levels of employment. In another words aggregate
supply is the supply of goods and services produced in an
economy at a given overall price in a given period. Keynes
assumed ASF as given in short run and aggregate demand is the
most important factor determining the effective demand.
Aggregate Supply is the lateral summation of consumption
expenditure and saving of an economy. Symbolically –
AS= C + S ……(i)
The shape of ASF is the increasing function of employment. In the
beginning ASF rises slowly because employment will increase
rapidly at first as amount received from selling of output of the
economy rose from zero. Here the cost of production will not
initially rise rapidly. Later on, AS curve rise progressively as
employment increases. Because at higher levels of employment
cost of production will rise more rapidly. When the stage of full
employment is reached AS curve becomes vertical straight line
because increase in receipts will not increase employment.
Aggregate Demand Function: Aggregate Demand Function (ADF)
is the amount of money which the entrepreneur expects to get
from the sale of output at varying levels of employment. In short
aggregate demand is the total amount of demand for all finished
goods and services produced in an economy. Aggregate demand
is also called aggregate expenditure which has the following
components-
i. Consumption Expenditure (C)
ii. Investment Expenditure (I) and
iii. Government Expenditure (G)
Thus the Keynesian Aggregate Demand (AD)= C+ I+ G…..(ii)
Consumption Expenditure(C): The lateral summation of
expenditure made on consumption of private goods and services
for personal satisfaction is called consumption expenditure. The
size of income and propensity to consume are the two main
determinants of consumption expenditure.
Investment Expenditure (I): The expenditure incurred on buying
goods and services (machinery, tools etc.) to create and
accumulate productive assets is called investment expenditure.
Marginal Efficiency of Capital (MEC) and rate of interest are the
determinants of investment of an economy.
Government Expenditure: Government expenditure refers the
expenditure made on public goods and services.
In a closed economy –
AD= C+ I….(iii)
AD curve first rises steeply, but this rapidly tends to slacken at the
higher levels of employment. It implies that expected receipts
increases rapidly in the initial stages of rise in employment but
gradually this increase slows down when employment reaches
higher levels. Because when income and employment are at low
levels, the community is poor enough to save much of its
earnings. But at the high level of income, MPS becomes very
small, for which AD curve becomes flatter.
EMLOYMENT(N)(in lakh workers ) ADF (crore Rs) ASF (crore Rs)
1 10 4
2 20 9
3 28 19
4 34 34
5 38 55
Following chart and figure explains the determination of effective
demand, output, employment and income according to Keynes-
In chart at 4 lakh employment of workers AD=AS= 34 Lakh. This is the
point of effective demand.
EFFECTIVE
DEMAND
AS
F1
AD2
F
COSTS/RECEIPTS
AD1
A E AD
Less than full employment
equilibrium
B
O Na N Nf EMPLOYMENT
In figure x-axis measures income, output and employment and y-
axis measures aggregate demand and supply. AD, AD 1and AD2
are Keynesian aggregate demand curves. AS is the aggregate
supply curve. It has two segments – first from O to F which slopes
upward from origin and the second from F onwards which is
vertical.
At E AD intersects AS and become equal to each other. Thus E is
the point of effective demand and N is the equilibrium level of
employment which is also the income. If N a is the level of
employment, AD exceeds AS. Therefore employment will
increase. In figure Nf is the level of full employment. Thus though
the economy reach equilibrium at E, there exists NN f amount of
unemployment. Therefore Keynesian equilibrium is called
underemployment equilibrium.
If aggregate demand shifts to AD1, new equilibrium will be
established at F and ONf level of employment will be determined.
ONf is the full employment level. As soon as full employment level
is reached, aggregate supply function becomes vertical. In the
vertical range of aggregate supply curve, increase in aggregate
demand to AD2 will only increase the cost, but level of
employment cannot be increased.
