J.M.Keynes: The Principle of Effective Demand

The General Theory of Employment, Interest and Money

John Maynard Keynes

1936

"The Principle of Effective Demand" Chapter 3, section II

The outline of our theory can be expressed as follows. When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased, aggregate consumption is increased, but not by so much as income. Hence employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption. Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment. It follows, therefore, that, given what we shall call the community’s propensity to consume, the equilibrium level of employment, will depend on the amount of current investment. The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks.

Thus, given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium; since any other level will lead to inequality between the aggregate supply price of output as a whole and its aggregate demand price. This level cannot be greater than full employment, i.e. the real wage cannot be less than the marginal disutility of labour. But there is no reason in general for expecting it to be equal to full employment. The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.

This theory can be summed up in the following propositions:

1. In a given situation of technique, resources and costs, income (both money-income and real income) depends on the volume of employment N.
2. The relationship between the community’s income and what it can be expected to spend on consumption, designated by D₁, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of employement N, except when there is some change in the propensity to consume.
3. The amount of labour N which the entrepreneurs decide to employ depends on the sum (D) of two quantities, namely D₁, the amount which the community is expected to spend on consumption, and D₂, the amount which it is expected to devote to new investment. D is what we have called above the effective demand.
4. Since D₁ + D₂ = D = n(N), where n is the aggregate supply function, and since, as we have seen in (2) above, D₁ is a function of N, which we may write i(N), depending on the propensity to consume, it follows that

n(N) - i(N) = D₂

5. Hence the volume of employment in equilibrium depends on

- the aggregate supply function, n,

- the propensity to consume, i, and

- the volume of investment, D₂.

This is the essence of the General Theory of Employment .... the volume of employment is not determined by the marginal disutility of labour measured in terms of real wages, except in so far as the supply of labour available at a given real wage sets a maximum level to employment. The propensity to consume and the rate of new investment determine between them the volume of employment and the volume of employment is uniquely related to a given level of real wages - not the other way round. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater that the marginal disutility of the equilibrium level of employment. 

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insuffiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.